The “Early-Late” Stage Startups (Observations from “Circle One”)

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Dear Friends,

During the last year, we have witnessed the emergence of a new investment stage: “Early-Late” stage. This stage refers to companies who, for all intents and purposes, should have been defined as young startups. They are usually in just their second or third year of operations, and in most cases, their management teams are incomplete. However, when they present their company to potential investors in the hopes of obtaining a first round of institutional VC financing (a “Series A” round), it would appear as if they are instead seeking “Late” stage financing. This is mainly because their pre-money valuations are relatively high, and the amount of capital they are seeking to raise more closely resembles a late stage investment – in most cases, they contemplate raising $10M-$20M. Not only do these companies already have significant revenues and profitability, or at least a clear path towards profitability, but also their revenues usually exceed their initial projections while their expenses lag behind. Therefore, they tend to think they do not really need a lot of money, so part of the round is executed as a buy-out (secondary) transaction, meaning the shares from founders and other shareholders are purchased. Welcome to the emerging world of “Early-Late” stage investments in an era of accelerated growth.

Even though there are still just a few “Early-Late” stage companies, we are going to see more companies with such fast growth patterns. Here are some of the drivers of such high-growth companies:

First, markets are becoming bigger and technological solutions are being adopted faster than before, with an ever-growing audience. Customers are becoming more accessible via the global Internet’s infrastructure, services, and applications. As technology becomes pervasive, markets tend to become dynamic and efficient.  In parallel, the innovation cycles become shorter, and so does a company’s “time-to-revenue”. Today, we see much faster penetration patterns of new products compared to those in earlier days. Companies with a compelling offering get extra exposure in the market, which leads to excessive demand.

Secondly, it takes time to build companies from the early stages to a meaningful level of annual revenues and profitability. But as we move forward, the time required to reach maturity tends to get shorter by the year. Today, we see companies scaling their business to a significant monthly revenue run-rate in just 2-3 years from initial revenues. This is because these companies manage to quickly fine tune their business model and distribution plan, and continuously improve their value proposition.  Creativity at the business model level helps companies to reach maturity much faster than before.

A prime example of this can be seen by examining how startups typically forecast annual revenue. In recent years, private companies presented their business plan with annual revenue growth projections. As these companies grew and became publicly-traded, however, their growth began to be measured on a quarterly basis. In contrast, in today’s market where seed funding is widely available, startups are starting by projecting quarterly growth, and are measuring their growth on a monthly – and in some cases even a weekly – basis.

Finally, the traditional funding cycles and methodology are being disrupted as well. Startup funding used to be highly structured and funding was done gradually over time.  Companies started initially with seed money (total funding was below $1M), which was then followed by a series of venture fundraising rounds: Round A ($1-5M), Round B ($5-10M), Round C (over $10M), and so on. Through this progression, companies gradually transitioned to the “maturity” stages. With the rise of the startup phenomenon, however, a great number of startup companies obtained seed financing, yet found it very challenging to secure follow-on investments.  Only by demonstrating hyper-growth could these companies leap-frog to early maturity and on to their next round of investment. Over time, more and more companies began to circumvent the traditional investment cycle altogether and go directly from seed stage to later stage, hence the emergence of “Early-Late” stage companies.

So VCs and other investors get their money back sooner rather than later – what’s so bad about that? Well, the time period between the seed investment and the late stage investment used to play a crucial role in that it allowed entrepreneurs to adapt to corporate build-up and growth, while allowing investors to observe portfolio progress. However, as this time period continues to disappear, investors increasingly need to make “late stage” investment decisions in early stage companies, and entrepreneurs have to deal with both seed and late stage dilemmas and decisions at the same time. In other words, the technology world is losing its formative, “teenage” years.

The challenge of accelerated growth patterns will continue to grow, and the players in the market will need to address key issues like how to manage growth pains, and how to deal with the risk and opportunities of hyper-growth investments.

As always, your thoughts and comments are welcomed.

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