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Losing the way from A to B

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Open ... and Shut For many startups, getting Series A funding isn't the problem. The problem is using that cash to clear the increasingly high hurdles investors are imposing on early stage startups for the Series B round.

For as recent funding data shows, venture capitalists remain willing to spread bets at the Seed and Series A rounds of funding – and to channel money into later, expansion stage deals to maximise returns from safer, de-risked businesses – but are opting out of the crucial Series B round.

In other words, venture capital is becoming less likely to venture.

As noted, Seed and Series A funding is actually doing quite well, a fact borne out by both National Venture Capital Association and PWC MoneyTree data (warning: PDF) . But the problem is the early acceleration Series B round, when momentum is hopefully starting to show and the start-up needs cash to fund it. For a variety of reasons, some of which GigaOm's Stacey Higginbotham captures, Series B funding is drying up, leaving early stage startups to seek a buyer or dying out altogether.

It's relatively cheap for VCs to spread Seed and Series A investments, especially since start ups at this stage needn't hit a billion-dollar home run for the VC to get a reasonable return. But once a start up reaches the Series B round, the money required is much more substantial and the ante is raised: the company had better have shown the potential to be huge or it's likely not going to get funded.

Back when I was raising a Series B with Strobe, I wondered why it was so much harder than my past experience with other startups. But then I heard from others out raising B rounds - over and over again - that they were struggling, too. VCs were requiring more evidence of significantly more adoption and/or revenue traction than in the past. And many entrepreneurs were having to figure out how to continue without an infusion of cash.

This is why some call Series B the "sucker round". VCs want to see a "repeatable and scaleable business model", but that's actually hard to achieve on an A round, particularly since AWS and the internet, generally, have made it easier to build a product for less money than historically was required.

This leads to a big increase in the number of early deals getting done, but at much less money, as Redmonk analyst Stephen O'Grady writes.

And while this might be considered a "boom," many of these companies will hit the Series B wall and bust, precisely because their Seed or A rounds were too small to sustain them through the VC's magical moment when risk has been minimised and the only question is: "How big will this thing be?"

All of which means it's relatively straightforward to get early or late stage funding, but that B round? Tough.

As such, while startups have generally worried more about growth than profitability, VC Mark Suster is likely right to argue that: "Most companies (98+ per cent) in the world (even tech startups) should be very profit-focused."

Profitability not only improves one's negotiation power, but it leaves startups with the ability to not have to run the Series B gauntlet at all, a gauntlet that not only wastes inordinate amounts of entrepreneurial time and energy, but also may lead to behaviors that make VCs happy but not customers, as 37 Signals' David Heinemeier Hansson argues.

None of which is to suggest there's a serious problem in tech land. Many startups (perhaps most?) deserve to die, as they offer no compelling value that isn't available elsewhere. But entrepreneurs should not fool themselves into thinking that an easy Series A raise necessarily translates into a seamless Series B raise. From talking with a wide range of entrepreneurs, and based on the NVCA and PWC MoneyTree data, Series B fundraising has become much more difficult of late.

While that might be good in an industry-wide, Darwinian sense, it's not going to help aspiring entrepreneurs pay their rent. ®

Matt Asay is senior vice president of business development at Nodeable, offering systems management for managing and analyzing cloud-based data. He was formerly SVP of biz dev at HTML5 start-up Strobe and chief operating officer of Ubuntu commercial operation Canonical. With more than a decade spent in open source, Asay served as Alfresco's general manager for the Americas and vice president of business development, and he helped put Novell on its open source track. Asay is an emeritus board member of the Open Source Initiative (OSI). His column, Open...and Shut, appears three times a week on The Register.

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