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5 Reasons Startups Fail

By David Skok 99

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2.7KSHARES
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Reason 1: Market Problems

A major reason why companies fail, is that they run into the problem of their being little or no
market for the product that they have built. Here are some common symptoms:
 There is not a compelling enough value proposition, or compelling event, to cause the buyer
to actually commit to purchasing. Good sales reps will tell you that to get an order in today’s
tough conditions, you have to find buyers that have their “hair on fire”, or are “in extreme
pain”. You also hear people talking about whether a product is a Vitamin (nice to have), or
an Aspirin (must have).
 The market timing is wrong. You could be ahead of your market by a few years, and they
are not ready for your particular solution at this stage. For example when EqualLogic first
launched their product, iSCSI was still very early, and it needed the arrival of VMWare
which required a storage area network to do VMotion to really kick their market into gear.
Fortunately they had the funding to last through the early years.
 The market size of people that have pain, and have funds is simply not large enough

Reason 2: Business Model Failure

As outlined in the introduction to Business Models section, after spending time with hundreds of
startups, I realized that one of the most common causes of failure in the startup world is that
entrepreneurs are too optimistic about how easy it will be to acquire customers. They assume that
because they will build an interesting web site, product, or service, that customers will beat a
path to their door. That may happen with the first few customers, but after that, it rapidly
becomes an expensive task to attract and win customers, and in many cases the cost of acquiring
the customer (CAC) is actually higher than the lifetime value of that customer (LTV).

The observation that you have to be able to acquire your customers for less money than they will
generate in value of the lifetime of your relationship with them is stunningly obvious. Yet despite
that, I see the vast majority of entrepreneurs failing to pay adequate attention to figuring out a
realistic cost of customer acquisition. A very large number of the business plans that I see as a
venture capitalist have no thought given to this critical number, and as I work through the topic
with the entrepreneur, they often begin to realize that their business model may not work because
CAC will be greater than LTV.

The Essence of a Business Model

As outlined in the Business Models introduction, a simple way to focus on what matters in your
business model is look at these two questions:

 Can you find a scalable way to acquire customers

 Can you then monetize those customers at a significantly higher level than your cost of
acquisition

Thinking about things in such simple terms can be very helpful. I have also developed two
“rules” around the business model, which are less hard and fast “rules, but more guidelines.
These are outlined below:

The CAC / LTV “Rule”

The rule is extremely simple:

 CAC must be less than LTV

CAC = Cost of Acquiring a Customer
LTV = Lifetime Value of a Customer

To compute CAC, you should take the entire cost of your sales and marketing functions,
(including salaries, marketing programs, lead generation, travel, etc.) and divide it by the number
of customers that you closed during that period of time. So for example, if your total sales and
marketing spend in Q1 was $1m, and you closed 1000 customers, then your average cost to
acquire a customer (CAC) is $1,000.

To compute LTV, you will want to look at the gross margin associated with the customer (net of
all installation, support, and operational expenses) over their lifetime. For businesses with one
time fees, this is pretty simple. For businesses that have recurring subscription revenue, this is
computed by taking the monthly recurring revenue, and dividing that by the monthly churn rate.

Because most businesses have a series of other functions such as G&A, and Product
Development that are additional expenses beyond sales and marketing, and delivering the
product, for a profitable business, you will want CAC to be less than LTV by some significant
multiple. For SaaS businesses, it seems that to break even, that multiple is around three, and that
to be really profitable and generate the cash needed to grow, the number may need to be closer to
five. But here I am interested in getting feedback from the community on their experiences to
test these numbers.

The Capital Efficiency “Rule”

If you would like to have a capital efficient business, I believe it is also important to recover the
cost of acquiring your customers in under 12 months. Wireless carriers and banks break this rule,
but they have the luxury of access to cheap capital. So stated simply, the “rule” is:

 Recover CAC in less than 12 months

Reason 3: Poor Management Team

An incredibly common problem that causes startups to fail is a weak management team. A good
management team will be smart enough to avoid Reasons 2, 4, and 5. Weak management teams
make mistakes in multiple areas:

 They are often weak on strategy, building a product that no-one wants to buy as they failed
to do enough work to validate the ideas before and during development. This can carry
through to poorly thought through go-to-market strategies.
 They are usually poor at execution, which leads to issues with the product not getting built
correctly or on time, and the go-to market execution will be poorly implemented.
 They will build weak teams below them. There is the well proven saying: A players hire A
players, and B players only get to hire C players (because B players don’t want to work for
other B players). So the rest of the company will end up as weak, and poor execution will be
rampant.
 etc.

Reason 4: Running out of Cash

A fourth major reason that startups fail is because they ran out of cash. A key job of the CEO is
to understand how much cash is left and whether that will carry the company to a milestone that
can lead to a successful financing, or to cash flow positive.

Milestones for Raising Cash

The valuations of a startup don’t change in a linear fashion over time. Simply because it was
twelve months since you raised your Series A round, does not mean that you are now worth more
money. To reach an increase in valuation, a company must achieve certain key milestones. For a
software company, these might look something like the following (these are not hard and fast
rules):

 Progress from Seed round valuation: goal is to remove some major element of risk. That
could be hiring a key team member, proving that some technical obstacle can be overcome,
or building a prototype and getting some customer reaction.
 Product in Beta test, and have customer validation. Note that if the product is finished, but
there is not yet any customer validation, valuation will not likely increase much. The
customer validation part is far more important.
 Product is shipping, and some early customers have paid for it, and are using it in
production, and reporting positive feedback.
 Product/Market fit issues that are normal with a first release (some features are missing that
prove to be required in most sales situations, etc.) have been mostly eliminated. There are
early indications of the business starting to ramp.
 Business model is proven. It is now known how to acquire customers, and it has been
proven that this process can be scaled. The cost of acquiring customers is acceptably low,
and it is clear that the business can be profitable, as monetization from each customer
exceeds this cost.
 Business has scaled well, but needs additional funding to further accelerate expansion. This
capital might be to expand internationally, or to accelerate expansion in a land grab market
situation, or could be to fund working capital needs as the business grows.
What goes wrong
What frequently goes wrong, and leads to a company running out of cash, and unable to raise
more, is that management failed to achieve the next milestone before cash ran out. Many times it
is still possible to raise cash, but the valuation will be significantly lower.

When to hit Accelerator Pedal

One of a CEO’s most important jobs is knowing how to regulate the accelerator pedal. In the
early stages of a business, while the product is being developed, and the business model refined,
the pedal needs to be set very lightly to conserve cash. There is no point hiring lots of sales and
marketing people if the company is still in the process of finishing the product to the point where
it really meets the market need. This is a really common mistake, and will just result in a fast
burn, and lots of frustration.

However, on the flip side of this coin, there comes a time when it finally becomes apparent that
the business model has been proven, and that is the time when the accelerator pedal should be
pressed down hard. As hard as the capital resources available to the company permit. By
“business model has been proven”, I mean that the data is available that conclusively shows the
cost to acquire a customer, (and that this cost can be maintained as you scale), and that you are
able to monetize those customers at a rate which is significantly higher than CAC (as a rough
starting point, three times higher). And that CAC can be recovered in under 12 months.

For first time CEOs, knowing how to react when they reach this point can be tough. Up until
now they have maniacally guarded every penny of the company’s cash, and held back spending.
Suddenly they need to throw a switch, and start investing aggressively ahead of revenue. This
may involve hiring multiple sales people per month, or spending considerable sums on SEM.
That switch can be very counterintuitive.

Reason 5: Product Problems

Another reason that companies fail is because they fail to develop a product that meets the
market need. This can either be due to simple execution. Or it can be a far more strategic
problem, which is a failure to achieve Product/Market fit.
Most of the time the first product that a startup brings to market won’t meet the market need. In
the best cases, it will take a few revisions to get the product/market fit right. In the worst cases,
the product will be way off base, and a complete re-think is required. If this happens it is a clear
indication of a team that didn’t do the work to get out and validate their ideas with customers
before, and during, development.

Business ModelStartup Help

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ABOU T TH E AU TH OR

David Skok

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