Understanding the Series A Funding Crunch

Raising initial seed capital can often be less daunting than securing Series A funding, and there's a clear rationale behind this.

According to reports from Crunchbase and the Wall Street Journal, the startup ecosystem is currently facing a significant Series A funding crunch. While a substantial number of companies have successfully raised seed rounds of $1 million or more, many of these companies are finding it challenging to transition to their Series A funding.

While I won't delve into the specific reasons for this trend (you can consult the linked articles for deeper insights), it’s important to note that the challenges associated with Series A funding are not new. Although the situation may seem more acute at present, even when seed-stage startups manage to progress to Series A, the success rate is far from perfect. In essence, moving from seed to Series A is quite a hurdle, and many founders struggle to make this leap, regardless of the prevailing market conditions, primarily because they fail to focus on what truly matters to Series A investors.

A Founder’s Dilemma

I recently met with a founder who was facing difficulties in closing his Series A round. “We only have five months left before we run out of funds,” he lamented over burgers at a local diner. His startup had previously secured a $1.5 million seed round 18 months ago, but the Series A was proving elusive. “We need to secure funding soon or make significant cuts, or else we’re finished.”

“Or?” I prompted, hinting at another possibility.

“Or what?” he replied, raising an eyebrow.

“There’s another option you haven’t considered,” I said. “What about that third option?”

“I don’t see a third option,” he sighed. “Things are looking bleak.”

I shook my head. “This is a common issue among seed-stage companies,” I explained. “They become so fixated on their financial runway in relation to fundraising that they overlook this crucial third funding option. Ironically, this option is often the most vital!”

The Runway Mentality

Entrepreneurs frequently use the term "runway" to refer to how long their startups can remain operational. The founder I was speaking with was doing just that, indicating he had five months left before his startup would deplete its cash reserves. This is a precarious situation for any entrepreneur, as five months can feel alarmingly brief in the startup world—almost like being on life support.

Calculating a startup's runway is fairly straightforward: you compare monthly expenses against the total funds available in the bank plus any expected revenue. For instance, if a startup spends $100,000 monthly, has $350,000 in the bank, and generates $50,000 per month in revenue, it has a runway of seven months (since the company loses $50,000 each month). While the math might not always be that straightforward, the concept is clear.

Technically, the idea of "runway" applies to all new ventures, but it’s usually reserved for those backed by venture capital because it is often discussed in two contexts.

The first context involves the way the founder used it during our lunch; he described how much time his company had left before running out of funds.

The second context arises during fundraising discussions, where it serves to illustrate how long a specific funding round will support a company. For example, if a founder states, "I am raising a $4 million funding round," a VC might inquire, "How much runway does that provide you?"

While this concept is easily grasped, its simplicity can be misleading, which is why the founder I met was overlooking the crucial third funding option. When founders begin to frame their startups in terms of "runway," they implicitly accept a fundamental principle: their startups should be spending more than they are earning. This mindset can be detrimental.

The Risks of Runway Focus

“Given that you say you’re nearly out of runway,” I said to the founder between bites of my burger, “I assume you’re factoring in your revenues. What do those look like?”

“They're not impressive,” he replied. “We’re bringing in around $20,000 monthly.”

“And what’s your monthly burn rate?” I asked.

“It’s about $50,000 per month,” he responded.

I quickly calculated in my head. “So, if you claim to have five months of runway left, you likely have around $150,000 in the bank, correct?”

“Yes,” he nodded.

“Then your third option,” I suggested, “is to acquire more customers. More customers lead to increased revenue, and higher revenue decreases your burn rate, allowing you to extend your runway.”

I began scribbling figures on a napkin to illustrate that reaching $40,000 in monthly revenue within the next four months could drastically alter his company's trajectory. He would be close to breaking even, buying him ample time to secure his Series A.

“But how can I double my revenue in just four months?” the founder questioned, seemingly identifying a flaw in my reasoning. “If I could do that, I wouldn’t even need VC funding.”

“Exactly!” I exclaimed, finally pinpointing the core of his dilemma and a common issue for many companies that struggle to transition from seed to Series A. “By the time you're soliciting substantial VC investments, your business should ideally not rely on investor funds for survival. Instead, you should possess a viable business model, and the VC funding should be aimed at scaling. However, that’s not your situation. You’re still chasing funds merely to stay afloat, which is why VCs hesitate to invest. To put it simply, you aren’t a compelling investment unless you can significantly ramp up your revenues.”

I witness this recurring pattern time and again, which is why numerous seed-stage firms fail to reach Series A. When pitching a seed-stage company, entrepreneurs present an untested vision and seek funding to validate it. Conversely, when pitching for Series A or later, the expectation is that you have already established a viable business and are now seeking capital to accelerate growth.

As you develop your startup, keep this in mind. While it is feasible to secure initial seed funding based on an appealing vision, to successfully navigate the Series A funding crunch, you must demonstrate your ability to attract customers.

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