The Second VC Round – A True Test of Scalability

early stage, founder, Revenue Growth, Scalability, startup CEO, Uncategorized

The Second Round, or “B Round”, or “Follow On” round can be the achilles heel of a startup. It requires much more than a first injection of funding especially in the current healthy seed and angel investing environment.

No doubt the first round of external funding for a startup is usually critical to a startup as it can be the difference between continuing your startup or shutting it down. But it’s a different milestone than the second round of funding. The first venture round is often based on an idea, past successes, a business plan, or a market hunch. The decision to invest is based on an educated guess by investors. Often the investors are family and friends or angel investors, who have less sophisticated standards for measuring the likely success than top tier VCs.

The current phenomenon of Internet multi-millionaires recycling their money back into the startup markets is creating “super” angels like Ron Conway. For them, a $500,000 seed investment requires very little due diligence or proof of long term scalability. They sometimes invest in multiple companies within one meeting. There’s a slang term “spray & pray” describing this type of investing – put a little bit into a lot of startups and you’ll win by statistical odds.

The second round, however, is based more on cold hard facts. Is this company catching on? Have they built the foundation for the next 3-5 years? Does their product line hit the mark? Is it positioned correctly? What are the follow on products? Where is the market going?

The second round is often for some or all of the following – corporate growth, go to market, turn the prototype into a robust offering, marketing costs, or to hire a sales force. It’s no longer based on a hunch, unless the company is in trouble and needs money to finish what the first round started. (This problem often leads to a lowered valuation or “down round”. Not a great scenario.) If the company is doing well, the second round is easier to acquire. Facebook is a great example of this. They’ve had 9-12 rounds, depending on how you count, with investors still begging to get in. Their 2nd/3rd rounds were bigger than most startups ever see.

Facebook Funding Seed, A, B:

Total $2.34B
Angel, 9/04 19
Peter Thiel
Reid Hoffman
Series A, 5/05 20
Accel Partners
Mark Pincus
Reid Hoffman
Series B, 4/06 21
Greylock Partners
Meritech Capital Partners
Founders Fund
source: Crunchbase
The second round  can also be a mezzanine, or pre-IPO round, or even the IPO itself. In one scenario in my career I was with a company that had taken only one round of equity financing. With rapidly increasing revenues, we felt we had enough momentum and cash to execute an IPO without any more funding, thereby retaining more equity and control of our company, but we were getting a lot of pressure to take on another round. Our current venture partners felt we needed some insurance money in case of a downturn, more marketing money, a bigger team of investors, and a new logo. They turned out to be right about everything but the new logo.
Most startups that get a first round never make it to the second round. In todays soft-bubble economy this is more true than ever since so many first rounds are happening. Some don’t even want a second round. But the second round is truly a measure of scalability for your startup. Please feel free to contact me by DM to discuss more.  @tomnora or @cowlow

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