Why Most Startups Fail

The reasons for running out of funding are not exclusive to the current market downturn

You might think your idea is excellent. Before testing on real markets, you really can’t tell.

In the last months, I’ve had numerous conversations with different stakeholders from the European startup ecosystem regarding the current fundraising environment for tech companies. One thing is clear: With the market correction in 2022, fundraising has become more difficult.

After a few years where funding was in abundance and nobody seemed to care about spending, we now keep seeing a drastic change in behavior. Startups have to continue to adjust to the ‘new normal’ caused by macroeconomic challenges such as recession, inflation, and the still ongoing war in Ukraine. This often means drastically cutting costs, and in nearly all cases keeping an eye on liquidity. In fact, nearly all VCs predict that many startups will not survive.

Already 2.5 years ago, during the first stages of the COVID-19 pandemic, I jotted down a few thoughts for myself about what type of fundraising behavior we were seeing at the time and why I believed many companies will fail in the long term. Back then, I was actually frustrated about the behavior of some founders as they often seemed irresponsible to me with regard to how they handled their investors’ money. My thoughts from the past are still relevant today, maybe now more than ever…

Why do most startups fail?

If you regularly read TechCrunch, Forbes, or Business Insider, you probably know by heart all the success stories of audacious entrepreneurs who started cutting-edge companies.

However, most startups fail. It seems like this has been forgotten during the last prosperous years before the aforementioned macroeconomic shifts started to happen last year. Many founders and employees complain about the current funding environment, often blaming others and investors for company closures and mass layoffs.

While I admit that the situation is particularly tricky at the moment, it is important to mention: The last years before market corrections in H1 2022 were not normal or healthy. It is not the rule that almost every startup out there receives funding round after funding round and never goes out of business. Those of us who are a little older know that…

Almost half of all startups don’t even recognize a market need accurately: CB Insights analyzed 101 startups that closed shop, and 42% of them responded that they shut down due to that simple reason. People didn’t really need their product or service. It’s easy to fall in love with your ideas, but testing them on real markets is where you identify your company’s actual potential and dissolve empty dreams. The second reason (29%) is a no-brainer: lack of liquidity.

Solving problems takes money. Lots. Of. It. Especially at a growth stage, this might push some founders out of their comfort zone. On the other hand, acting like an established company can be a temptation too. But before you get a seat at the table with the big guys, you want to keep your feet on the ground and check a few boxes.

Translation: cut unnecessary costs whenever you can.

The secret is to recognize when to spend capital and differentiate between ‘need’ and ‘waste’. Here are a few things to consider in this regard:

1. Are fancy offices vital?

Especially in times of crisis, working remotely continues to prove to be useful for a lot of companies. However, I have to admit that I think getting together in an office or, old school, a “garage” is much better. It creates that special battlefield atmosphere and a very strong “WE-feeling”. In any case, let’s face it: Having a fancy office located on a Japanese-designed skyscraper on Madison Avenue can’t be entirely classified as a need. You are not Don Draper. Keep it simple.

2. Don’t massively increase burn before you have found product-market fit

Remember the first reason why startups fail: Don’t love your ideas too much. Test, test, and test again. Best case scenario means receiving a big boost from investors.

This idea also opens an interesting topic regarding the motivation to take money from friends & family. The book “The Founders Dilemma”, written by Noam Wasserman, introduces an uncomfortable but necessary question: Is it an indicator that shows if founders have laid solid groundwork for success?

While there are many counterarguments against taking family money, I wonder if founders who have done so might handle investors’ money any differently.

But in any case, a good method to explore is the “Lean Startup Methodology”. To sum it up quickly, it pretty much means taking a scientific approach to take uncertainties out of the equation.

The steps are easy:

1. Build an MVP
2. Identify key metrics
3. Measure
4. Evaluate success
5. Make changes where necessary

It’s best to have your project tested on the market and then tweaked than wait too much to have the perfect product. Remember that the ideal product in your mind might not be at all what users want. You need to know how the market reacts to your idea. The point you want to prove is that you can make money before spending too much at once. In my experience, I see far too often, specifically over the last years, companies spending cash before finding a proper product-market fit with adequate traction within its audience — which is a problem. Hopefully, this changes again now.

3. Take a long-term approach toward operations

Once companies have found their product-market fit, one of the most significant issues I also see very often is fast expansion without the right economics. Step number one is to know what your customer is worth. There are literally thousands of examples, and I see them every week. Take US-based startup Homejoy, for instance. Their growth strategy focused on short-term goals (user acquisition, expansion) and ignored long-term issues (user retention, diminishing funds). After five years, they shut down and had burned through 40 million U.S. dollars by then.

In Germany, I‘ve seen many e-commerce companies founded after 2010 with very unprofitable gross margins wanting to raise vast amounts of money (sometimes even achieving it) to expand, but without having any data to support their optimistic views. There are often flawed assumptions, such as believing organic customer influx will kick in once you reach a specific size or decreasing customer acquisition costs. I’ve come to see that most hypotheses based on feelings are random, unrealistic, and obviously, not proven with data. Hope is not a strategy!

Many companies tend to expand into other countries, ignoring two issues:

1. Unit economics are not proven
2. The home territory still bears enormous opportunities and is only penetrated insignificantly

On the one hand, they often try to hide that they cannot expand within their home territory anymore — at least at marginally higher cost, that is. On the other hand, overoptimism leads them to believe they have the right metrics and that they can replicate the same success without any problems in various countries.

It is fine to believe that customers will buy more than once, but if none of your cohorts is profitable yet, and they don’t show reliable signs of becoming so, why do you still waste vast amounts of money on expansion?

If the machine is not oiled, don’t let it run at full speed. You most likely will make the same mistake but at a higher level. This means bigger consequences.

Weirdly so, most of the SaaS companies I talk to are far better at observing KPIs and determining when the moment to scale has come. One reason might be that numbers are more comparable to one another.

4. Go easy on hiring

Hiring staff prematurely is always a problem. Consider the roles that are absolutely necessary right now but also in the future. We see it every year on football signings. When a team hires new players in winter for just six months, they almost always end up with a player no longer needed with a big contract. Startups always feel like there is too much work to be handled. But days only have 24 hours, and you can only multi-task to a certain extent. Prioritize, and remember that tasks, roles, and responsibilities become more evident with time. In contrast to football clubs, a company should ideally not have much HR turnover.

5. The six months challenge

Take into account that anything less than six months' worth of cash should trigger an immediate alert. This is Investing 101. Always save six months of money for emergencies in case of failure.

Every founder should write two particular metrics on their foreheads: the amount of cash available and the monthly burn rate. Companies are built on money, not just dreams. Of course, burn rates depend on a variety of aspects: the nature of the product you’re launching, the amount of investment required to achieve a competitive advantage, the amount of competition grabbing for land… And yes, some money will always be spent inefficiently, but if you don’t want to end up closing shop, stop spending money like a drunken sailor.

Cover your bases

After all, the points mentioned above are almost ‘eternal truths’ that have been valid in the tech world already in the past and will continue to do so.

In the coming months and years, startups that were supposedly ‘successful’ will go out of business because of the listed reasons. Additionally, some of them might also simply have bad luck that their timing is not in line with the current lifecycle of the market.

You can’t plan for market downturns, but you can always make sure to cover your bases by handling and spending the money you raised with the right degree of discipline to increase your chances of success in the long run.

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Quote of the day

“See things in the present, even if they are in the future.”

— Larry Ellison, Co-Founder of Oracle

Picture of the day

The RMS Queen Elizabeth returning home to New York with American troops after World War II in 1945.