“It’s a Trap!”
Or, the Myth of the Mid-Stage Round
Nearly half of Series C rounds were flat or down in the third quarter of 2016, prompting the industry refrain that “flat is the new up” and implying that entrepreneurs should be happy with the current state of affairs. Happy or not, entrepreneurs seem to recognize the new reality, with two-thirds of CEOs admitting that they believe the balance of power is shifting from entrepreneurs to VCs, according to the State of Startups survey from First Round.
The real implication is that a significant number of Series B rounds have been over-valued, and disciplined Series C investors are restoring order. In my experience as a venture investor since 1992, Series B rounds — sometimes known as “mid stage” — can be the most problematic to price. When Series B investors fund startups with significant increases in capital and valuation (compared to Series A), the premise is often that it is time to scale. In other words, these Series B rounds are being conceived and priced as growth equity capital.
It makes sense that growth stage companies attract more capital and higher valuations than early stage deals, because these companies should be less risky than their early stage counterparts. Funding data from 2016 shows this premise is reflected in Series B valuations. According to Cooley, in Q3 the median Series A valuation was $14.0M compared to $36.5M for Series B (a 1.6x increase over the previous round), and $68.0M for Series C rounds (only a 0.9x increase). Similarly, in Q2 the median Series A valuation was $15.0M compared to $50.0M for Series B (a 2.3x increase), and $99.2M for Series C rounds (only a 1.0x increase). The biggest jump in the first four valuation setting events, from Series Seed to Series C, consistently occurs between the Series A and Series B rounds.
The problem for Series B entrepreneurs is that growth equity investors demand predictability. As we know from public stock market behavior, investors apply huge penalties for lack of predictability. The same thing can happen in the private markets, with Series C investors using flat and down rounds as a penalty for lack of predictable performance. It’s not that these startups aren’t making progress, it’s that they have not truly become predictable, growth stage companies yet.
To understand what it means to become a growth stage company, I’ve borrowed a framework from venture capitalist Frank Foster, who believes there are only three relevant stages in the lifecycle of a startup: 1) build it, 2) prove it, and 3) scale it.
“Build it” means building the product or service. “Prove it” means proving the business model, including segmenting the customer base and verifying pricing and addressable market. “Scale it” means applying capital to scale the business predictably. These three categories correspond perfectly to the three main types of capital offered by investors: Seed, Early, and Growth.
These categories allow us to adopt more objective definitions of startup funding stages:
- Seed Stage: The product is not yet complete and if there is any revenue, it is generally only a paid pilot (“build it”)
- Early Stage: The product is complete, the company has entered the market, and there is some revenue, but the business model is still being tested (“prove it”)
- Growth Stage: The company has articulated its economic model, and capital can be deployed against traditional operating functions like sales, marketing, manufacturing, and finance to generate predictable revenue streams and expenses, with stable margins (“scale it”)
These definitions show that the transition from early stage to growth stage is a much bigger leap than the transition from seed stage to early stage. That’s because if the economic model of a startup is like an engine, there are only two modes: it works or it doesn’t. You either have a replicable, proven model or you are still tinkering, i.e., “engineering,” and trying to prove you have a system of understood inputs and outputs. While founders often focus on the product, venture capitalists (generally) focus on whether the business works and can be grown to produce a large, profitable company. Notice, there is no “mid stage” in these definitions. A mid stage would simply be more experimentation, where the business model is still being tested, albeit slightly better understood than at the early stage. That means the model is still unproven and risk has not really been removed from the venture.
We are beginning to see some especially mature entrepreneurs reject the most lucrative Series B term sheets they receive, recognizing that taking money at prematurely high valuations can be the financial equivalent of painting yourself into a corner. These rich Series B rounds are being positioned as “mid stage” — which often means they are early stage companies, still iterating a business model, but raising growth rounds at later stage prices. But “mid stage” is really a no-man’s land between early stage and growth stage. If the economic model is not fully understood, it is a huge danger to increase expenses, as typically happens when a growth round is raised. Increased spending is a high-priced poker game, and luck won’t carry these most of these companies through.
On the one hand, it’s smart to take capital when it’s available. But it isn’t a good idea to spend capital as though you have proven your business model when you are really still experimenting — this wastes money, and the next step after wasting money is usually a down round. Only the most charismatic CEOs can continue to raise capital at increased valuations with an unproven business model. As a board member, I don’t believe this is a reliable option!
Smart investors have pointed out that a down round is not the end of the world. Fred Wilson of Union Square Ventures has written, “I have never seen a down round destroy a company. And I have seen many down rounds save a company.” Bill Gurley of Benchmark noted in early 2016 that a down round “will seem like a massive failure to many modern entrepreneurs, but they should quickly adjust their thinking… The only thing you are protecting is image and ego and in the long run they absolutely do not matter… A down round is nothing. Get over it and move on.” That said, no one wants to set the stage for a down round deliberately.
So what should good entrepreneurs and their investors do about this trend? The most obvious answer is to make sure you are truly a growth stage company before you try to raise capital at growth stage prices. And if you do manage to raise a large Series B, don’t deploy it until you really understand your economic model. Doing anything else is a trap.
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Scott Lenet is President of Touchdown Ventures, a Registered Investment Adviser that provides “Venture Capital as a Service” to help corporations launch and manage their investment programs. Touchdown’s Los Angeles-based Senior Associate Selina Troesch (aka, Asajj Ventress) contributed to this article.
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