Why startups fail, according to company founders and investors


That won’t be me.

In the nearly two decades he’s spent teaching business-school students and aspiring entrepreneurs, Noam Wasserman has heard that phrase more times than he can count. Even if students aren’t so audacious as to say it out loud, he knows they’re thinking it.

Avoiding difficult conversations with your cofounder around splitting equity? Letting passion and excitement cloud your judgment? Few entrepreneurs believe it could happen to them — or that it could lead to the death of their startup.

Wasserman is the dean of Yeshiva University’s Sy Syms School of Business; he previously taught at Harvard Business School and the University of Southern California Marshall School of Business. Business Insider recently sat in on a Founder Bootcamp presented by the Yeshiva University Innovation Lab in New York City.

From 8 am to 4 pm, Wasserman ran through a deck on the science of startup success and paced between desks in a basement-level conference room, moderating the debates that sprung up between entrepreneurs in the crowd.

Some thought starting a company without cofounders was advisable; others disagreed. Some were convinced that a founding CEO should see the company all the way through an exit; others were open to the possibility of replacing that person.

Above all, Wasserman advised the entrepreneurs present to look at case studies in which founders ran into problems and to consider how they’d handle the situation. Simply by acknowledging the risk of startup failure, they’re arming themselves against it.

In fact, Wasserman said, a simple motto can keep entrepreneurs on their toes as they review the challenges that other startups have faced.

When this is me.

Most startups fail

It’s hard to measure precisely the rate of startup failure.

The number is high, but probably not quite as high as you think. Global investment firm Cambridge Associates tracked about 27,000 venture investments between 1990 and 2010 and found that the rate of startup failure (defined as companies that provide a 1X return or less to investors, though VCs typically want much higher returns than that) has not increased beyond 60% since 2001.

And according to the US Small Business Administration, about half of businesses with employees survive at least five years.

Yet a single startup’s failure can have powerful ripple effects beyond the founder’s personal disappointment. As Business Insider’s Paige Leskin reported, Pitchbook data found that just 12 startups that failed in 2018 took $1.4 billion in venture-capital funding with them. That’s because VCs have to bet widely, knowing that few if any of their portfolio companies will produce the desired return.

And depending on how far a startup has progressed, an entire team of people may lose their jobs.

Read more: The startup founder’s guide to letting people go efficiently and compassionately

So, how do you prevent (or at least minimize the risk of) startup implosion? Business Insider spoke to several founders whose companies have failed, as well as investors and business professors. In exclusive interviews, they told us about the biggest factors affecting startup death.

Our sources include:

  • Henry Ward, founder and CEO of Carta, a platform for buying and selling shares in private companies. Ward previously founded Secondsight, a suite of investment tools that failed when he wasn’t able to raise a seed round.
  • Brian Scordato, founder of Tacklebox Accelerator, a program for founders who haven’t yet quit their day jobs. Scordato is also the founder of three other startups, including a dating app and a recruiting platform for college basketball, that are no longer operating.
  • Coleman Greene, founder of Sqord, a Techstars company that used technology to encourage kids to stay physically active. Sqord was purchased by Good Parents Inc/Kiddowear in 2019. Greene called this an ” acquihire,” an alternative to a wind-down that means the company was valuable for its team and not the actual product.
  • Sahil Lavingia, founder and CEO of Gumroad, an e-commerce platform for artists and creators. Lavingia bought back his company from most of his investors and is no longer venture-backed.
  • Daniel Ahmadizadeh, cofounder of Riley, a Y Combinator company that helped real-estate agents follow up with and maintain clients. Riley shut down in 2019.
  • Tristan Mace and Scott Howard, founders of retail tech company Margin, which shut down in 2019.
  • Patrick McGinnis, managing partner at the investment and advisory firm Dirigo Advisors.
  • Orla Byrne, lecturer in entrepreneurship and strategy at University College Dublin.
  • Ronald Mitchell, a professor of entrepreneurship at Texas Tech University.

Read on to learn about the most common causes of startup death — and how to avoid them.

The problem: Thinking you’re the next Steve Jobs

Entrepreneurs have a tendency to be overly optimistic about their chances of success, research suggests. It’s part of what keeps them going in the face of tremendous adversity — and part of what makes them attractive to VCs.

As Andreessen Horowitz managing partner Scott Kupor previously told Business Insider, he’s actively looked for founders who were so confident in themselves they were willing to “walk through walls and do something that everybody has told them to their face is a waste of time or can never happen.”

Read more: The first-time founder’s ultimate guide to pitching a VC

But this heightened sense of optimism and confidence can also work to entrepreneurs’ detriment.

It goes back to Wasserman’s observation: When founders hear about mistakes that other founders have made, they assume they’d never fall into a trap like that. And so they ignore valuable lessons that could save them time, money, and effort down the road. Or maybe save their business.

The experts’ solution: Pay close attention to patterns in startup failures

A growing body of evidence suggests that you can learn to be a successful entrepreneur (or investor, for that matter) by studying patterns in the failures of other entrepreneurs.

For example, Mitchell, the Texas Tech professor, scoured the entrepreneurship literature and identified six key factors behind startup death: failure to innovate, create value, persist over time, make the utmost of scarcity, defend against people stealing your results, and remain flexible.

In a 2003 paper published in the Journal of Private Equity, Mitchell reports that when VCs applied a mathematical model using this six-attribute framework, the percentage of correct investment decisions was 65%, versus 52% when they relied on their own intuition. (In the context of this particular study, a correct investment decision meant backing a business that achieved profitability and still existed within five years.)

McGinnis’ experience as an investor has showed him that many startup founders — secretly or not no secretly — see themselves as the next Steve Jobs. What they don’t realize, McGinnis said, is that Jobs was more capable than the average entrepreneur.

So remember: Even if you learn from stories about Jobs, McGinnis said, “there’s a bunch of things he never had to deal with that you probably will mess up.”

The problem: Dismissing interpersonal issues as trivial

At the Founder Bootcamp, Wasserman suggested that people problems — i.e., issues within the founding team or between founders and investors — are the leading cause of startup failure. That’s according to his own research on more than 6,000 startups and 16,000 founders since the year 2000, plus other studies he cited during the Bootcamp.

In particular, anyone starting a business with friends and family should know how risky it is.

As many as 55% of entrepreneurs in Wasserman’s sample started companies with someone they knew. Yet Wasserman’s research also suggests these partnerships tend to be the least stable founding teams. Partnerships between acquaintances or strangers (i.e., people you barely know), on the other hand, tend to be the most stable.

That’s largely because friends and family often avoid important but tough business conversations (like splitting equity) for fear of damaging their personal relationships. When they finally do confront these issues, it’s typically too late. Acquaintances, on the other hand, don’t have to worry about damaging their bond because they don’t currently have one.

The experts’ solution: Understand and address people dynamics as early as possible

If you understand and address people issues early on, Wasserman said, you can prevent major problems as your company grows.

And if you’re cofounding with friends and family, be sure to have those tough conversations before signing any contracts. Wasserman recommended planning for different scenarios in advance, and outlining those provisions in your equity ownership agreement.

For example, if one founder isn’t able to contribute as much time or energy to the company as the other founders, they might lose a certain amount of equity in the business.

The problem: Blindly pursuing your passion

Sahil Lavingia, CEO of Gumroad, bought back his company from investors.
Courtesy of Sahil Lavingia

Passion — defined as positive and intense feelings about something meaningful — helps an entrepreneur weather the inevitable low points in their career. But it can also work to their detriment. That’s because passionate founders are more likely to make irrational business decisions.

Ward learned that lesson the hard way. Before Carta, he studied market finance and ran a failed finance company: a suite of investment tools called Secondsight.

In an email to Business Insider, Ward wrote: “Secondsight was built from my imagination and then presented to customers that I assumed would be interested. They weren’t.” That is to say, Ward’s excitement about the idea led him to misjudge the market opportunity.

The experts’ solution: Balance passion with preparation

Ward took a markedly different approach when building Carta.

“I embraced lean, iterative development, and even talked to customers before we wrote any code at all,” Ward wrote. He continued to maintain a “tight feedback loop” with customers, to make sure the product was in fact something they would use.

Ward also took the time to learn about product development. He spent the first two years at Carta “really learning how to build product and surrounding myself with product-oriented people,” including investors and early employees.

The problem: Not having enough experience

An entrepreneur may inspire people with their passion. But in order to successfully execute on an idea, they still need industry knowledge or experience.

McGinnis said he’s seen plenty of entrepreneurs forge ahead with a “passion project” in an area where they have minimal expertise. Maybe they love food, so they open a restaurant. “But if you’ve never worked in the restaurant industry,” McGinnis said, “your chances of success are far lower than they should be.”

Sure, an industry outsider can sometimes bring in a much-needed fresh perspective. But McGinnis thinks that scenario is the exception, not the rule. In fact, a 2018 working paper by MIT researchers found that the most successful entrepreneurs are in their 40s, largely because they’ve built up enough relevant work experience.

Read more: The glitz of ‘entrepreneurship porn’ leads startup founders to make fatal business mistakes. Here’s how to avoid them

The experts’ solution: Leverage the knowledge and skills you already have

You don’t necessarily have to wait until your 40s to start a company. The takeaway here is that your chances of success are higher if you know a lot about the area you’re working in.

When Scordato selects founders for Tacklebox, his startup accelerator, he looks specifically for people who have developed deep domain expertise over the course of their career. He’s especially impressed by founders who have some unique experience — for example, if you’re one of the only finance professionals who has traded a specific derivative.

Read more: The ultimate guide to figuring out how (and if) you should start your own company

“You should have been subconsciously preparing to build this company for a long time,” Scordato said in a previous interview with Business Insider, “in a way such that your skill sets and knowledge bases have already distanced you from any competition.”

The problem: Getting attached to your hypotheses

Daniel Ahmadizadeh, founder of Riley, which shut down in 2019.
Courtesy of Daniel Ahmadizadeh

As a startup founder, you don’t want to get overly attached to any particular business hypothesis.

Daniel Ahmadizadeh made that mistake at real-estate tech company Riley. In a letter to investors that he reproduced in a LinkedIn blog post, Ahmadizadeh said the company initially grew fast, but wasn’t able to maintain customers. Riley would have done better to zero in on the sliver of real-estate agents who did stick with the product and figure out how to best serve them, Ahmadizadeh wrote.

Ahmadizadeh told Business Insider that too many founders get stuck on a hypothesis about what customers want and how they can best provide that. Even when their hypothesis is proved false, they stick with it.

The experts’ solution: Take a scientific approach

Ahmadizadeh said early-stage founders should be running tons of experiments — and taking the results seriously. That might mean organizing focus groups to see whether your product is a bigger hit with, say, urban millennial dads or urban millennials without kids (or neither).

“What’s most important is to get to a conclusion as quickly as possible,” Ahmadizadeh said. “It’s not really a positive or negative conclusion. It’s just like a science project.”

Scordato, the founder of Tacklebox, said the most successful founders look at the data, see what resonated, “and then focus very, very intently on that.” You can think of it as a more extreme version of the Pareto Principle, or the idea that 20% of your efforts produce 80% of your results — so you’d be wise to focus on the 20% activities and ignore the rest.

The problem: Not being able to meet VCs’ standards

Once you take money from investors, you’re committing to meeting their expectations about the company’s growth — specifically, that you’ll return their money many times over. It’s better to realize before you raise venture capital that this isn’t the type of company you’re building.

Lavingia came to this realization too late.

In a Medium post, Lavingia describes Gumroad’s evolution: At 19 years old, he raised capital from top VCs and saw success with the e-commerce platform. But then growth stalled. His investors lost money.

Lavingia decided that, instead of shutting down the company entirely, he and his team would seek to become a profitable “lifestyle business,” which can sustain itself without venture capital (and probably won’t ever become a unicorn). He’s since bought out the majority of his investors.

Today, Lavingia told Business Insider, Gumroad is hitting about $5 million in annual revenue and growing at a rate of about 40% per year — which is to say, it’s still creating value for customers.

Riley, which raised $3.1 million in a seed round, also failed as a venture-capital investment, Ahmadizadeh said. It “ended up not being able to scale at the rate that is required to be venture-backed.”

Ahmadizadeh made the decision to wind down Riley; in the letter to investors, he said he hoped to return 20% of their initial investments.

The experts’ solution: Think carefully about raising venture money

Approaching your startup like a “business-school case,” in Lavingia’s words, can save you a lot of stress in the long run.

Specifically, Lavingia wishes he’d laid out a concrete business plan for Gumroad: “Within a year, within two years, within three years, these are the metrics that we need to hit in order to build a billion-dollar company.” And just as importantly: “These are the ways that we’re going to check each of these assumptions and make sure that it’s true until we move onto the next step.”

Had Lavingia taken these precautions, he might have realized he wasn’t building a billion-dollar company — and might not have raised venture capital in the first place.

Ahmadizadeh also wishes he’d considered the downsides of raising venture capital.

Riley was “a very good small business, a profitable small business,” he said. But because he’d raised millions in venture dollars, he couldn’t, say, sell the company for $1 million when things got challenging. “It was all about growth, fast growth,” Ahmadizadeh said, “but that’s what we signed up for.”

Read more: The ultimate guide to selling your startup for a boatload of cash, from founders who sold their startups for billions

The problem: Ignoring scary numbers

Coleman Greene, founder of Sqord, which was sold in 2019.
Courtesy of Coleman Greene

According to tech market intelligence platform CBInsights, the No. 1 cause of startup failure is not having a strong market need for the product or service. (That’s based on 101 startup failure post-mortems by founders and investors.)

Oftentimes that’s not because the founder didn’t analyze the market; it’s more because they chose to ignore what they saw.

Take it from Greene, who said that his experience at Sqord taught him the importance of being honest with yourself about the company’s future.

Sqord raised a total of $5.2 million, then ran into trouble when they couldn’t prove to investors that they’d built a sustainable enterprise model (i.e., selling their products to large companies). Ultimately, they sold the company to one of their customers in an acquihire, which is sometimes referred to as a ” soft landing” for a struggling startup.

The experts’ solution: Be honest with yourself

Don’t just look for “the metrics you’re going to put in your next pitch deck,” Greene said — i.e., the impressive stuff. “Make sure that you’re really taking a deep look at all the good and the bad that’s emerging from what you guys are building.”

McGinnis, for his part, has seen far too many founders focusing on “vanity metrics,” like their Instagram followings and press mentions. “Unless you’re selling any products,” McGinnis said, “it really doesn’t matter.”

Even founders who did put together a business plan start to “forget” how they defined success, McGinnis added. They “start re-forecasting if they fall behind.”

That’s partly because confronting reality can raise some uncomfortable questions. McGinnis offered an example: “If your goal was to create a $100 million business and now you find out that your business could only probably be a $5 million business, is it still worth it to you? And what should you do about that?”

What to do if you think your business is failing

Consider cutting your losses

As a startup scales, founders can fall prey to the sunk-cost fallacy, a term social scientists use to describe the tendency to stick with something just because you’ve already invested considerable resources in it. It’s the classic case of “throwing good money after bad,” like paying, yet again, to get an old, failing car repaired. Even if you know on a rational level that your company isn’t working out, it’s tempting to stay the course.

The story of Margin is a prime example of this phenomenon.

As cofounder Mace details in a blog post, Margin, the retail tech company, released its MVP just as credit-card companies started cutting card benefits. Margin then pivoted to an email-alias product, but by that time they didn’t have the resources to sustain the company, and they shut it down.

Even though Mace and cofounder Scott Howard could see initial signs that the card-services industry was going to implode, they kept trying to make their product a hit.

“At the time, we were convinced that partnering with industry players was the best path for the company’s success,” Mace and Howard wrote in an email to Business Insider, referring to their partnerships with people like the former CEO of Saks Fifth Avenue and the cofounder of Gilt Groupe. “The reality is that partnerships with the world’s biggest financial companies takes lots of time — time that startups don’t have — and we failed to suspend that disbelief with ourselves.”

A second fundraising round fell apart, Mace wrote in the blog post, and Margin didn’t have enough capital to survive.

Get outside counsel

Byrne, the University College Dublin lecturer, helped explain why founders have a hard time being objective about their business: “You’ve invested so much to get this baby established, up off the ground, and grown.” When you see market data that doesn’t line up with your vision for the company, it can be hard to reconcile the two.

What’s more, most companies go through rough patches and pull through. It can be difficult to know, Byrne said, “whether something just requires resilience, versus pulling the plug.”

Still, Byrne added, “Every entrepreneur I’ve spoken to has said they regretted not making the decision to close their business sooner.”

One way to avoid this mess is to get impartial advice. Byrne recommended looking for someone who “understands business thoroughly” and is as objective as possible when it comes to your startup’s fate. Where you might find it difficult to honestly assess your company’s progress, that person might say, “Look, this is what’s really happening here.”

Keep the interests of your employees, investors, and customers in mind

As much as your startup is your baby, you’re not the only person with a vested interest in seeing the company succeed. Keep in mind that your employees, your customers, and your investors (if you have them) will also be hurt by the company’s failure.

McGinnis has seen too many founders forget this part. If you’re having trouble raising additional capital or you’re running out of money, you must plan for your company’s failure.

“Don’t just run it to the point where you have no money left, because then you can’t wind down the company appropriately because you won’t have the money to do so,” McGinnis said. Specifically, you won’t be able to offer your employees’ severance pay. “Always have a cushion of capital there to unwind the company.”

Lavingia said he had his customers’ best interests in mind when he declined to shut down Gumroad entirely. He imagined telling his customers he was shutting down because he wasn’t able to fulfill his dream of building a billion-dollar company — even though the company was profitable and customers were making money. And he imagined those customers outraged, saying, “What the hell?”

You might also consider returning your investors’ money if things aren’t working out — something that McGinnis has seen happen just twice in his career.

McGinnis said leaving everyone in the lurch is generally a bad look; it “reflects poorly upon your investors and the other people that are part of your company.”

But there’s also a practical reason not to act selfishly: You might start another company some day. “If you screw people over,” McGinnis said, “you inhibit your chances of getting those same people to work with you in the future.”



Source link Businessinsider.com

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