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Defending the Funding Gap – Economic Darwinism at its Best

Nate Lentz
July 9, 2012

As an early stage technology investor, I hear all the time about the funding gap.   People are constantly asking me:

“Why is there so little money available between friends & family rounds and Series A?”

“Why are even angel funds expecting to see revenue traction?

“Who can I speak to in order to fund my concept?”

Everyone hears the stories of three recent college graduates living and working in a loft with nothing but their dog and a concept who get a $10M pre-money valuation to turn their concept into reality.   Not exactly an urban myth, but very far from the norm.

Face it – in most cases the entrepreneur is unwilling to give up enough equity to compensate a pre-revenue / pre-product investor for the risk that the investor is undertaking.  The facts are that 90% of software start-ups never get to a million dollars of revenue.  Those that do get there often take significantly longer and take much more capital than anticipated.  And those that attain a million or more do it with one or several pivots or strategy alterations along the way.  Many of the investors who used to fund in the pre-revenue or very early revenue stage learned their lessons the hard way and have either moved upstream or had their checkbooks taken away by their partners or spouses.

I would ask entrepreneurs – would you rather make cheap mistakes and rapid adjustments and do this in private, or instead make very expensive mistakes, slower adjustments, and do it in front of investors or a board of directors?

At Osage we look for a million dollars in revenue traction.  It doesn’t have to be trailing revenue.  It could be annualizing last month’s (or next month’s) recurring revenue.  Some people say that this is not early stage investing, but for us it has proven to be early enough and is still fraught with risks.  Nevertheless, at this level of revenue, we see many risks worth betting on.  A million dollars in revenue means much more than an income statement line item:

  • It means that the product has been released – at least at minimal viable product level  – and it is being used
  • It means that there are companies willing to pay for the product – and these are referenceable users – who should be able to speak about ROI and their decision process
  • It means that there is a team that extends beyond the founders, which helps us judge who the founders can and choose to hire and offers an early indication of the ability of leadership to attract talent
  • It means the founders are “boot-strappers” who  understand the value of modest angel (or personal) capital invested and have scratched and clawed their way to this level of the business achievement
  • It means the founders most certainly have lived through multiple “near-death” business experiences from which they have learned tons
  • It means the company has real tangible value – as it stands – not just in a concept on a piece of paper

There have been many articles written about the number of very successful companies that have been founded and started in deep recessions.  These articles suggest that there is an economic Darwinism in play and that in tough times, only the strong survive and ultimately are positioned to thrive.  I would argue that the funding gap creates the same survivor mentality and that the companies that come through the gap to become the 10% that break through the million dollar revenue threshold are positioned to accelerate and to win.

Too much capital too early in the start-up cycle dilutes the gene pool and allows weak concepts and unready entrepreneurs to continue longer than the natural course would have predicted – this is not only bad for investors, but also not the best outcome for those who would have made it through the natural selection.

Bottom line – the winners have taken advantage of the funding gap to separate their businesses from the pack.  What doesn’t kill you makes you stronger.