Since startups are experiments to test innovative and often counterintuitive hypotheses, risk is an inherent part of the process. And risk here means the potential for failure.
Startup fail rates are high
But what does failure even mean in this context? The most intuitive definition of failure is liquidation. The new venture is dissolved and ceases to exist, with its assets converted into cash (if possible) and the proceeds are distributed to investors. Typically, investors don’t get a penny in recovery. According to Shikhar Ghosh, a senior lecturer at Harvard Business School, this type of failure spans 30 to 40 per cent of startups.
Under the most comprehensive definition of failure, “failing to see the projected return on investment – say, a specific revenue growth rate or date to break even cash flow – then more than 95 per cent of startups fail, based on Mr. Ghosh’s research.”
When a startup gets on the fundraising treadmill, they either get to the point of self-sustaining cash flow or they keep raising new funding. This gets progressively more difficult: “After analyzing over a thousand startups that raised seed funding, CB Insights (a market intelligence firm) revealed in a report that about 67 percent of the entities stall at some point in the venture capital (VC) process and fail to exit or raise follow-on funding.”
This stands in contrast to the conventional wisdom prevalent in the venture capital community: “The common rule of thumb is that of 10 startups, only three or four fail completely. Another three or four return the original investment, and one or two produce substantial returns. The National Venture Capital Association estimates that 25 to 30 per cent of venture-backed businesses fail.”
Ghosh is probably closer to the mark. The vast majority of exits are either in the form of liquidation or sales with disappointing outcomes. Unicorns are rare: “As startups proliferate in the tech world and shoot for the so-called unicorn status, the probability of such entities actually achieving the vaunted US$1 billion-plus valuation only stands at about one percent, according to CB Insights.”
Entrepreneurs can mitigate the risk of failure
CB Insights has written extensively about startup failure, analyzing post-mortem summaries of what went wrong.
We can distill these down to a set of categories of failure:
- Finance: running out of cash because the startup couldn’t raise it, couldn’t raise enough of it, or couldn’t raise it faster than they burned through it.
- Management: the wrong team, the wrong strategy, an inability to focus, poor leadership, an inability to recruit, disharmony, or burnout.
- Demand: inadequate demand, ineffective marketing, weak sales process, inability to listen to customers, poor market research, lack of responsiveness to consumer demand, too many pivots, too few pivots, poor timing, or the wrong business model.
- Product: a product that is too minimal, poor design, or legally vulnerable intellectual property.
Let’s review these in turn and consider ways in which the founding team can reduce or, at least, shape their exposure to the ways in which the startup can fail.
Startups fail when they run out of cash
Companies need cash to pay the bills — including employee compensation, taxes, rent, marketing, and product development costs.
There are two ways to get that money. You raise it from outside investors, or, in the context of running your business, you generate cash. Generally, this latter type is called positive free cash flow. It does not include cash inflows from debt or equity you may raise. Positive free cash flow is the surplus cash left over after you pay all your costs and obligations.
You can plow that free cash flow back into the business, investing in new staff or a new plant.
If operations are causing the company to burn through the cash in the bank, then it is said to have negative free cash flow.
Founders can raise cash from outside investors when they have either positive free cash flow or negative free cash flow. They must raise cash from outside investors if the rate at which negative free cash flow is consuming the bank balance is high enough.
Why would someone want to raise outside investment if they have positive free cash flow? It might make sense to do so either to speed up the date at which they can sell the firm and/or to make the ultimate sale larger. A smaller piece of a bigger pie can absolutely be larger. It can also be more attractive if you get it sooner.
One obvious way for a startup to fail is to have large negative free cash flow combined with an inability to convince outside investors to put money into their companies, or at least to inject capital at a rate that exceeds the speed at which the business is chewing through it.
Note also that companies with large negative free cash flow are always either preparing to raise funds or they are in the process of raising money. This can be indescribably distracting for management, a fact that may increase the rate at which they burn through their cash. Even worse, if the investors have bad ideas about how to run the business, founders may be forced to act on such advice.
Founding teams and the investors who back them need to balance the tradeoffs between cash burn and accelerated growth carefully, mindful of the shifting sands of early-stage capital markets. One way to get tripped up here is to assume that capital markets are continuously open, only for that door to shut quickly because of, say, a global financial crisis.
Startups fail because of weak management
Managing any business is difficult, but established firms have business processes, teams, and maturity working in their favour. The founders of a startup make up a small team who need to juggle multiple balls in the air with little support. They need a broad set of skills and the judgment to use them to maximum effect.
A key risk contributing to failure is lacking the right mix of human capital.
Judgment is a product of experience and skills accumulated over time through training and applied context, so it’s ironic that there is a cult of youth when it comes to startups. The preference in the mainstream press seems to be for a brilliant, single, callow iconoclast wearing a hoodie to the middle-aged team that has weathered multiple events.
Perhaps, we shouldn’t be surprised that the numbers tell a different story. Researchers at the MIT Sloan School of Management found, contrary to popular perception, that founders, on average, were actually middle-aged.
“The team looked at ages and startups in areas like California, New York, Massachusetts, and specifically Silicon Valley. The closest any founder’s age got to ‘young’ was in VC-backed firms, where the average age was 39 in New York,” the paper read. “Similarly, the average founder age for one of the ‘youngest’ technology sectors – in this case wireless telecommunications carriers – was 39 years old.”
“’In theory, we know that with age a lot of benefits accumulate,’ (MIT Sloan PhD student Daniel) Kim said. ‘For instance you get a lot of human capital from experience, you also get more financial resources as you age, as well as social connections, all of which will likely boost your odds of success as an entrepreneur.’”
For a startup management team to be strong, they require at a minimum the right people working on the problem. This means having the right people to design the experiment, but more fundamentally to pick an experiment that is more likely to succeed than not.
The founding team needs to be cohesive. Intra-team strife, when not addressed (or prevented in the first place with proper vetting), can be one of the most significant causes of startup failure.
Leadership is vital. The team needs to be motivated to work through extraordinarily difficult conditions, mindful of and bought into a well-positioned strategy, and confident in one another.
Culture is perhaps more important than strategy. Culture is the input to the phrase, “people like us do things like this.” What does it mean to say that we are people like us? How do we do things? Are we honest, kind, and generous with one another? Are we hard chargers with sharp elbows focused on nothing but the task at hand? Where a company falls on this spectrum can be the difference between robustness to shocks or brittle failure.
Sometimes, you hear the cliched phrase that “it comes down to execution.” Good management and strong leadership are necessary conditions for this.
Is the company’s process for identifying markets, and developing, producing, and selling products something that they can sustainably and profitably replicate?
Startups fail because the demand hypothesis was wrong
If customers don’t want to buy what the startup is selling, or if the startup can’t sell the product, then it will die, or at best struggle in a zombie-like existence of small scale.
The startup must be selling the right product at the right time to the right people. Marketing is about finding this “tribe” of people who are willing to experiment with change, at this moment in time.
A pivot is when a startup tries to sell a product, receives negative feedback, and then alters their approach in some way. They might change the product. They might change the way they sell it. Or they may change the target audience.
The ability to cycle through pivots to get to the point at which the product sells itself is critically important to entrepreneurial success.
This is easier said than done. It is possible to pivot too easily with a product that a target audience might be willing to buy if the team only gave the effort more time. Pivoting too frequently gets in the way of true market discovery.
Pivoting too late could mean that the startup keeps drilling dry holes, burning cash that could have been used to fund some potentially more successful alternative.
The startup might be trying to sell the right product but with the wrong business model. This is another way to get the demand hypothesis wrong.
A business model is the way in which a company earns revenue. There are many different kinds of business models.
Most companies charge for their products individually. If I buy an iPad from Apple, I pay for the device at the point of sale.
A subscription model is one in which the supplier sells a good or a service for a fixed monthly subscription fee. Netflix offers streaming media content as a service for a flat fee.
Another company might give away its service for free to its users while charging others for the right to access data and to present content to the users the company aggregates. This is the Facebook model.
Would Facebook have been able to succeed as much as it has if it had charged users a fee for being part of its social network? Arguably, this would have been the wrong business model for them to create the most value as a company.
Another way for startups to drop the ball is with what is referred to commonly as their “go-to-market strategy.” A go-to-market strategy describes the way in which they sell. Do they sell directly, by soliciting customers with email and phone calls? Do they sell passively, waiting for customers to come to them after consuming content on the company website or hearing about the offering by word-of-mouth? Do they sell indirectly, employing an army of resellers to bundle the company’s product along with other services, paying the reseller a commission for including their good or service in the package?
All of this takes place against a backdrop of alternatives with which the startup is competing. The most important competition the startup faces is the status quo. Why should the customer change? Does the startup provoke a potential group of users to change? How big could this group be?
Startups fail because the product was wrong
Does the company have the right product? Did they design the experiment correctly? This sounds obvious, but it’s a nuanced point.
In some markets, you can start the experiment with what is called a “minimum viable product:”
“A minimum viable product (MVP) is a concept from Lean Startup that stresses the impact of learning in new product development. Eric Ries defined MVP as that version of a new product which allows a team to collect the maximum amount of validated learning about customers with the least effort.”
Many startups focus on the word “minimum” in the term minimum viable product. They build something basic with limited functionality. It can be too basic, meaning that it does not generate the right kind of customer feedback. Theoretically, they should be iterating through different, more built-out versions of the product to get information about demand. But they may be discouraged to the point that they prematurely abandon something that could have had significant customer interest if they had been able to flesh it out.
In some industries, the concept of minimum viable product is effectively meaningless. Customers in these markets will not consider a product unless it is fully baked. This may be, for instance, because the consequences of failure are too high in a mission-critical business process.
A better concept may be the minimum delightful product:
“For consumer apps, I like to think about ‘minimally delightful product (MDP)’ instead of MVP. The reason for this is that in the consumer world ‘viable’ isn’t really compelling. It’s like someone in the ICU. They are alive, but not really fun to hang out with. Create a product with just enough features (lean) and the right UX to be delightful, and you’ll capture the passion of consumer users.”
(If this sounds like it’s an art form, you’re beginning to understand.)
In a world in which business applications are becoming more consumer-like in their user experience, this lesson applies broadly.
Design is increasingly important.
Finally, of course, there are instances in which intellectual property rights can be significant obstacles to startup success. We can imagine cases in which the startup failed to protect its rights to software developed by its employees, for example. Or cases in which it infringed upon the intellectual property of larger organizations willing to defend themselves.
Startups need to be sustainable to survive
Startups are in a race to develop a replicable process for satisfying demand they create for a novel product. This is a race against time to find and grow a tribe of customers who are willing and excited about the change the startup promises and delivers. There are myriad reasons for failure. But when it works, it is glorious.
This is the third of a series of articles about startups and venture capital, where we’ll explain some of the concepts people might see discussed in the press. We’d love to hear your feedback.