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Why So Many Startups Never Reach Their Second Funding Round

Why So Many Startups Never Reach Their Second Funding Round
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The "valley of death." I hear this term used a lot in startup circles, representing the gap between a great idea and the task of turning it into a business. From a financial standpoint, it points to the moment when the feel-good times funded by an initial seed investment come to an abrupt end after a search for formal venture capital fails.

Josh Lerner, Harvard Business School's venture capital guru, estimates that 90 percent of new businesses can't bridge this gap and end up shutting down because of it. That's a frightening stat, and it begs an explanation.

Let's start with seed funds vs. Series A funding. Seed funds come from a variety of sources, many of which aren't necessarily validators for success. The most common sources of seed funding are friends and family who often care more about the founder as a person than about the business's viability. Seed and grant funding can also come from regional or state economic development offices whose major metric is job retention and creation, not necessarily value in the businesses.

These seed investors have drastically different goals than those of a venture capitalist. The former might pay lip service to ROI, but I can tell you that VCs--your Series A guys--invest only in businesses that can scale quickly and will offer a significant return on their investment within five to 10 years.

Another issue that may be holding the VCs back: too many cooks in the kitchen. Along with that first investment dollar comes an entrepreneur's first major encounter with what I call "people risk." With investors, co-founders, board members and option-holding employees weighing in, that startup is no longer a one-man band. People, especially the ultra-intense, driven personalities drawn to startup culture, rarely get along well with everyone. When they don't, the results can be devastating. New companies don't have the luxury of time and resources to survive bad hires or poor management dynamics. One toxic hire or partner can bring down the whole show, and that risk increases with each new person added to the team.

The way I look at seed funding is that it gives a company more opportunities and time to fail, not to succeed. In fact it's why so many successful early-stage funds and incubators focus on the "fail fast, fail cheap" mentality.

The silver lining to this dark reality is that there are lifelines available to bridge the valley of death. Crowdfunding is a viable way to get new products to market and dollars into company coffers long before any VC will pay attention. Also, angel networks are as active as they've ever been and fit well in that funding gap. While neither can guarantee a big Series A payday, they can make the walk a lot less deadly.

Sam Hogg is a venture partner with Open Prairie Ventures, a Midwest-based venture-capital fund investing in agriculture, life-science and information technology.

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This article was originally published in the December 2013 print edition of Entrepreneur with the headline: A Seed Doesn't Make a Series.

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