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Thought Leadership

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You thought raising Series A was hard? Here comes Series B!

VC advice on best practices raising and deploying the Series B round

Innovation series by Matthew Kropp
June 5, 2018
Short URL: http://vator.tv/n/4b9b

Ask 99 percent of entrepreneurs and they’ll admit that no round of funding, from the earliest to the latest, is easy to raise. Each round comes with its own specific set of challenges.

The very earliest companies - those that are at the seed/angel stage - have to find investors willing and able to take a chance on something totally unproven. There is barely a product, let alone customers or a clear market. It’s the time to sell a vision. To advance to a Series A, the startup must show a minimum viable product (MVP) along with some product-market fit, validation that the product has repeatable customers.   

But it’s at the B round where the rubber hits the road. This is the hardest round to raise.

It is the stage where numbers and metrics like LTV (lifetime value) and CAC (customer acquisition costs) matter. You need to have proven not only product-market fit but also be able to show customers, usage and revenue are growing rapidly.  And if you thought landing the round is tough, imagine how high expectations are around deploying it wisely and efficiently. Pitfalls await, especially for companies that aren’t used to having money.

What are some best practices to set your startup up for raising a Series B and how do you then deploy that capital and set yourself up for the Series C?  We asked some of the best VCs in the business for their advice to founders on this tricky stage.

A metrics-mindset matters

Part of the reason that raising a Series B can be so difficult for entrepreneurs is that, after multiple rounds where metrics haven’t been a big consideration for investors, suddenly they matter more than the vision and the team. That can be a shock to the system for a company that has not been very data-driven.

In fact, this mindset should kick in pretty early.

If companies want to get a B, they need to start thinking about metrics by laying out several milestones they plan on accomplishing with the Series A money, said Vishal Vasishth, Co-founder & Managing Director of Obvious Ventures.

“A good approach is where you take Series A money and say, ‘These are four things we need to accomplish,’ realizing that it may not be possible to accomplish each one. If you accomplish 70 percent of the tasks, and you are transferring the 30 percent that you still need to work on, that is an easier story for a Series B investor to buy into than just saying these are the milestones we hit without any explanation,” said Vasishth, adding that the Series B is the hardest to raise since investors are putting a lot more money down while still having to take on operational risks.

Operational risks are in the scaling of a product, or replicating what’s already being done in one market or with a small sales team. The risk is that what may work at a smaller scale may not work at a larger one, or may peak out at a certain level that’s still unknown. That’s why it’s often more important to know what levers are working at a smaller scale than having achieved multi-millions in revenue that’s doubling or tripling.

“I would fixate less on the absolute numbers, or even the relative numbers, and fixate more on: am I running a business where, operationally, I am tracking my key metrics?” said Michael Yang, Partner at Comcast Ventures. “The whole company ethos has to be one that is about constantly measuring everything.”

If a startup demonstrates that it has created a numbers-driven-business operation that guides product, sales and marketing, then it can explain why CAC (customer acquisition cost) is a certain number or why an LTV (lifetime value) to CAC ratio is a certain level, explained Yang.

“To me, it’s less about the number and more about, ‘Why are you operating with those CAC and LTV levels? Let’s understand that and see if it’s logical.”

Spending leading up to and at the B level

Since a large part of what investors want to see at the Series B is growth, some company founders feel pressure to overspend just to get to where they believe the investors think they should be.

For a Series A company with under $10M revenue run rate, “if you can demonstrate that you’re tripling or quadrupling or quintupling revenue at that stage, even if you have to burn more money to do it, you’re going to get a Series B. People are going to give you more money,” said Jules Maltz, Partner at IVP.

Add in a new round of fresh capital, that spending mentality comes into full swing. There’s a strong incentive for companies to start deploying money wildly at this stage, in part due to pent-up demand.    

“Usually you’re starving yourself and stretching to get from the A to the B and now you’re flush with cash, so it’s just human nature that when the bank account has never looked so good with so many zeros, you want to put it to work,” said Comcast’s Yang. “Money starts going out the door a lot faster than you’d think.”

There are also things that have likely needed fixing for a long time, and which the company can now finally address, and that is what the money should be used for.

“In terms of capital allocation and use of proceeds for the B, it’s often the case that the tech stack was built rapidly and there’s been a lot of patchwork done, duct tape, etc. and now you need to go back to rebuild and solidify the product,” said Yang. “There’s an ever-consistent work stream against product, tech, R&D. At the same time, you should also now be using the capital for sales and marketing, and putting the pedal to the metal to accelerate growth.”

But, Yang warned, companies should be careful and “make sure that some of the positive signals that got you to this point don’t plateau and flatline,” which can cause companies to start burning money faster than their growth warrants.

Setting yourself up for the C

Yang’s point is even more crucial as you position for the Series C because as growth continues it often reaches an inflection point. This can be illustrated through an S curve, which describes the performance of a company or product over time, from slow adoption, to acceleration to maturation and slower growth.

“The way I often think about businesses is they have natural S curves,” said IVP’s Maltz.

“You have growth in some vertical, or something you’re doing, and then it flattens out. As an example, let’s say you grew really fast by placing ads on Facebook acquiring customers relatively cheaply. At some point, that S curve flattens and you won’t be able to buy Facebook ads 10x the amount vs. today or in perpetuity.”

That’s why it’s important to always be looking for the next S curve, the next area where the company will see some growth, to help make the Series C round more likely.

“Test a new marketing channel, like radio or direct mail. Test new products, come up with product ideas number two or three that you can layer on,” Maltz said. “What is working now that got you to raise that Series B will probably not work to get you to raise the Series C.”

As an example, Maltz pointed to Dropbox, the document-sharing company that IVP invested in at the Series B.

“Dropbox got to a Series B with no sales people, no marketing and very few engineers. They were very efficient running on Amazon infrastructure. But with its Series B, it built out a salesforce and its own infrastructure. A lot of investment went into the ability to scale even further, which went beyond where it would have been if it had said, ‘We’re a freemium storage app, and we run on AWS forever and we’ll have no sales people forever.’”

Dropbox may be an outlier company since it raised $250 million in its Series B. So for other startups, anticipating new growth opportunities is good to keep in mind, but during this stage, it’s also appropriate to focus on replicating what worked at smaller levels.

“Focus on the things that got you to product-market fit and hammer them until they grow,” said Obvious Ventures’ Vasishth. “That means more operational stuff, which in B2B cases means hiring folks. Or it may be something else, like partnerships. Whatever that thing is that started to work, deploy dollars into those areas, keeping in mind that you need to continue to innovate and become better. The approach should be, ‘I have something which worked and now let me scale it’,” he said.

Importantly, no sooner have you finished raising your B, you should start thinking about metrics for the C.

“What I would say on capital deployment is start thinking as soon as you raise the round, or even before, ‘What are my milestones that I think I need to get to for the next raise?’ Talk to your inbound investors that are leading your B about what that might look like,” said Yang.  Some may say, ‘Listen, I’m just trying to get the B done, I can’t even process what the C needs to look like,’ but you can never start early enough on that side.”

Conclusion

The Series B can be tough on entrepreneurs. After a few rounds of selling the blue-sky vision, now they have to prove that the idea actually works and is worthy of being replicated and scaled.

It’s the round where metrics suddenly matter, where starry-eyed startups have to suddenly show that they can grow up to be real companies. It’s the round where they have to show that they are able to grow, even if that means burning through cash to do it. All the while, the company already has to be thinking about how to prepare for a Series C.

It’s not easy.  Only a handful of companies complete their Series A tenure having their thesis clearly proven out and can confidently command a significant valuation. One analysis calculated by Dow Jones VentureSource for Vator estimated that just over a quarter of startups that raised a Seed and Series A round went on to raise a follow-on round that’s more than $10M.   

But for the rest of the mortals - a majority of the companies seeking a Series B - there may be parts of the plan working but still a fair amount to prove.  This is not an impossible sale, after all there are plenty of VCs investing in B rounds and most deals include a fair amount of uncertainty that investors ultimately see beyond.  But make no mistake, it will be hard.

As Obvious Ventures’ Vasishth points out, the B round is the bridge between A and C - the bridge between a dream and a solid, scaling business. They are two dramatically different worlds and an entrepreneur needs to prove that it can successfully transition from one to the next.  

Bring your compelling story to the pitch but have your metrics at the ready - you’re going to need them.

(Image source: images.readitquik.com)


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