We pick this up where we left off in Part #5….why do startups fail? You will notice (I trust) that the very questions raised, propositions made, provide the answers as well. Perhaps I should have said some thing to this effect, “Startups: Part #6, Anatomy of Failure and Suggested Remedies”. I didn’t, deliberately. Anyway, semantics…so moving right along….
Amol and I were with a leading captain of industry, and an authority on the Startup ecosystem, just this past Monday, and the discussion centred around the rather vexatious subject. We discussed Scale challenges, operational challenges, skill challenges. We also discussed specifics about how certain well-known Private Equity, Venture Capital firms were struggling, and were facing serious challenges in finding viable exits or the ability to cash out.
The stats (75%+ failure rate as alluded to in earlier articles) are so appalling, that it kinda forces one to wonder why the Startup ecosystem attracts the kind of money it does, locally, regionally and globally.
It also makes one wonder that with the kind of money thrown into Startups, there would be effective checks, balances, systems and processes in place to ensure judicious investments, effective monitoring and efficient exit strategies. Perhaps I’m wrong, however the failure rate certainly doesn’t lend any credence to the popular belief that checks and balances are in place. Perhaps check and balances are in place, but they aren’t followed stringently?
Chatter on the net paints a fairly sordid picture, and what we are hearing isn’t looking pretty.
Discussions and/or debates on this subject tend to be pretty long-winded, even heated and acrimonious. There are a million opinions and then some, so I will present the topic the only way I know how. Go to the brass tacks, and not dwell on the esoteric valuation methodologies, techniques and such. Heaven knows how the 10x, 20x and 30x valuations even come into the picture, and that too shortly after the first round of funding. Smell an exit rat? These are financial specialists we are taking about, and they known their numbers, nay… they live, breathe and sleep the numbers game.
So then why?
Power of Two
There are only two types of money…..money from my pocket and money from someone elses pocket.
There are two types of entrepreneurs, those that are looking at staying invested, growing the company organically, creating wealth and value, and eventually letting the successful business model, based on good ‘ole business principles, of unit costs and unit profits drive the valuations, and eventually the exit.
Then there are others who are looking to exit at a valuation that is x times y, and not really focus on organic principles. The ones looking to exit are the Promoters and the Investors alike, so on several accounts, they are collaborators, insofar as it comes to exists at unrealistic levels.
Both models do work, but the risk of failure is far higher in the case of those ventures that are merely looking to ride the valuation wave to make a killing.
Anatomy of Failure
What emerges then is that businesses fail because of several reasons, and as you read on, be warned, the list isn’t brief.
Failure to Scale
We hear that failure to scale seems to be a rampant and serious issue. More often than not, initial predictions of growth numbers in terms of value and scale, remain just that, predictions, and when the rubber hits the road, the actual doesn’t even come close to the projections. Possible reasons?
- Overly optimistic projections on the part of Promoters, when formulating their financial models, as they are far too subjective about their pet ideas. I mean, owning the space and passion are all good things, but not to the extent that you fall by the wayside on account of this obsessiveness.
- Overly aggressive projections, as Promoters are almost compelled to conjure up big numbers to attract any serious interest from the Investing community.
- Lack of adequately skilled resources.
- Absence of appropriate processes.
- These are but examples, more on this later.
Behaviour – Cash Tends to Burn Faster Post Funding
Sure Startup funding is based on the fact that cash burn will take place, however, the velocity of the burn seems to accelerate once funding has come in.
Perhaps this happens due to the fact that in the early or pre-funding stage startups use bootstrapping as a fundamental basis of startup operations and practice acute cost containment. Post funding that mostly gives way to the loosening of purse strings. We aren’t playing with our own cash now, are we? I daresay this is not in the nature of blowing up cash, but rather is using Business Development as the basis of expenditure.
It’s easy to burn substantial amounts of cash, and quickly at that, on air travel, star hotels, entertainment, all falling nicely within the head of expense called Business Development Cost, which is something that is difficult to monitor closely, and indeed curtail, as this is how the numbers will come in.
The honeymoon period is probably when it begins to go awry, for this is when both the Investor and the promoter are inclined to consummate the relationship.
Investors assume, incorrectly at times, that promoters are specialists and know their markets and products, and as time passes, there is discovery that this may indeed not the case. I’ve seen so many businesses, products and services built up in silos, and not aligned to market need. In far too many instances, entrepreneurs have had a certain experience when they have had jobs, and tend to build their Startup business model based on just this one experience. Realisation comes a tad too late and quicker than you can say “Jack Rabbit”, money has been burned and not much to show in terms of reciprocation. By the time Investors realise that something is awry, it’s usually far too late. Cash has burned, results aren’t as predicted, there is a cash crunch, and the mad scramble to get cash at any means begins.
Cash needs or cash burn are so often underestimated, and in reality the level of funding initially taken up, falls far short of the actual genuine cash requirements. By the time Series A funding comes up, Promoters are so starved for cash, that they are almost prepared to agree any terms put forth by Investors.
Now I’ve put together realistic financial plans for a few startups, and in several cases the advisors look askance and almost demand that the numbers are inflated 2x or even 3x. The reasons are not far to seek. The effort and costs to assess, appraise, invest and monitor smaller ventures and bigger ventures is similar, therefore, the VC’s naturally tend to focus on those Ventures that talk big numbers. Effectively the larger and smaller Startups are fishing for cash in the same pond.
This drives a certain behaviour, both, from Investors and Promoters. The Promoter wanting a toe in the VC door and the Investor passing over the smaller tickets. Therein lies the recipe for disaster?
The bigger the ticket the bigger the fee for the intermediaries, and for the Investors the lesser the number of Portfolio companies to monitor. Typically the thumb rule is that for VC/PE’s to look at a proposition, it should be in the region of USD 8-10 million, give or take. To make the cut, Startups requiring smaller financial backing, will inflate the numbers to be considered as viable propositions.
Governance, Governance, Governance.
To say that Governance is the primary key to success would be the understatement of the century.
Board of Directors & Board Meetings
Mere decoration or namesakes in terms of appointment of luminaries on the Board of Directors is usually what transpires. The BoD is where the cold hard questions are asked, or are they? In plenty of cases they aren’t! Why? Simply because what ends up happening is that the Board ends up being constituted by Promoters, their well wishers and Investors and/or their nominees. When push comes to shove, there is usually a polarization between the Promoters and well wishers on the one hand, and the Investors and their nominees on the other hand.
Recording of dissent is as important as recording of decisions taken in the Minutes of Board Meetings. I’ve seen meetings being completed in a record fifteen minutes! Agreement, debate and dissent are equally important, yet what happens oftentimes is that minds are not spoken, voices aren’t voiced, and a concerted effort is made to keep the proceedings “amenable”. This is probably the worst possible thing that can happen, and is at cross purposes to the very idea of constitution of a suitable Board.
Business & Operational Challenges
Sales Exert Undue Pressure – Compromises Galore
Startups are always under pressure to bring in sales, and more often than not, Product is rolled out with known gaps, and the cost of implementation as initially budgeted, blows into astronomical time and cost overruns.
Product & Service Compromises
Well laid Roadmaps fall by the wayside, and features are prioritized based on preferences of the potential new orders. Result? Compromised product design, temporary solutions, and the very Product that was to come out, does come out, but in a form that is often unrecognisable from the initial designs.
The level of design and build compromise is further compounded when combined with the compromises made during the sales cycles. Sales teams in any case promise the earth, moon and stars, even in mature organisations, so imagine the promises made when selling products and services on behalf of a startup that just has to bring in the numbers for their very survival?
People: Talent, Skills, Teamwork, Performance, Retention.
That Startups struggle with hiring top talent and end up with second and even third string players is known, so to expect peak performance is fallacy itself.
A glaring lack of skills within the Promoter organisations. Most Promoters tend to be technocrats, therefore certain skills tend to scarce within the organization. The gaps will almost certainly be within Business Development, Operations, Finance, Legal and People teams.
To my mind one of the biggest reasons why Startups fail is because they fail to build well oiled teams, and there are glaring imbalances. The top teams, mostly at a Promoter level tend to be focussed, driven and competent, but that doesn’t cascade down the ranks.
When managements throw money at key resources, far in excess of their worth, they end up creating disparities and discord amongst the team. Not only that, titles and designations are thrown around as part of retention strategy, and we end up calling less than capable resources by fancy titles.
Effectively, we are creating a double whammy. Not only are we setting up people to fail as leaders, we are also rendering them unemployable elsewhere, thus compelling them to remain in the system via any means possible. This only leads to inefficiencies.
The mad race to succeed creates a huge work-life imbalance and more often than not leads to burnout. For some reason or the other, what should have been fleet-footed and nimble becomes rigid and inflexible.
Conventional means of sourcing may not work. With heavy hitters reluctant to leave lucrative and secure jobs, managements tend to fall back on past relationships to resource and to sell. The actual depth of the issues faced tend to be withheld from potential hires, or a rosy picture is painted on spreadsheets, as inducement to come on board. The result then, when things go awry? Ill will, diminishing morale, sullied relationships and finally resource and customer attrition.
Resource turnover is a drain even on the most efficient organisations, and for Startups this is disaster.
Weak Processes (Lack of Transparency): People, Operations, Sales, Finance
Lean and Mean, Do More with Less, Stretch Targets, Fly by the Seat of the Pants. These are great principles to abide by when running a company, but all too often, these very principles tend to do companies in.
From an Indian standpoint, the very nature of tech resources being immature, and closed-minded, means that technical knowledge is concentrated in the hands of a few, and if handover are in question, then what you’re going to end up with is glaring gaps in technical knowledge amongst the incumbents.
Combined with the lack of processes, even simple and obvious processes as handing over when people leave, then this is almost a death knell.
Lack of investment in automation, is a big contributor, and when basic development and delivery processes, such as QC and Testing are compromised, what you’re going to end up with is shoddy quality.
When this happens, the product that hits the market, one that smelled of roses at the drawing board stage, starts emanating a stink during implementation and rollout. Cash flows are adversely impacted and everything is now urgent, and there is no longer a distinction between urgent and important, tactical and strategic.
Startups tend to live in a constant state of crisis, since they aren’t meticulously planned, inadequately funded, lack appropriate resources, and seldom heed to sound advise.
Promoter Behaviour & Competency
Entrepreneurs can be an arrogant bunch, brimming with overconfidence, and seem to carry this “I know best” attitude, and are not amenable to counsel, when counsel is the very thing needed during the early days. Promoters can be so rigid that this rigidity becomes the bane of the success of the venture. Lack of delegation or too much delegation. If the Promoters have done a startup after a long stint at a lucrative and steady job, they usually struggle in the transition to working in a Startup environment.
I’ve spoken to so many IB’s and what they tell me is that, Investors are effectively funding an individual or a small group thereof married to a business idea that seems viable. I’m not saying that all Promoters are like that, but I would propose that given the high failures, is it possible the Promoters are putting on a “game face”, which seems to kinda come off as the game progresses?
Much too much time is spent on creating a “story” that can be sold to the Investor, and far too little time in really fine honing the business model.
Investor Behaviour – Back to the Power of Two
There are two types of Investors.
One is just in it for the returns, and doesn’t really care about the execution. The other is truly a partner is every aspect, be it sales, mentoring, advise, networking and so on.
Investors can be really rigid on the subject of exit, and at the time of bringing in subsequent series of funding, and tend to make unrealistic demands in terms of exist valuations, dilution of Promoter stake, etc.
Perhaps Investors have far too much money at their disposal, perhaps they don’t take the time and trouble to do as in depth a due diligence as they should.
Conducting the technical and legal due diligence is something that is easier to validate than the estimation of revenue prospects, of the Sales pipeline. Perhaps this is where Investors need to focus the most.
The impact of failure is felt across the board. It hurts Investors, Promoters and most of all it adversely hurts people who go out on a limb and opt to work for Startups.
It has much wider ramifications on the economy, as it is nothing but the inefficient use of billions of Dollars of Risk Capital, and by extension, throwing away billions of Dollars that could have been put to better use, and backed ventures that would contribute to the global economy, rather than drain it.
There is a huge social impact as well, as people’s livelihoods are affected and plans thwarted.
I’ve said this before and I say it yet again, there an impact on Clients who buy products and services from companies doomed to fail, as the IRR on their investments just doesn’t compute when Startups they supported fall by the wayside. If it is a software investment, their purposes aren’t served, operationally they suffer on account of the automation strategy failing.
Call to Arms
Given that there is a serious problem within this huge eco system, is it a time for a call to arms? Is it time to come up with a support structure that will assist in reducing the rate of failure, of controlling waste, in stemming the rot within the system? Is there a need to come up with a service that assists in turning such companies around, to intervene and to resurrect?
These have been the foremost questions on my mind, based on my own experiences, my own mistakes, mistakes I have seen others make, and in some very real cases, seem people play the gaps in the system to their advantage, with little fear of recourse?
I have spoken to so may people who matter about this by now, and nobody I’ve spoken to is really surprised, everybody who is somebody already knows this. I’ve been advised to turn things around on their head, and come up with solutions, and that’s music to my ears. It’s also only fair…. it’s never a good idea to identify problems, and leave them hanging….it’s preferable to come up with solutions.
By no stretch of the imagination can I suggest that I have covered it all, but I daresay, I’ve seen and expereinced a lot. No doubt, this juurney is not anywhere near completion, and I can only look forward to learnings and come up with possible solutions.