Rethinking Startup Failure: An Alternative to Series B

By Krista Morgan, Stage GP

Originally published on Nasdaq.com

several crossing paths as seen from above

2021 was a banner year for early-stage investments; venture funding doubled year over year to $200 billion across 8,000 startups. The uncertainty and disruption of a global pandemic did not compress valuations as initially expected, and the amount of funding per round means an average Series A company has now raised over $20 million. And yet, amidst this investment fervor, 50% of Series A companies will fail to raise a Series B round, taking them off the venture path.

The economic model behind venture funding necessitates focusing on their top-performing investments. They rely on the outliers to deliver on fund returns, on the unicorns and now decacorns. Only 2% of seed-funded companies will become unicorns, so VCs constantly evaluate their portfolios to focus the most capital on those with the potential to deliver an outsized return. Founders are being told that it’s better to swing for the fences or die trying.

The past three years have seen public markets break records repeatedly. There has been so much liquidity that investors are seeking out new asset classes and venture capital is seen as a strong option because wealth creation is happening in the private sector. As money pours into the venture sector, startups that arguably would never have been funded are being given a chance.

Over 24,000 startups globally received early-stage venture funding from 2019 to 2021. The average amount of funding increased alongside valuations; over the last ten years, the average global Series A round increased from less than $6 million to more than $18 million. An early-stage startup can quickly and easily raise over $20 million, when combined with seed funding. That is a lot more capital than ever before, and arguably, this means post Series-A companies have a greater chance of being sustainable without more capital.

The problem is the inherent market assumption that startups who fail to raise their next round are destined to fail or have no other option. Many Series A companies have unique technology, they have customers, and they can demonstrate product-market fit. While they cannot show exponential growth, they can show market traction. Those companies have value, and they deserve to keep going, even if it’s not on the venture path.

Early-stage companies have big ideas, take significant risks, and set out to solve complicated problems. The worst outcome would be to waste this explosive growth in venture capital by losing the resulting innovation simply because a company isn’t on track to becoming a unicorn. With so much capital to build on, there will be thousands of startups unable to raise more venture capital but still have the potential to positively impact, albeit at a smaller scale.

Venture-backed entrepreneurs face an incredible task. They are creating a product, often educating a market, hiring, and motivating a team, building a brand, all while constantly fundraising. And while they have been given capital, they are left largely on their own to sink or swim. Worst of all, once a company fails to raise a round, they are left to languish by investors who want to focus on their winners. This binary approach not only wastes the capital resources that have been deployed, but perhaps more importantly exacerbates the mental health stress that entrepreneurs face.

There is a nascent but growing market of early-stage investors looking to leverage the capital invested in early-stage ventures, and effectively repurpose it. Clear the slate for the founder and start a new journey from a solid foundation. These models often involve more active management because these founders were never taught to build a profitable business; they believe, rightly or wrongly, that growth is everything. Combining their passion with an approach based on business fundamentals is powerful. The end goal is not an IPO but rather an exit to strategic or financial buyers looking to acquire stable technology companies with predictable revenue and cash flow that can be scaled.

These early-stage private equity-type deals, when appropriately structured, are a win for everyone involved. Founders get a second chance to build their company and find a meaningful exit, VCs don’t have to manage the “walking dead” in their portfolio, and a new private market asset class is being created.

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