The Series B Trap – And How to Avoid It

The original version of this post was published in PandoDaily on January 20 2014

Over the last two years, much has been made of the “Series A Crunch”, a steep drop off in the number of seed-funded companies that are able to close an institutional Series A financing.  For the companies that make it that far, there is another financing pitfall – something I call the “Series B Trap”.  This one is just as fatal and even more heartbreaking because it is highly likely yet entirely avoidable.  I’ve been a part of it as entrepreneur and investor, and my experience was confirmed reading an old Fred Wilson post on why venture-backed startups fail.

The Series B Trap happens when a company raises a large VC round (usually at a high valuation) and ramps up spending, but doesn’t achieve the growth targets it promised at financing because its fundamentals weren’t sound.

The Series B Trap is shorthand for a situation in which a company with meaningful revenue and/or customer traction raises a large venture round, most often led by a large venture fund.  A typical company in this situation might be single-digit millions in revenue and doubling – or have a growing base of several million active users waiting to be monetized.  Often this is the sweetspot for what most mainstream venture firms consider a Series B financing; sometimes it’s a Series C; and sometimes it is the first round that a bootstrapped company may be raising.

Whatever the case, this seemingly fortunate growth situation can turn into an unfortunate one quickly.  This happens because companies and investors get themselves into a financing/growth trap that is hard to escape.  Here’s how it can go bad quickly:

1. Your company is growing and scaling well, often on little invested capital.  You decide you’re ready to scale and raise millions, so you pitch big venture funds on a big growth story.
2. Investors pay a high valuation to get into a good deal, betting on continued fast growth.
3. To meet growth and revenue targets, you hire and spend like never before.  You rush a few key hires, overbuild the team, ramp marketing spend.  A few quarters in, you realize that product/market fit is not quite there, or you’re not as far up the sales learning curve as you thought, or your LTV/CAC is suddenly in the toilet.
4. But it’s too late to change course.  After several consecutive quarters of high burn, missed targets and lowered expectations, you’ve wasted a year and $10M.  Investors who paid up for your financing are not happy.
5. You fall into the spiral of death: head of sales gets replaced (at least once), CEO gets replaced (at least once), a down-round financing happens (if lucky).

Companies fall into a Series B Trap because they spend unnaturally and prematurely to achieve revenue growth they promised in their financing pitches.

Sometimes companies raise too much money too soon because VCs are throwing capital at a hot sector.  Sometimes they rush because there is a (usually false) sense that a window of opportunity might be closing.

With more money in the bank than they are used to and investor expectations to meet, companies start spending soon after the capital influx, driving down LTV/CAC, bringing in non-core customers (churn!), hiring B players to fill the roster and generally doing everything they avoided when they were running lean and smart.  As we’ve written before, sometimes it just takes time to find product/market fit, or climb the sales learning curve.  As many entrepreneurs have painfully discovered, pouring gasoline on the kindling isn’t usually the best way to make a fire.

The Series B Trap is closely related to survey findings from the Startup Genome Project that 70% of startups scale prematurely and 74% of high-growth Internet startups *fail* due to premature scaling.

How to avoid this dubious fate?  Here are a few strategies worth keeping in mind:

1. Don’t rush to raise  – the ideal time to raise capital is when you’ve figured out how to scale the business efficiently to the next level.  While this seems like an obvious statement, most companies actually raise capital when they are running out of money and when they haven’t really figured things out.  The best way to avoid this situation is to keep costs from running too far ahead of figuring out the business fundamentals.  At M Ventures, we are strong believers in the adage, attributed most recently to Marissa Mayer, that “creativity loves constraints”.  Keeping it lean gives you more time to figure things out – the more you’ve figured out, the better fundraise you can execute.
2. Don’t overreach on valuation – when it does come time to raise, entrepreneurs who push for every last penny to maximize valuation have, by definition, the least room for failure and forgiveness.  If you can execute flawlessly, then go for it.  Otherwise, settle on a reasonable valuation that gives you the leeway to figure things out.  We don’t push our companies to get the highest valuation they can in a follow-on financing; we counsel them instead to find investors who are aligned in vision and temperament.  When there is a big step-up in valuation from one round to the next and the company doesn’t perform, CEOs have the added pain of dealing with investors that suddenly have different objectives because of different economics.
3. Pitch honestly – the best way to align expectations from the start is to be open with prospective investors about the things you don’t know.  I love working with entrepreneurs who are honest about the parts of their business that are not working, yet thoughtful about how they are going to figure them out.  If you can have a constructive dialogue with a potential investor that feels more like an advisory conversation than a funding pitch, then you are on the right track to finding a good partner.
4. Focus on fundamentals – when millions of dollars are burning a hole in your bank account, it is almost impossible to have the discipline not to spend and ramp.  But remember – especially you bootstrappers – that what has made you successful so far is better product, clever distribution and the intense focus that comes from having a lean bank account.  There is definitely a way to “buy revenue” in the short-term to meet quarterly goals but often at the cost of building strong fundamentals in the business.  Instead of talking with your board just about growth, focus on fundamental measures of business health: organic lead volume, CAC and LTV unit economics, engagement, virality, sales productivity, customer sat, retention, upsell, etc. For specific growth metrics, check out blogs from my friends Jason Lemkin and Joel York (for Saas startups) and Dave McClure (for Internet startups).
5. Obsess about product – just because you’ve reached a certain scale does not mean that you have achieved permanent product/market fit.  Board discussions for scaling companies can become too focused on metrics, financials and growth, mistaking them as proxies for product quality.  Product often get relegated to a token update from the head of product or engineering.  Your company is never too big to be obsessed with product.  The best ones are.  Shortly after Larry Page became CEO of Google in 2011, the company was doing nearly $10B/quarter.  One of his first moves?   He created a product-focused management structure.
6. Scale thoughtfully– Building a startup is a continuous process of figuring out your product, market, distribution model, hiring process, culture, etc.  Each of these is an iterative learning process that takes time.  Things that worked well in a bootstrap stage don’t always scale with capital.  Be especially careful about the transition from organic to paid marketing or from a small founder-led sales team to one led by a “sales professional”.  You will become less efficient.  Think carefully about how you deploy your newfound capital and think of your spend as if investing a portfolio, not just paying the bills.  As a rule of thumb, we like companies to spend 50% of their new capital on things that they know will scale, 25% on experimenting with new growth levers and 25% as financial reserve cushion.
7. Pull the emergency brake – If you ramp up expenses and the business does not scale up as expected, you may have only one chance to pull the emergency brake and cut expenses.  This is incredibly hard to do and I’ve almost never seen it.  Why?  This is the human nature side of the Series B Trap.  It is almost impossible because of the commitment bias that binds investors and entrepreneur alike.  Neither the buyer nor the seller in a financing transaction want to admit they were wrong, so all too often they avoid admitting error and changing course, sticking instead with a foolish growth plan the may ultimately doom them all.

In my experience as an entrepreneur and investor, the most common way that good companies get into trouble is by raising too much capital and spending it before they are ready.  It’s equally easy for investors and entrepreneurs to get excited about growth, fixate on financings and lose sight of fundamentals.

There are many traps along the way to entrepreneurial success.  The most fatal one may be the one you set for yourself.