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: Failure to find Product/Market Fit
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. Our experience indicates that it takes about 50 conversations with customers that are not friends to find out if the product concept is really going to sell. Unfortunately because most founders come from a technical or product background, they find it very uncomfortable doing 50 cold outreaches into customers, and so skip this step before starting to build the product. That is extremely unfortunate as they will only get the feedback when trying to sell to those customers after they have built the product, by which time it is too late to incorporate the feedback, and many months will be lost.
This topic is covered extensively in the following article:
Startup Roadmap: 9 Steps to Repeatable, Scalable, & Profitable Growth
Reason 3: Failure to find a Repeatable and Scalable Sales Motion
Once a product has started to show that it has product/market fit, i.e. it delivers business value, and customers want to buy it, there is another tricky journey to figure out: how to sell the product. Sometimes this is called Go-to-market fit. I prefer to call this phase the search for a repeatable and scalable growth model, as the words repeatable and scalable tell such a clear story about what has to be accomplished. This article provides a lot more detail on Steps 4, 5 and 6 in the 9 Step Startup Roadmap: Startup Roadmap: 9 Steps to Repeatable, Scalable, & Profitable Growth.
Reason 4: Failure to find a profitable Growth Model
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.
Unit Economics: CAC and 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.
The Capital Efficiency “Rule”
To have a capital efficient business, it is very important to have an efficient sales and marketing motion. How can you tell if you do have an efficient sales and marketing motion? Two metrics help you understand this: Sales Efficiency, and Months to recover CAC (cost of acquiring your customers). Both metrics measure the same thing, but in slightly different ways. Sales Efficiency measures how much Net New ARR is generated by $1 of sales and marketing spend. A very efficient SaaS company will have a Sales Efficiency of 1. A not particularly efficient SaaS company will only generate $0.50 in Net New ARR for every dollar of sales and marketing spend, so will have a Sales Efficiency of only 0.5.
The other metric, Months to Recover CAC is very similar to Sales Efficiency, but it differs slightly different because it looks at Gross Margin of the Net New ARR that is created by spending one dollar in sales and marketing. But for simplicity sake, imagine that we have 100% Gross Margin, in that case an efficient business will spend one dollar on sales and marketing, and generate $1 in Net New ARR, which means that it will recover CAC in 12 months (and have a Sales Efficiency of 1). An inefficient business will take 24 months to recover CAC (and have a Sales Efficiency of 0.5)
Reason 5: 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.
Reason 6: 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.
This topic is covered extensively in the following article:
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 sales motion is still being developed to make it repeatable and scalable, 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, or if the sales motion is not repeatable. 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 sales & marketing motion (Growth Model) has been proven, and is profitable. That is the time when the accelerator pedal should be pressed down hard. As hard as the capital resources available to the company permit.
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.