Why Startups Fail: A Look at Pre-Seed and Post-Seed Risks

An image created with GPT4 depicting the startup lifecycle in the early days, including highs and lows, successes and failures. It symbolizes the hurdles of growth amidst tough conditions

This memo explores the reasons startups fail at different stages based on my own experience as an entrepreneur and long-term angel investor (over 100 startups), focusing on some pre-seed and seed challenges.

Pre-Seed Risks

1. Founder Conflicts and Departures: Startups can be derailed by founder disputes, personal financial strains, or alternative opportunities. This can lead to key team members exiting the company, creating issues of morale, a mess in the captable, and an inability to execute.
2. Extended Product Development Time: Startups often face delays in launching their initial product. Reasons range from technical difficulties, regulatory hurdles, challenges in product management, to attempting to deliver a fully-featured product rather than focusing on a minimum viable product (MVP).
3. Technical Feasibility Issues: At times, startups find that their product cannot be developed as envisioned. This could be due to reliance on 3rd-party platforms, regulatory restrictions, or the absence of necessary APIs.
4. Monetization Challenges: Just because someone likes your product, tests it and gives you positive feedback, solves a real need, or a customer signs an LOI, doesn’t mean that they will pay for it. It’s crucial to validate early on whether customers will pay, and whether they will pay the price you have in mind.
5. Vitamin vs. Painkiller: Many products fall into the category of ‘nice-to-have’ versus ‘must-have.’ Both consumers and businesses, busy with their daily routines, may find a product or solution very useful but can still delay the decision to adopt it (even when the reasons to delay the adoption are irrational), opting instead to continue with the status quo. In general, humans (customers) keep doing what they are used to and do not like to be distracted by a new thing, even if it is “better.”
6. Limited pricing power: When your solution contributes to a value chain (eg B2B2C), the cost savings or additional revenue it generates doesn’t always directly influence its pricing you can charge, and whoever owns the final customer has most of the leverage. Ideally, you’d set a price proportional to the value created (i.e., a share of the product’s value). However, you might lack the leverage to do so, especially if the buyer aims to retain most of this value and there are cheaper alternatives from competitors in the market, even if they are of inferior quality. Unless your product is significantly superior (eg 3x better, not only 30% better), customers may prefer the cheaper options, forcing you to reduce the prices you had in mind. Consequently, pricing often reflects not the value delivered, but merely a markup over the cost of goods sold (COGS) (i.e. you get commoditized). Ultimately, there are 3 pricing strategies: a) COGS plus a markup, common in commodities like supermarket foods; b) competitive pricing, using the price of similar products as a benchmark, regardless of their quality, COGS or value; c) pricing based on the value to the customer, which is what everyone prefers but often hard to achieve due to market forces, leading most to resort to (a) or (b).
7. Selling Mission Critical Systems — Most preseed startups fail or pivot. Therefore, established customers often view startups with skepticism, questioning whether they will be alive in the long term, a concern especially relevant when the startup’s solution is integral to the mission-critical operations of a customer (e.g., managing hospital patient data or banking credit card records, or buying life insurance from a startup). The initial reluctance is due to the high risk of startup failure, since the majority of startups fail (or are acquired by a larger company with different plans for their product). If adopting your solution means customers are locked in, even if it provides a competitive edge once integrated, overcoming the initial hesitation is a significant hurdle (the cold start). To persuade customers, startups may need to ensure an easy transition to another solution should they cease operations. While this approach may facilitate adoption, it can also reduce the defensibility of the startup. So what seems like a defensible strategy (i.e. customer lock-in), makes the product impossible to be adopted.
8. Future Competition vs competing with the status quo: Startups often claim their product will be better than the existing competition and the current status quo. However, launching a product to the market requires time, and even after launch, it also takes time for customers to become aware of the company’s offerings. What they may not realize is their real competition isn’t with today’s market solutions but with those that will be present at the time of their own product’s launch (e.g., in 12 or 24 months). During this time, incumbents might upgrade their offerings, or new startups, currently operating in stealth mode, might launch with similar offerings. As A16Z puts it, the goal is to get distribution before the incumbents get the innovation.

Seed and Series A Risks — mainly about growth potential

1. Poor Product/Market Fit: Launching the product may reveal a significant mismatch between the product and market needs, indicating weak initial traction.
2. Unsustainable Unit Economics: Even with a decent product/market fit, the unit economics don’t work. This includes high operational/variable costs to deliver the product, unfavorable revenue versus the cost of goods sold (COGS), inefficient distribution channels that either saturate or are too expensive or competitive (you get outbid), and substantial product friction in converting leads to paying customers.
3. Crowded markets—competing with multiple startups that appear to offer similar solutions (even if they are very different when you double-click on them) is challenging because there is too much noise in the market.
4. Distribution channels don’t scale or saturate — The methods used to acquire the first few customers often differ from those needed to scale up, as marketing strategies may change at larger volumes. It’s also common for certain markets to saturate, necessitating the search for new customer groups elsewhere. However, reaching these new groups can pose challenges: the approach may need to change, costs could rise (increasing customer acquisition cost, or CAC), and there might be more competition on those channels.
5. Loss of interest in the category from investors: Trends in investment can shift, leaving categories that were once popular struggling to attract funding, as investors tend to move in herds. Think of micromobility, spacetech, or at home health tests.
6. Betting on the wrong platform: We saw this a few years ago on mobile (iOS vs. Windows Mobile vs. Blackberry vs. Android), social, video game platforms, or the availability of APIs (Twitter, Facebook).
7. Lack of talent for growth: The first employees shape the company’s culture and future hiring. If they’re not top-notch, they won’t attract better talent (nobody wants to report to mediocre managers) or effectively grow the business. Sometimes, that great talent does not exist in the geo’s where the startup is based. While luck plays a role in success, companies with only average talent will struggle to leverage any good luck they encounter. Thus, the question isn’t if a business plan has the potential to grow 10x, but rather if the specific team in place can drive the company to achieve that 10x growth.
8. “Unfair” Competition: Startups may face competition from larger entities (or better-funded ones) that can afford to subsidize their products or services, making it challenging for smaller startups to gain the necessary market traction. For example, we have seen this with well-funded startups subsidizing food delivery or the gig economy (considering this part of the CAC) simply to gain market share or Microsoft or Google offer DevOps tools for free to attract developers.
9. Markets do not develop and grow as anticipated —predicting the time axis for an innovation’s adoption curve (innovators, early adopters, early majority, late majority, laggards) is very difficult. Startups want their markets to be big in 4–6 years but predicting the future is hard. We have seen these technologies like VR glasses, the metaverse, self-driving cars, fusion power, and commercial space tourism. On the contrary, some markets explode in popularity much faster than expected. Think of the rapid adoption of chatGPT, the rise of social media, the growth of the gig economy.

Why writing this memo

I have written this memo to illustrate the difference in risk between investing in pre-seed and post-seed (stating the obvious: at preseed, there are many more risks :-)).

But Why?

Over the last few weeks, I have been having hot discussions about the high valuations for YC startups at demo day. Some argue that for companies with potential $10 billion valuations, the entry price of $10M, $20M, or $50M doesn’t matter. However, many of these companies are just a few months old, with only 1–2 founders and unproven ideas and hypotheses about markets and customers. While the potential upside is exciting, the risk across them varies significantly (many raise at similar valuations). And most Pre-seed companies inherently carry a higher risk profile, which should also be reflected in their valuation.

Pre-seed vs. Post-seed

While pre-seed startups have challenges, they typically present more risk than the post-seed stage, suggesting a difference in valuation.

Therefore, waiting might be a better strategy if you could invest in a post-seed company with similar potential but significantly less risk, just at a slightly higher valuation. Interestingly, some YC companies from previous years that progressed within 20 months, reducing their risk profile for Seed or Series A funding, raised capital at valuations only slightly higher than their pre-seed demo day valuation. This indicates that initial high valuations often adjust to “fairer” valuations at later stages. So by investing later, you pay a little more, get a lot less risk, and avoid early stage failures. . Additionally, there is the time value of money, since investing 2 years later at a similar valuation has a much better IRR.

Investment considerations

Of course, this approach assumes that successful pre-seed companies won’t experience a disproportionate valuation increase in later rounds, making early investments advantageous (but, on average, we are not observing this). Additionally, it assumes you’ll have the opportunity to invest and have an allocation in later rounds.

A recent breakfast meeting I attended with Howard Marks reminded me of his quote: “Success is not about investing in good companies, but investing at good prices.” This assumes that the scorecard of investing is about the returns and not only about finding the best companies. While there’s some correlation, it’s not perfect (e.g., investing in Instacart or Loom’s later rounds).