Avoiding the funding trap: Don’t scale before Product-Market Fit

For startups, finding product-market fit (PMF) and defining the ideal customer profile (ICP) are crucial steps before scaling revenue. However, the pressure to scale quickly can lead to committing to a solution without knowing the ideal customer profile and then missing expected growth targets. As Marc Andreessen said, "Product-Market Fit means being in a good market with a product that can satisfy that market." It is a precursor to meaningful scale.

Enter the Series B trap. Many startups raise an inflated Series B and scale aggressively before finding PMF because they want to hit artificial growth targets. Ultimately, this scale isn’t sustainable and at Series C they cannot showcase the necessary progress to seek investment from growth investors.

Why the Series B trap is so common

The first significant checkpoint that a startup faces is the ability to build the MVP after raising a seed round, upon which they monetize to secure a Series A round. This initial traction proves the product not only works but that there is a willingness to pay by the customer.?

However, the journey from Series A to Series B presents a new distinct set of challenges. The startup is testing and learning to see what resonates with customers, experimenting with product features and altering positioning to different customer profiles and channels. They gather feedback and once an approach works, they achieve PMF, by seeing abnormal improvements in organic growth, upsells, retention rates, and satisfaction scores that persist. Then they raise a Series B, post-PMF, and invest capital around expansion of growth, whilst always knowing that they need to stay in their efficient growth range .

Yet, as round sizes become larger, and investors impatient, startups become tempted to raise before PMF and scale aggressively, often in the form of marketing and hiring sprees. This bold strategy can resemble a high-stakes gamble that they may stumble on a fit in their market. When startups lose the gamble, and thereby cannot raise the next round, they’ve fallen into a trap. Altos Ventures says it well in their blog post :

“The Series B Trap happens when a company raises a large VC round (usually at a high valuation) and ramps up spending, but doesn’t achieve the growth targets it promised at financing because its fundamentals weren’t sound.”

One of the most dangerous drivers in this trap is confirmation bias which subtly, yet significantly, skews their journey. This cognitive trap convinces them to prioritise information that aligns with their existing beliefs or hypotheses, causing them to inadvertently ignore contrasting data. They see a small uptake in growth as evidence of PMF. They see what is desired most and raise an early and large Series B prematurely.

So how do startups know that they’ve actually achieved PMF?

As startups continue to test and learn strategies after the Series A, they need to look closely at metrics to see when they start showing signs of market alignment. This may happen when pivoting to a new customer segment, focusing on a different pain point, or changing the feature set of the technology. To feel confident about PMF, look for:?

1. Strong User Retention: Users not only try the product, but they continue to use it consistently over time.?
2. Organic Growth: People are discovering the product through word of mouth, positive reviews, or referrals, indicating genuine satisfaction and value.
3. High Product Usage: Users are actively and repeatedly using the product, and they are using the core features, not just peripheral ones.
4. Decreased Customer Acquisition Costs: As PMF sets in, it generally becomes easier and less expensive to acquire new customers because the product’s value is clear and easier to communicate.
5. Positive Customer Feedback: The company is receiving unsolicited positive feedback, and users are disappointed if the product is taken away from them. They can clearly articulate the value it brings to their lives.
6. Evidence of Scalability: The team is able to grow without significant tweaks to the product. The product works, and it can handle increased usage without requiring a complete redesign.
7. Positive Unit Economics: The net revenue from a customer (over their lifetime) and their willingness to pay is significantly greater than the cost of acquiring and serving that customer.

“Projecting AI”: A Cautionary Tale of Scaling Too Soon

To illustrate how this can go wrong, let’s introduce the fictional “Projecting AI," a promising software startup that developed an innovative AI-powered project management tool.?

The Premature Series B Triumph

Almost 6 months after a successful $10M series A, the CEO was still experimenting with the startup’s ICP, and received feedback from customer success that junior project managers at startups liked the interface and feature set. Soon after, marketing ran a few targeted nurture campaigns, where conversion rates increased. Success, he thought, we’ve done it, we’ve found market fit! He collected a few months of data, and as the funding market was rife with capital, he started to raise a Series B. With some positive initial metrics, a compelling pitch deck, and a charismatic founder, Projecting AI was offered a generous $50M Series B funding round from eager investors. Investors believed the initial traction between their Series A and B showcased this company had found its calling and encouraged them to invest in growth before competitors could catch up. After all, they had a 1-year head start.

The investors justified a high valuation to make the investment work, and the company agreed to 10x growth in a year, on the basis that they would blitz their acquisition channels, expand existing contracts, and retain a majority of customers. Assuming they could achieve this, the team planned to do a huge $150M raise in the next 18 months, knowing that the 10x growth would make this an easy sell. After all, they had PMF.

The Scaling Gamble

Emboldened by this financial backing and driven by the desire to capitalise on the perceived market opportunity, Projecting AI launched an aggressive expansion. They hired large marketing and sales teams and asked them to spend heavily on advertising, targeting a broad array of industries with the notion that their tool was a universally perfect fit for all project management needs. On paper, the initial results seemed sparkling—with soaring user sign-ups, promising revenue numbers, and being featured as the next “hot” project management solution. They also offered very compelling pricing and undercut the competition.

Ignoring the Signs

Amid this rapid growth, the Projecting AI team was inattentive to crucial indicators. They celebrated the influx of new users but didn’t probe deeply into how these users were interacting with the platform. They didn’t realise that, despite their widespread marketing reach, the core features of their product resonated strongly with junior project managers who enjoyed the fact that it was cheaper than the competition. Feature use was limited to a few basic features (that could have been done in Excel) and NPS scores were low. Negative feedback started to spread, as the solution felt over-engineered and acquisition became more difficult.

The Churn Reckoning

As months passed, customer retention rates dwindled, and engagement metrics, when finally scrutinised, were alarmingly low. What initially appeared as robust growth was increasingly revealed to be a facade and a failed PMF, as a substantial number of users were churning, finding that the product didn’t meet their specific needs or expectations.?

Investors pushed for growth with brute force, and the company completely missed its board-approved plan. Instead of the 10x plan, they were only at 2x, which is itself impressive, however, not when you factor in that they had spent $30M of cash to get there and that gross retention was at 50%. At this rate, even 2x would be difficult to achieve again. Also, as non-decision makers were buying individual subscriptions there wasn’t an opportunity to upsell, and so net dollar retention was disappointing.

The Series C Roadblock

When Projecting AI began seeking Series C funding to further fuel its operations, it communicated a goal of 2x growth. As some VCs diligenced Projecting AI, it became abundantly clear that the business model was broken. These investors, expecting to see a sustainable and scalable business model, were instead presented with stalling growth, a high burn rate, and the resultant absence of PMF. Churn and customer feedback were their greatest concern. The company tried to sell them on fixes and solutions, but it was clear they hadn’t found PMF, and instead had grown before they knew their ICP.?

The Stark Reality

Despite their initial funding success and rapid, albeit shallow, market penetration, Projecting AI found itself in a precarious position. With the Series C funding proving elusive, the team was forced to confront the painful reality that they had scaled prematurely and only had months of cash left. It was time to accept the internal down round to keep them going. That was far better than the alternative.

The Lesson

To avoid the funding trap, startups must dedicate ample time and resources to find PMF and deeply understand their ICP. Investing in customer research, soliciting feedback, and being a metric hawk are all key. Most importantly, you need to treat PMF as a hypothesis, starting with the assumption: “I haven’t achieved product-market fit.”?

Look at the data and intel that’s accessible, for instance, a sample of data from sales being tested with product changes and new customers. With each test, the team is trying to achieve a high confidence interval. Testing a hypothesis on a sample of data can never give certainty on the population, but it can improve confidence, so when looking to scale, you have adjusted risk to set yourself up for success.

The Importance of Capital Efficiency and Being Patient

From the first post in the series about creating leaner companies to this final post, it goes back to capital-efficient growth.?

The belief in growth efficiency is rooted in three core aspects, one of which emphasises the attainment of PMF. Test the hypothesis and hold yourself to a high confidence level. Once PMF is established, then shift focus to a "rinse and repeat" model that involves expanding features, securing larger contracts, and building momentum.?

Thinking back to the efficiency of scale in the last article, with PMF, you are able to grow efficiently faster. You need to show that you can build a breadth of revenue with diverse client types and depth of revenue through land and expand contracts. That won’t guarantee a successful Series C raise, but it certainly will make it much easier.?

About Conductive Ventures

Conductive Ventures is a venture capital fund with $450M in assets under management. Our investment focus lies in capital efficient, post-product expansion stage companies in the software, hardware, and technology-enabled services sectors. We believe that capital efficiency leads to optimal outcomes for CEOs, fosters sustainable businesses that add value to the world, and stands the test of macroclimates.

If you are an early-stage startup CEO or an investor who shares our belief in treating venture dollars as finite resources, please reach out to me at arif (at) conductive (dot) vc.