Valley of Death

What is the valley of death?

Valley of death (early-stage funding gap) describes the period between the development of a product or technology and the point at which revenue covers the ongoing costs. In this phase, the funds from the initial financing are largely used up, while the evidence that growth investors expect for a larger funding round is only just emerging. The image describes a valley in the curve of cumulative liquidity, that is, liquidity added up month by month. It falls as long as more is paid out than comes in, and rises again only when the business sustains itself.

The term is used in two contexts. In startup financing, it describes the stage after the founding or seed financing, that is, the first capital from founders, business angels or early-stage funds. It extends up to a Series A, the first larger funding round with professional investors. In research and innovation funding, it means the gap between publicly funded research and market-ready products. There it is usually measured by the technology readiness level (TRL), a scale from 1 for basic research to 9 for proven deployment. Those involved are founders, early-stage investors, grant providers and later growth investors. The gap becomes visible in liquidity planning, in the financial model and in grant applications.

Why the funding gap arises

Three developments coincide in this phase. First, the costs have already been built up: a development team, infrastructure and initial sales resources cause fixed monthly payments. Second, revenue comes later than planned, because pilot projects, certifications and procurement processes at business customers take longer than product development itself. Third, follow-on funders demand evidence of market acceptance, which is produced only in the course of this phase.

In addition there is a gap in the supply of capital. Early-stage investors and grant programmes finance development and first market tests. Growth investors, by contrast, often require recurring revenue and reliable indications of product-market fit. Public funds are moreover usually tied to a particular project. The grant award notice (Förderbescheid) stipulates what they may be used for; market launch and building up sales are often not covered.

The valley of death in figures

Arithmetically, the funding gap can be read from the cumulative liquidity curve. It adds up the monthly balances of receipts and payments since the start of development. As long as payments predominate, the curve falls. It reaches its low point in the month in which the company for the first time takes in more than it pays out. The depth of this point corresponds to the total funding need until self-sufficiency.

For ongoing management, two time quantities are decisive. The runway shows how long the available funds last at the current outflow. The second quantity is the time to the next milestone that makes follow-on financing possible on reasonable terms, for example a certain level of recurring revenue. If the second period is longer than the first, there is a gap that must be closed before it becomes acute. This includes the duration of the financing process itself, in a funding round often 6 to 8 months.

Instruments for bridging the funding gap

Several forms of financing are available for bridging, which differ in cost, availability and lead time:

• Equity from existing investors: an extension of the last round or a bridge round (interim round), in Germany usually through a convertible loan that is converted into business shares in the next round.
• Public funds: grants from funding programmes, subsidised loans and the tax research allowance for research and development projects. They do not dilute shareholders but require lead time and are earmarked.
• Customer financing: paid pilot projects, down payments and annual contracts with prepayment. They improve liquidity and at the same time provide evidence that customers pay for the product.
• Debt capital: venture debt, a loan from specialised lenders to venture-capital-backed companies, is usually granted in connection with an equity round and supplements it. Bank loans mostly require collateral or a stable earnings position, which are often lacking in this phase.

The instruments are not mutually exclusive. A combination is often planned, in which public funds and customer financing extend the reach and interim financing covers the remaining distance to the next round.

How investors assess companies in the valley of death

Investors reviewing a company in this phase look above all at four points:

• Depth of the gap: how far the cumulative liquidity curve still falls, that is, how much capital is missing until self-sufficiency.
• Milestones: how realistic the targets until the next round are, for example paying pilot customers or a certain recurring revenue.
• Capital efficiency: how much measurable progress the company achieves per euro consumed.
• Time: how many months of runway remain until the next financing.

A short runway does not rule out an investment, but shifts the negotiating position in favour of the investor and influences valuation and terms.

In the review of the documents, the liquidity planning, the sales pipeline with closing probabilities and the terms of ongoing grants are examined, for example clawback risks on deviations from the funded project. For the management of a GmbH (German limited liability company), the phase also has a legal side. If the company can no longer make payments that are due, it is unable to pay its debts under Section 17 of the German Insolvency Code (Insolvenzordnung, InsO), and Section 15a InsO obliges the management to file for insolvency. If the assets no longer cover the debts, over-indebtedness under Section 19 (2) InsO threatens. It does not exist only if continuation over the next twelve months is predominantly likely. Rolling planning that shows bottlenecks months in advance is therefore also part of proper management.

Worked example: calculating the funding gap in the valley of death

A company for industrial sensor technology has raised EUR 2.0 million of seed capital and received a development grant of EUR 0.5 million, which for simplicity is treated as already paid out. The plan provides for three stages.

• Months 1 to 12, development: net burn EUR 150,000 per month, together 12 × 150,000 = EUR 1.8 million.
• Months 13 to 24, first customers: net burn on average EUR 100,000 per month, together EUR 1.2 million.
• Months 25 to 30, growing revenue: net burn on average EUR 50,000 per month, together EUR 0.3 million.
• From month 31, receipts exceed payments. Low point of the liquidity curve: 1.8 + 1.2 + 0.3 = EUR 3.3 million.
• Funds available: 2.0 + 0.5 = EUR 2.5 million. Funding gap: 3.3 minus 2.5 = EUR 0.8 million plus a safety buffer.
• Reach of the funds: After twelve months, EUR 1.8 million is used up; the remaining EUR 0.7 million lasts at EUR 100,000 net burn for seven further months, that is, until month 19.

If the follow-on financing is to arrive in month 19 at the latest and a process takes 6 to 8 months, it must begin between month 11 and month 13. The funds then last only nine or seven more months, and only little revenue evidence is available. If at least 12 months of reach are to be available at the start of the process, the process would have to start already in month 8, in the middle of development. The example shows why founders in this phase must either extend the reach or align the follow-on financing with earlier, achievable milestones.

Distinction: valley of death, runway, default alive and bridge round

• Runway: measures the reach of the funds currently available. The valley of death describes the entire phase in which this reach is shorter than the path to self-sufficiency.
• Default alive: tests whether a company reaches break-even with the funds it has. Anyone in the funding gap is as a rule not default alive.
• Bridge round (interim round): an instrument with which the gap to the next round is closed, not the gap itself.

Common mistakes

• Counting on the follow-on round as certain. Financing without a signed commitment belongs in a scenario in liquidity planning, not in the base case.
• Underestimating sales cycles. Pilot phases, procurement approvals and integration projects at business customers often delay the first revenue by several quarters.
• Not allowing for the duration of the process. Anyone who starts the follow-on financing only when the runway is a few months negotiates under time pressure.
• Applying for grants too late. Application and approval procedures need lead time; funds that flow only after the bottleneck do not close the gap.
• Overlooking earmarking. Grants approved for a development project may not simply be used for sales or market launch.

Frequently asked questions

How long does the valley of death last?

That depends on the business model. For software, the phase can span a few quarters; for hardware, medical technology or industrial applications with approval and certification steps, often several years.

How do investors recognise that a company is in the funding gap?

From the combination of a short runway, still low revenue and a funding need that exceeds the available funds. These quantities are asked about in the first conversation and in the review of the liquidity planning.

Is interim financing in this phase a warning sign?

Not necessarily. It depends on the occasion. Interim financing that funds a concrete, measurable milestone until the next round is assessed differently from one that merely buys time.

Can grants bridge the valley of death?

In part. Grants and the research allowance extend the reach without dilution, but are tied to particular projects and flow with a time lag after the application. They usually do not cover market launch and building up sales.

Where does the valley of death lie on the TRL scale?

Depending on the source, roughly between TRL 4 and TRL 7. At level 4, the technology is validated in the laboratory; at level 7, a prototype runs under operating conditions. In this stretch, classic research funding often runs out, while private capital still expects revenue evidence.

The Roemer Capital view

The companies we accompany in funding rounds from EUR 1 million have their product on the market and generate revenue. For them, it is about the last section of the funding gap: the round is meant to take the company to self-sufficiency or to the next milestone relevant for valuation.

We therefore size the round from the low point of the cumulative liquidity curve in the cautious case of the financial model, not from the amount that currently appears customary in the market. A round that ends just before this point leads to the next interim financing on less favourable terms.