Why Most Startups Fail and How to Improve Your Odds
In the last two months, there has been a lot of talk about the declining economy and its impact on startup funding. While some experts have argued recession fears are largely overblown, there is some evidence of real headwinds for startups seeking venture funding. Notably, last week CB Insights reported that venture funding decreased by 23% last quarter. From our end, we have seen other funds slower to deploy funds, pull term sheets late in diligence, and flat out say they are not doing new deals in order to protect their current portfolio. From a higher level, what we do know is that more venture capital was raised from LPs by funds over the last two years than any other time in history. And that capital will need to be deployed over the months and years to come. While near term tightening undoubtedly impacts how companies will raise today, the jury is still out on the impact of future fund pacing. While today’s uncertainty indicates a not-so-ideal situation for startups, we currently don’t know the long-term implications of this. With that in mind, it’s important to consider now, more than ever, why most startups actually fail.
Launching a startup is an inherently risky endeavor. Out of the gate, an average 9 out of 10 new companies go out of business. Even as a repeat founder your odds of success are only slightly better, at 30%. Of those that are fortunate to survive the first few years, only half make it past the five year mark. Failure can come from a variety of causes. When we ask founders what are the biggest risks to their business over the next 3-5 years, many think lack of funding. In other words, the ability to raise capital is the only thing they believe is holding their company back. What we find is that those founders able to articulate risks beyond capital show greater thoughtfulness about the real challenges - immediate or future - to their businesses.
To highlight this point, look no further than the multitude of companies that had no trouble raising massive rounds to quickly fall by the wayside. A recent example of this is Airlift, a Pakistani quick delivery service that raised an $85M Series B eleven months ago and then announced in June 2022 that it was shutting down. And Airlift is not an outlier; it's one of a long list of mature companies that have failed despite previously raising strong rounds. So, if these companies didn’t have access to capital problems, what’s the real root cause of their failure?
Well, for one, the answer likely doesn’t come down to a single issue. Of the 111 post-mortem startups CB Insights tracked, the majority cited two or more underlying reasons for their failure. For most, lack of money was an issue, but it wasn’t as prevalent as you would think. In a more recent survey, only 16% of defunct startups claimed cash problems caused their business to close. Perhaps more shockingly, 56% claimed some type of market problem caused their demise. Specifically, most cited lack of product-market fit as the killer of their business. Conclusion: running out of runway is pretty bad, but not knowing who your product serves is far worse.
If poor market strategy is the leading cause of startup deaths, we can intuitively conclude that the opposite is true. A good market strategy improves the longevity of your startup. While prevailing research does seem to validate that, how does a startup actually go on to find great market fit? Fortunately, the internet is full of resources covering this topic (here’s one from Hubspot and another from Shopify). At a high level, these are the suggested guidelines on achieving minimal product market fit:
1. Get out of the building! Talk to your customers about your product, solicit feedback, and watch them use the product;
2. Continuously improve and iterate on features;
3. A/B test your available marketing channels for the most effective; and
4. Wait to scale until you’ve proven market fit
The fourth is key in the cash conversation. In a 2011 UC Berkeley and Stanford joint study of 3,200 startups, 70% reported that premature scaling killed their business. In those cases, all the access to capital in the world couldn’t have solved the core concern for these companies: who would buy their product at the price they needed to sell it? Attempting to scale before answering this just meant unnecessary cash burn, until these startups no longer had money to operate.
This was exactly Airlift’s problem. In less than a year the company burnt $85M cash and had little traction to show for it. At no time before or after its Series B was it remotely cash flow positive. To grow, it was reportedly negotiating deals with retailers that reflected gross margins of less than 5%, far lower than what was needed to cover other expenses like salaries and marketing. Airlift never really cracked the product market fit equation, where it could offer a price the customer would willingly pay and operationally made sense. Rather than solving that issue the correct way, Airlift attempted to get around it entirely by effectively buying market share and burning through an insane amount of cash. When that strategy inevitably didn’t work, the company went out of business.
So, what’s the big takeaway here? In this market, a winning formula may be to balance deliberate growth with explosive growth, as the former is a more reliable recipe for success and the latter is far more speculative. Build out a strong product. Understand who your target customer is and what value proposition you can offer them. Determine the right price to sell your product, at which point both you and your customer can be satisfied. When you’ve figured all of that out, then look to bring in meaningful capital to scale your business. If you do all of that, your startup will be in a much better position to succeed. Once you achieve product market fit, raising capital will be a more predictable process and much less impacted by the macroeconomic headwinds and market noise.