Weekly Briefing Note for Founders 21/3/24

20th March 2024

This week on the startup to scaleup journey:

  • When early growth becomes a deadly illusion

When early growth becomes a deadly illusion

The transition from Seed to Series A is one of the most talked about topics in venture. There are two big reasons - one positive, one negative.

First, this critical phase typically marks the coming of age for a startup. It has developed a product the market wants and is now ready to fund the first significant step on the scale-up journey - Series A.

Second, it is also the phase where the greatest number of startups fail. The numbers are stark. McKinsey has shown that almost 4 out of 5 European startups that close a Seed round fail to make it to Series A (or an exit).

For those that do successfully 'cross the chasm' and secure their A-round financing, little is discussed about what happens next. Some think that the risky, formative work is over. The road to growth is now more predictable and perhaps not so 'newsworthy'.

But this is not the case. Nearly half (49%) of the startups that raise a Series A round never graduate to Series B (or exit). They either fall out of the venture pathway to pursue a lower growth, self-sustaining strategy; become 'zombie' businesses (alive but not really active); or shut the doors completely.

Why do so many seemingly successful startups drop out of the race as soon as they begin to experience early growth?

The growth illusion

Having closely followed the fortunes of dozens of startups over the past decade, it is clear that for some early growth does not necessarily signal that all is well.

The metrics may appear to be tracking but something else is awry.

Eventually, perhaps after several quarters of increasing commercial momentum, early growth begins to slow. It's sometimes so gradual that it's hard to spot at first. This is when everyone is still a little distracted with the euphoria of closing the Series A. But soon it becomes apparent there is a real problem.

The problem is serious because all this is happening post Series A. Investors have committed big sums and they have high expectations to match. They agreed to a big jump in valuation over the Seed round and they need to see that valuation continue upwards.

Investment capital is now being quickly deployed, mostly on new hires and go to market initiatives. Investors believed that this would immediately fuel exciting growth. Instead, revenues are slowing while costs are growing.

Everything is starting to go into reverse and investors are sounding the alarm bell.

The diagnosis

After many years of helping founders diagnose such situations, we have found several recurring themes where things go wrong. They fall into 3 main categories:

  1. Weak product/market fit
  2. A fragmented go-to-market strategy
  3. Poor business model economics

In some cases it's a combination of all three.

Here, we focus is on the first of these, Product/Market Fit or 'PMF'. We do so in the context of B2B enterprise sales as this where the warning signs are often the hardest to spot. In subsequent posts we will examine the other two categories as well as other business models.

But why should PMF be a concern post Series A? Surely, reaching PMF was a prerequisite for this 'coming of age' funding moment?

There are 2 primary reasons in our experience:

  1. There is weak PMF with the mainstream market, and/or
  2. The startup has been 'taken hostage' by 'fake' early adopters

Weak PMF with the mainstream market

In our earlier blog, Crossing the Chasm - from Seed to Series A, we explained the challenges associated with finding the beachhead market. The beachhead is the landing point in the mainstream market that enables the first phase of sustained growth.

To navigate to this take-off point the focus has been on the early adopters. They play a vital role during the early stages because they act as 'guides' providing friendly feedback. They share the founder's vision and help validate the problem/solution thesis. They are risk takers and are happy to adopt a new product even if it is incomplete. This is the first customer cohort where PMF is initially experienced.

But reaching PMF with early adopters is rarely the same as reaching PMF with the mainstream market. There can be many reasons for this. The bottom line; early adopters are easier to please. Mainstream market customers are the antithesis of this.

A common challenge is understanding which customer types are early adopters and which ones are mainstream customers. Getting this right is crucial, as:

  • The scale of the early adopter 'market' can be small. Unless and until the startup begins to open up the first segment of the mainstream market (the beachhead), growth stalls.

  • To open up the beachhead, PMF must be recalibrated with this different customer cohort. If not, weak PMF may result in torturous sales cycles and customers that are not fully committed. The early adopters were a relatively easy sell and were forgiving that the product was not yet 'mature'. Mainstream market customers are a different game altogether. They have no interest in guiding the startup along this path (as we describe further below) and think only of themselves.

Boards that don't appreciate the difference between these two customer types often just push the founder to chase revenue. This can end in disaster if the startup is still only addressing the early adopter market because;

  • It is often too small to sustain any real growth. Revenue should not be the primary metric here. It is all about reaching the mainstream market quickly and efficiently.

  • Resources are not yet being allocated to finding strong PMF in the mainstream market. PMF attainment should again be the key metric here. Only once PMF is found should revenue growth become the priority.

Startups often have to find PMF multiple times as the company grows; as they target new types of customer, fend off competition, and extend the product offering. PMF is rarely a static position.

Being taken hostage by 'fake' early adopters

Confusingly, some customers within the mainstream market present like early adopters. They willingly engage, buy the product and start 'using' it. But their purpose is not rapid adoption. Growth here can be an illusion.

This is common in enterprise markets where big customers have teams that regularly evaluate new technologies. We call these customers 'fake' early adopters. Perhaps a less contentious term would be early evaluators.

Unlike genuine early adopters, they are not risk takers. They may say they buy into the founder's vision but the reality is that this is often just a lure. Their intent is to fully road test the product's capability, often comparing alternative offerings side by side. This process can take many months or even years for complex solutions that are still being rounded out.

These early evaluators often try to bring multiple vendors into the same solution space by getting them to compete on functionality - before finally trading them off on price. If the startup doesn't have really strong USPs and a deep moat, this can spell real trouble.

But what startup doesn't want to engage with a big, marquee-name account? In addition to the market credibility earned by the logo 'win', these customers are usually happy to pay for proof of concept projects and pilot studies. They can sometimes spend £M's doing so. This is hard for almost any startup to refuse.

But rarely do these big Tier 1 players have the mindset of an early adopter. As a result, there is a misalignment of interests until the product is fully proven in the specific use case of the customer. The resources required to keep these early evaluators happy often far exceed what is economic for the startup to provide in the early stages. Growth stalls as there are no resources left to pursue genuine early adopters.

The key is to see early evaluators for what they are, whilst also engaging with genuine early adopters. The early adopters will always move faster, often teach you more, and help you create initial market momentum. They will give confidence to the more risk-averse mainstream market customers when the time comes.

This dual-track strategy, if executed diligently, can lead to great success. But it requires extreme discipline in resource allocation.

Remember, the fake early adopter doesn’t want the startup to find product/market fit. They selfishly want it to find 'product/customer fit', and this is very different. Exclusively pursuing early evaluators is rarely a scalable growth strategy in the early stages.

In summary

PMF is not a static position. It must evolve as the startup transitions through the early adopters, into the early majority, and then expands into adjacent market segments.

Pursuing revenue growth before locking down PMF at each stage is dangerous. Boards must be more cognisant of this and not set the wrong priorities.

Early evaluators are not early adopters. They can be an expensive distraction and give the illusion of imminent growth. But this rarely comes quickly - and sometimes never.

A dual track strategy that employs extreme discipline in resource allocation can deliver genuine growth without the startup being held hostage by the big early evaluator.

A Series A round is an accelerant for startups that have truly graduated into the mainstream market. But it is a liability for those whose early growth turns out to be just an illusion.

Let's talk!

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