Premature Scaling

I find it really interesting to see what kind of deals are doing the rounds in London. There are a few patterns that one can discern with regards to stages and how far down the line companies are or should be at that stage to avoid premature scaling, which is one of the major startup killers. If you scale prematurely, your chances of becoming successful are slim indeed:

1. 74% of high growth internet startups fail due to premature scaling.

2. No startup that scaled prematurely passed the 100,000 user mark.

3. Startups that scale properly grow about 20 times faster than startups that scale prematurely.

4. 93% of startups that scale prematurely never break the $100k revenue per month threshold.

There is more information here.

Here is what I see that works. This is what I would say is not premature scaling in a London-based Internet business context:

Pre-Seed – £100k to £250k

Typically there is no evidence of product market fit [1]. There is just the founders with an interesting idea, maybe there is a product to look at, maybe it is a bit fleshed out with some concierge service customers or similar. SEIS protection means this is throw-away money. I frequently see that experienced founders finance this stage themselves. (Btw, some people have started calling this the ‘Genesis’ round.)

Seed  – £200k to £800k

Companies that raise a Seed round typically have early evidence of product market fit. However, this evidence typically hasn’t been collected for very long and may be somewhat tenuous. The team consists of the founders plus some advisors/ board members, and typically a team of junior (and some senior) ‘doers’. EIS protection means angels have partial protection at this point.

Series A – £1m to £10m

The business has solid evidence of product market fit. It has achieved an acceptable level of efficiency in their business model. It is more or less ready to scale. The team consists of the founders, has a group of advisors and NEDs working with it and a more or less complete team of both junior and senior doers. There is sometimes EIS relief at this stage, obviously not for VCs.

What I see is a lot of is people raising inappropriate amounts of money for the stage in which their company is at. Examples of this kind of premature scaling are:

• Raising a Seed / Series A round without having launched a product and thus not having any evidence of product market fit whatsoever, typically just a team of founders (come on, either finance it yourself or start smaller);
• Businesses who have launched a product, but failed to get early proof of product market fit, raising a Seed or small Series A round to ‘take it to the next level’ whereas what they should do is admit failure and repeat the previous round to try and get to some proof of product market fit (I see that, too, and have to applaud the founders for being honest);
• Businesses that jump over one stage and try to go to a full Series A round with some very tenuous product market fit and a weak team (this typically ends up being a waste of time and when it works has the potential to derail the company).

My comment with regards to premature scaling is that raising an inappropriate round when compared to the stage at which the company is at is bad for the company. At best this effort fails and is a waste of time. At worst it succeeds and you end up with investors who typically invest much later stage and whose expectations and modus operandi screw up your business. Or even worse, you see the funding as validation of product market fit (it is not) and spend the money pursuing of an incorrect set of targets. Both are terrible.

For example, if you are doing a Seed round, the first thing that the company needs to achieve is product market fit. Not refining the business model. Or scaling marketing. Or hiring lots of ‘senior’ people. Or spending a lot of money every month. You focus on the wrong things and spend too much money trying to achieve them.

Funding expectations

My second general point is something that seems to coincide with premature scaling, which is incorrect expectations, both on the founder and on the investor side.

Many of us read in the press about amazing Seed rounds, Series A rounds etc. The reason why these get reported is because they are outliers. The press doesn’t care about the norm. This means that what is written about is not ‘normal’. The problem that that creates is the same for both founders and investors: unrealistic investment expectations.

Let’s look at the founder side first.

I see quite a few founders who believe they can or should raise £1m+ rounds when they don’t even have anything like product market fit. Quite the opposite. Maybe in the valley you can do Seed deals of $1m, I doubt they are the norm. However, in London this is exceptionally rare. And even when it does happen, I would still contest that this is premature scaling and actually ends up harming the company. As a former founder, I regret taking what was probably too much money in first funding round of my own business. This was most certainly a mistake. [2]

Now let’s look at the investor side.

I see quite a few investors, particularly inexperienced angel investors or VCs trying to go early stage who are asking for inappropriate levels of achievement before they are ‘prepared’ to invest. If you are an investor investing in a Pre-Seed (SEIS) round, you have to accept the fact that there will not be any evidence of product market fit. You are just investing in the people. If there was evidence, the company would be raising a Seed round. If you are investing in an Seed (EIS) round, then you should be able to see some evidence of product market fit, however, you cannot expect this to be solid. Neither can you expect a full team. If the evidence for product market fit was extensive and the team was more or less complete, the company would be raising a Series A round. I see a lot of investors wasting a startup’s time, as they are trying to get deals that are simply not realistic.

A founder whom I know summarised both points succinctly:

“Founders watch the news from the West Coast and expect that here (not realistic) and investors want to buy a perfect business with full product market fit and opportunities for 30x return at a sub £500k valuation.”

Premature scaling kills companies. Trying to raise too much cash before you are ready is both a waste of time and can harm a company. Asking for evidence and teams that are inappropriate for the round wastes a ton of time.

Maybe we should avoid all of the above.

————————-

[1] Product Market Fit means that the company has identified a repeatable and scalable business model. You can read Steve Blank’s article on this here. In my experience startups typically get initially to some form of product market fit where the evidence is somewhat tenuous. The evidence base is then solidified and strengthened over a number of months.

[2] It is very rare for a company to attempt to raise too small a round, but it does happen. If you have some form of product market fit and the beginnings of a real team, you should probably not try to raise a Pre-Seed (SEIS) round. You are beyond this point. You will probably just cut corners that don’t make sense.