May 22, 2008

Why Startups Fail

An entrepreneur recently asked me why startups fail. Startups fail because they run out of money. You’re probably thinking, “Tell me something I don’t already know!” Read on and you’ll see that statement is deceptive in its simplicity

This post is based both on my experience as an investor and as entrepreneur (when I’ve boot-strapped and venture-funded).

They spend too much on sales and marketing before they’re ready. Many venture companies move to a high burn rate too quickly and it’s hard to go back. Sometimes even a frugal entrepreneur winds up spending too much either because he doesn’t manage the money or is tempted by having money in the bank. This often happens when a startup raises too much money too early.

Other times, this occurs with entrepreneurs who are accustomed to having lots of resources. They ramp up sales before the product is ready. Of course, there’s a lot of work required to get sales early on. But a product with a truly great value proposition that delivers in a measurable way will practically sell itself. Companies that ramp sales and marketing too soon waste a lot of money.

Sometimes even when the product is great, the sales process itself isn’t understood to a point where it can be scaled: who are you selling to, how much will they really spend, and what profile of sales person does the company need to hire who will succeed at selling that particular product. All of this has to be understood before sales can efficiently scale.

Spending on the sales and marketing operations means there is no return if customers don’t bite. When you spend money on the product that work can be leveraged in future versions. (In fact, the key to effective product delivery is to try a lot of things and see what sticks.) For every venture dollar invested, I estimate that more than two-thirds go into sales costs and only a third into product development. Once you up the burn rate, there’s no easy way back.

The market outpaces the startup’s ability to execute. When you’re in a race, the only thing that matters is winning. To win a race, you have to be the fastest.

In the case of the startup in a hot sector that means how fast do you make critical decisions, hire key personnel, and manage limited resources. If, on average, you’re slower or less efficient than your competitors, you’re very likely burning more cash than they are as well. The chief executive sets the pace. If the CEO dithers on important decisions — let’s say making key hires — it slows the whole operation.

Take Company X (a composite). Entrepreneur X caught a case of what I call “analysis paralysis.” He took 14 months to hire for a key position. At Stanford, my professors would ask: “Would you choose X or Y, or do you need more data?” Students often wanted more data. The professors would chuckle and call them on it: “There is no more data.” A simple, but valuable lesson: In the real world, you rarely have a complete picture. You have to work your hunches, draw on past experience and the available information. Unlike solving engineering problems, there is no perfect answer when it comes to hiring — you need to get all the data you can through references, interactions, and simulated projects, but ultimately it’s very subjective.>

There is no Entrepreneur. I know what you’re thinking, “Every startup has an entrepreneur.” What I mean is an entrepreneur with a capital “E.” Let me explain: A lot people have good ideas and some are even able to execute on them. But rare is the man or woman who can take an idea and transform it into a sharply defined product and then sell it to top-level prospective hires, investors and customers. An Entrepreneur as opposed to his lower-case counterpart is a product picker and a market visionary.

Company Y (a composite) was a startup with near-flawless execution but no clear vision. CEO Y tried his last company’s strategy and when it failed found himself at a loss for what to do. The company ran out of money and was forced to sell out for a pittance. Meanwhile, CEO Y’s main competitor was more nimble. He reacted quickly to market changes with a viable contingency plan and as a result sold his startup for many times that sum.

Without strong product and market vision, a startup will burn through cash as its team collectively struggles to define its position.

The market takes too long to develop. Often, entrepreneurs are ahead of their time. Customers are not ready to spend money on or change habits for unproven benefits. The company runs out of money waiting for the market to develop or it tries to start over, but it’s too late.

Company Z (a composite) had a compelling concept, but customers weren’t ready to buy in. CEO Z proposed a restart: Rather than sell to the market segment he was in, he would target a different market segment. As a result, he would significantly reduce Company’s Z’s sales and marketing expenses. Company Z was mildly successful with its new plan, but burned through lots of cash before it re-configured. My guess is that it will be bought for little more than the amount that’s been invested.

Risky Business
VC’s play a high-risk game. We have to identify opportunity and risk and then accept that a certain amount of that risk will result in failure. Venture capitalists lump failures into one of two categories.

A failure like Company Z’s: A startup that struggles in a market where everyone fails. Things look good, but ultimately mainstream customers or a large volume of users were unwilling to take a chance on a new concept. Skilled execution and a reasonable backup plan won’t compensate for a market that fails to develop as quickly as originally anticipated. Some entrepreneurs are able to switch markets completely early on — if they haven’t raised and spent too much cash. But in this scenario, all companies in the given market flounder or fail. It isn’t a desired outcome but it’s not for lack of trying.

The painful failures — those that keep me and other VCs I know up at night – are the investments that fail due to self-inflicted wounds. A competitor winds up owning what turns out to be a very large market. The other company simply moved faster and out-executed.

It’s not just how fast you run the race that matters. It’s how fast the race is run. When it comes to startups, speed wins. But if you’re still early, don’t increase your burn and overspend on sales and marketing before you’re ready. Sometimes you have to slow down to speed up.


  • [...] a good market and what makes a product truly great is critical. I first wrote about this theme in 2008. Brad Feld, Dave McClure and others weighed in on the highly controversial [...]

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