August 13, 2016 by Fred Haney
Why Do So Many Startup Companies Fail? Insight from the venture capitalist’s desk.
Improve your chances of getting funding for your high tech startup from angel investors and venture capitalists.
Studies have shown that about 90% of high tech startups fail. I think the percentage is actually higher, because many startups never even make it to the surveys.
Why are the failure rates so high?
Venture capital firms say they fund one out of every hundred deals they see. Does that mean the other 99% never get funded? Not necessarily, since there are multiple venture capital firms. But it also doesn’t mean that, if you present to 100 venture capital firms you are certain to be selected for funding. Different venture capital funds have very similar objectives, and they think very much alike. So, while one out of every 100 deals may be a little pessimistic, it’s probably not a bad guesstimate for the percentage of high tech startups that obtain venture capital funding.
In order to understand why venture capitalists finance such a small percentage of tech startups, it’s important to understand how they think about risk. A startup presents many different risks:
- The risk that the product might not work.
- The risk that the product might be too expensive to build.
- The risk that there won’t be enough customers for the product.
- The risk that the chief executive officer won’t be effective.
- The risk that the company won’t be able to raise enough capital to succeed.
- The risk that, even if some customers buy the product, the market is not large enough to justify an investment
The problem with the entrepreneur hoping to write a business plan and receive funding over lunch is that this represents more risk than most angel and venture capital investors are willing to accept.
Venture capitalists consider many criteria in evaluating start up companies. Two of the most important are 1) the business potential of the idea, and 2) the past successes of the management team, especially the chief executive officer.
Imagine that you are a venture capitalist with 100 business plans on your desk sorted according to the potential of the idea and the success record of the CEO. So you have 100 business plans in a 10 x 10 array with the best ideas in the right hand column and the most proven management teams in the top row. Which one does the venture capitalist choose? Obviously, the one on the far right hand corner — the one with the most promising idea and the management team with the most proven record of past success.
Other factors will need to check out, but they are unlikely to override the two issues identified above.
In addition to these factors, “risk matters.” Every time you can eliminate or minimize a risk you improve your chances of getting funded. Which is why having a proven management team helps. Other things you can do to greatly reduce the risk are to:
- create a working prototype product
- create the product itself
- obtain some satisfied customers
- prove that customers will pay your price,
- prove that you can manufacture your product for your target price
A significant number of companies fail before they even get to present to investors. Many founders seem to think the way to start a company is to write a business plan and start talking to investors. This rarely works. The problem with this approach is that it requires investors to accept all of the risks at once. They are being asked to being asked to invest in a concept without a team, a CEO, a product, a customer, proof of concept, or proof of the business model. First-time founders often spend too much time polishing and word-smithing a business plan. Sometimes they pay someone else to write a business plan. But no amount of polishing can change the fact that investors are being asked to accept all the risks at once, which they rarely do.
If we go back to the venture capitalist’s desk with 100 business plans sorted by “strength of concept” and “management success record,” what happens if the deal in the far right-hand corner doesn’t work out? Perhaps because some of the facts don’t check out. Now where does the venture capitalist turn? Does he stay in the top row (the most successful chief executive officers) and settle for an idea with less potential? Or or does he stay in right-hand column (ideas that have the most potential) and settle for less experienced management? Usually, the latter because it’s not possible to turn a “9” idea into a “10.” But it may be possible to turn a “9” management team into a “10” by augmenting or replacing some people.
Most start ups that fail don’t have a product with enough business potential to attract investors. But some fail simply because high tech startups are fragile, and they cannot tolerate many missteps. Simple mistakes, like not consulting a lawyer at the right time, or not heeding a lawyers advice, or not consulting an accountant, or spending scarce capital too fast are often fatal.
Another very difficult question facing a high tech startup founder is, “To whom should I listen?”
This is a difficult problem. The world is full of people with advice for founders, but few have enough of the right experience to be able to provide useful advice. Executives or entrepreneurs who have had one or two successful companies are never bashful about offering advice. Nor are some consultants. But having one or two successes doesn’t give an advisor broad enough experience to deal with all the different situations that can arise in a startup. Similarly, an individual who has consulted with a lot of companies may not have enough in depth experience to handle the challenges presented by startup.
Most high tech startups fall into one or more of the categories discussed in this article. Stay tuned to learn how to avoid some of the pitfalls facing a startup.