Financial Due Diligence: What VCs Really Look For in Series B

Series B funding is the key second round of financing that a startup receives from investors, intended to help scale and accelerate growth after establishing product-market fit and generating early revenue. While the initial seed funding round can come from different types of investors, Series B rounds are usually funded by venture capital firms, as the intention is to raise tens of millions of dollars or more.

However, Series B funding can also be challenging. It’s estimated that as many as 90 percent of deals ultimately fail, underscoring the importance of proper financial preparation in a competitive market. As a one-stop shop for all of your startup’s financial and accounting needs, Graphite Financial specializes in serving startups from seed to exit and can provide preparations for Series B funding.

The Series B Paradigm Shift: From Promise to Proof

Seed funding is all about assessing a startup’s potential. However, with Series B funding, investors want demonstrated scalability and market validation. Series B investors tend to be growth stage specialists with different analytical frameworks than seed investors, making preparation all the more important for this financing round.

Macroeconomic conditions, including economic uncertainty, inflation and interest rate fluctuations, make it more challenging for startups to raise revenue adequately. These factors have also led to increased caution when it comes to venture capital investments, as firms focus more heavily on proven performance and long-term viability.

Why Financial Rigor Matters More Than Ever

Market volatility and uncertainty directly translate to VCs being more risk-averse and selecting when and what startups to invest in. Limited Partner (LP) capital restraints have further complicated this matter, which has impacted fundraising by placing more scrutiny on deals, establishing a higher bar for investment and encouraging a shift to safer investments.

The “power law of returns” suggests that a small number of investments will generate most returns, while the rest break even or fail. Noting this, investors strive to back startups with high growth potential that can generate these significant returns.

The Financial Metrics That Make or Break Series B Deals

Investors approach Series B funding rounds with a lot more scrutiny and assess a multitude of KPIs when deciding which startups to back. The three most important metrics they assess are revenue growth trajectory, unit economics sustainability and market expansion evidence. They also look for consistent growth rates, positive contribution margins and observe customer retention benchmarks.

VC firms carefully weigh these metrics during the initial screening process to model potential returns and assess fund fit when deciding whether to invest.

Revenue Quality and Predictability Analysis

VCs will scrutinize a startup’s revenue composition to determine its potential for continuous growth and profitability. Here are some of the key factors that VCs tend to assess carefully:

• Diverse revenue streams: VCs prefer multiple, reliable revenue streams that can reduce overall risk.
• Recurring revenue: Especially for SaaS startups, strong MRR and ARR are attractive for predicting future income.
• Cohort analysis weighs customer retention and determines whether it improves over time. For SaaS startups, investors are looking for low churn rates, strong retention and consistent cohort performance.

Unit Economics and Path to Profitability

Scalability through unit economics analysis is weighed through key metrics, such as customer acquisition cost (CAC), lifetime value (LTV), contribution margins and payback periods.

• CAC: The total cost a startup incurs to acquire a new customer, which is directly influenced by your customer acquisition strategy.
• LTV: The total predicted revenue a startup can expect from a single customer throughout their relationship.
• Contribution margins: The portion of a product or service’s revenue after deducting variable costs.
• Payback periods: A metric that indicates how long it takes for an investment to generate enough to cover the initial cost.

Startups must also demonstrate operating leverage and an ability to improve their unit economics over time to scale and increase profits while controlling costs. Series B investors heavily scrutinize key financial and operating metrics to determine investment strategies, underscoring the importance of focusing on these metrics and overall strategy.

Essential Financial Documentation for Series B Due Diligence

From core financial statements to operational and strategic metrics, VCs assess several financial documents before Series B funding deals to assess financial health, the startup’s overall business model, growth potential and identify any risks.

The core financial statement requirements may include audited financial statements, management reports and board-level reporting packages. Supporting documents include P&L statements by business line, cash flow projections and capital allocation analysis. Your startup’s financial data should also ideally tell a story to convey your journey, describe your challenges and outline how you’ve overcome them in a way that resonates with investors and meets the expectations of any venture capital due diligence checklist

Financial Forecasting and Scenario Planning

VCs are forward-looking and want to invest in startups that can generate the most return. That said, multi-scenario financial models with sensitivity analysis are especially important. VCs will use their own financial models and projections to evaluate your startup’s forecasting accuracy and financial planning by examining expenditures, burn rate, cash runway and other key benchmarks.

Top-down and bottom-up forecasting are two ways to validate financial forecasting. Top-down forecasting is ideal for strategic planning, while bottom-up forecasting is best for operational planning. You can also take a hybrid approach, combining the two strategies.

Operational Metrics Integration

There’s a fundamental and direct connection between financial performance and operational drivers. Operational drivers are the activities and processes that impact your startup’s revenue and costs and thereby help determine its financial performance. The key operational metrics that support financial projections include:

• User engagement: This measures the level of interaction between a user and the product/service.
• Conversion rates: This measures the percentage of users who take a desired action.
• Churn analysis helps explain why customers leave a business and can identify ways to improve retention rates.

VCs validate claims through metric triangulation, which involves assessing multiple methods, data sources and perspectives to ensure accurate and validated findings.

Common Financial Due Diligence Pitfalls That Kill Series B Deals

Various mistakes have the potential to derail Series B deals. Some of the leading deal-breakers include:

• Poor accounting: This can result in issues with revenue recognition and erode any pre-established investor confidence.
• Inconsistent metrics or poor calculation methodologies.
• Financial discrepancies and a lack of supporting data to validate what’s right and what’s not.
• Poor financial transparency, which can raise red flags during the legal due diligence process and lead investors to walk away.

The Trust Factor: Why Financial Transparency Is Non-Negotiable

Your startup’s financial credibility is the lifeblood of Series B funding deals. It’s key to closing deals and often the culprit behind deals that fall apart. Series B investors, including every venture capitalist involved, very carefully assess your startup before finalizing any agreement. They will likely move on if they discover irregularities or can’t get a good feel for your startup’s financial stability and operational efficiency.

Remember, surprises tend to undermine any pre-built trust. If there’s evidence of an increased risk of investing with you or proof of potential future problems, investors are more likely to walk away from deals. This all helps reinforce the importance of a sound business plan and proper accounting.

Industry-Specific Financial Considerations for Series B

The market you’re operating in will likely have different investor expectations regarding Series B investing. For instance, SaaS startups have different metrics expectations compared to eComm or marketplace models. Keep in mind that VCs tend to prioritize metrics like gross merchandise value, take rates and network effects.

VCs will also assess regulatory and compliance considerations when weighing relationships, two of which can significantly impact financial evaluation and perceived risk.

Graphite specializes in working with startups across all industries and can ensure that you’re positioned in the best possible way to secure Series B funding.

SaaS Financial Deep Dive: What Growth VCs Really Examine

When it comes to growth metrics, VCs are particularly interested in the following:

• Annual recurring revenue:
• Net revenue retention
• Logo retention vs. dollar retention
• Cohort analysis
• Usage-based revenue vs. subscription-based revenue (especially for SaaS startups)

Preparing Your Finance Organization for Series B Success

The foundation of good financial metrics is a good financial infrastructure. It’s imperative to have the right leadership and management team in place to establish the right systems, processes and capabilities. Having this infrastructure in place well before seeking Series B funding is also essential. Graphite can help ensure that your financial preparation puts you in the best position to attract investors.

Building Investor-Grade Financial Reporting

Building investor-grade financial reporting isn’t something that can be done overnight. You need to establish a reporting frequency and analyze your numbers to identify ways to improve. It’s also important to include management commentary within the context of your business to help communicate your results to potential investors and current stakeholders. This level of transparency and organization can significantly smooth the fundraising process and increase investor confidence.

The Strategic Advantage of Expert Financial Guidance

The stakes of Series B funding are high — is your startup prepared?

Graphite has helped hundreds of early stage companies with their financial reporting to put them in the best position possible to appeal to investors and secure Series B funding. Professional financial assistance has also helped lead to faster deal timelines, better valuations and stronger investor relationships. Contact Graphite today for more information on how we can help your growth-stage startup prepare for and achieve Series B funding.

Frequently Asked Questions

How long does Series B financial due diligence typically take?

Due diligence typically takes a few weeks to a few months, but this can vary based on the company’s financials.

What financial statements do VCs require for Series B evaluation?

Income statements, balance sheets and cash flow statements are all statements typically required by VCs.

How do Series B metrics requirements differ from Series A?

Series A funding is largely based on potential, while Series B funding requires evidence of success and scalability.

What are the most common financial red flags that kill Series B deals?

Financial red flags include revenue recognition issues, inconsistent metrics, poor calculation methodologies, financial statement discrepancies, poor supporting documentation and poor transparency.

Do we need audited financial statements for Series B fundraising?

It depends on the investors and how they’re performing their due diligence.

How should we prepare our financial forecasts for Series B investors?

Forecasts should be as detailed as possible and communicate your startup’s growth trajectory and profitability.

What level of financial detail do VCs expect in Series B data rooms?

For the best results, startups should have a very high level of financial detail to prove their path to profitability and scalability.

How do VCs validate financial metrics during due diligence?

VCs are often meticulous in reviewing a startup’s financials and assessing its business model and financial health.

What role should our fractional CFO play in Series B preparation?

Fractional CFOs help put startups in the best position possible to earn Series B funding. This includes establishing a successful financial foundation and assessing ways to improve performance.

How can we improve our chances of passing Series B financial due diligence?

The best way is to work with a professional who can establish the right financial foundation and put startups in the best position to earn funding.