The Startup Funding Gap
What is the Funding Gap?
I’ve been involved with over thirty startups in my career and they’ve all had issues securing early stage funding to some degree. It’s just hard putting a startup together and convincing people you have a great idea that’s worth taking a chance on. However, the gap between very early seed investments from family/friends/angels and larger funding rounds from angel groups & early stage VCs seems to be getting wider.
According to Pitchbook, the number of angel/seed rounds has fallen substantially over the last few years:
Why Does the Gap Exist?
The gap is partly driven by VCs raising larger funds. In the last five years, all but two of the 15 largest funds ever raised were created and the average fund size has doubled:
As the size of a fund increases, the average size of a given investment also goes up – it’s just too difficult for a small team of venture capital partners to manage a large number of small investments. The time they have to put into very early stage companies is also a factor. The result is that VCs in general have started to move away from making seed investments.
Angel groups used to fill some of this gap, but they tend to invest by committee, which slows the process down and often results in a need for at least one or two customers to get the naysayers comfortable.
Having a few customers is often the most critical milestone for both VCs and angel groups. Even individual investors sometimes start to waver as you get closer to securing your first few deals. When you first start out, all you generally have is a story about your vision and investors must make a decision based on that story alone. Once deals seem imminent, it’s natural for people to wait until they get outside confirmation that there is demand for your product or service. Unfortunately, this just makes the gap more severe and, of course, it happens just as you need to invest in order to close customer deals.
It’s also just Darwinism. If you can survive these early stages and get to revenue and product/market fit, you’ll also probably stand a chance of getting through all of the other challenges that lie ahead. Given the vast number of business plans most VCs receive, you can’t really blame them for winnowing the field a bit.
What to do about it?
Keep your costs as low as possible
It’s obviously critical to keep your cash burn rate as low as possible and avoid overinvesting in product development before you have customers. That’s a tough balance to strike, because you need to develop a product so you have something to sell!
The key is to avoid adding features that you don’t need and to build a true Minimum Viable Product (MVP) as quickly and cheaply as possible. Remember that an MVP is not supposed to be the final product – it’s just intended to test your hypothesis and make sure you’re not creating something that the market doesn’t need. If you can, try to assemble your MVP from open source components with the minimum of custom ‘glue’.
I’ve also used the approach of paying in stock instead of cash wherever possible. This obviously only works with people that have other sources of income. If they have other jobs and are helping you in their ‘spare’ time, make sure you’re not creating any IP ownership issues down the line.
Generate revenue
In addition to focusing on the cost side, a great way to fill the funding gap is to actually get out there and close some deals! This may seem obvious, but it’s amazing how often new startups are so internally focused that they forget that the goal is to sell something and that it’s never too early to start.
Most enterprise software companies end up selling some level of services alongside their product anyway, so a good place to start is to find people in your target market and offer them a services-led solution as soon as possible. That way, you can generate revenue while also getting much better insights into the needs of potential customers. In all cases, look to use your MVP as part of the solution as soon as possible, even if it’s not ready for anyone else to use other than your own staff. That way, you get revenue, experience of using the product AND customer references for solutions that include the product. If you can pull this off, it really is the best of all worlds – especially when you bear in mind that VCs will give you a higher valuation if you have proof of product/market fit and a decent revenue stream. They won’t care that the revenue is from services if you can show that the customers were also using your product and that product revenues will dominate in the future. They’ll go even higher if they see that you don’t need their money!
About the Author
Stuart Frost has 30 years’ experience in founding and leading successful data management and analytics startups. He has raised over $300m in funding and founded/co-founded 30 startups. Successful exits have included IPOs and acquisitions, including one by Microsoft.
In the last eight years, Stuart has created and incubated some of the leading companies in the IIoT market, including Maana (IIoT knowledge platform), OspreyData (oil and gas analytics), NarrativeWave (wind farm analytics), ThinkIQ (food traceability) and SWARM (AI agents for IIoT). During this time, he saw the market go from its very early gestation to the point where major industrial companies are starting to make significant, long term commitments to digitization. Through this unique experience, Stuart has developed deep knowledge of the market’s needs and how to successfully create and sell key technologies to meet those needs.
His latest company, Geminos Software, has created a platform that is designed to improve productivity of developers building AI-driven analytics by 10X.
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