Why zombie start-ups will rise from the tech bubble
They say that a decline in start-up birth rates is the death of entrepreneurship. We say that the implosion of the current start-up tech bubble will give rise to a population of start-up zombies that will suck the life out of entrepreneurship.
In an era were the cult of ‘failing-forward’ and ‘failing-fast’ is not just advocated, but embraced by VCs and policy-makers alike, a strange phenomenon is occurring: the rise of the zombie start-ups.
Like zombies, these startups refuse to acknowledge they are dead, and rather than cutting their losses (and those of their investors), they cling on for dear life in the hope of a miracle pivot, because “they will not admit defeat!”, and need to keep the illusion of the ‘entrepreneur-hero’ that is so publicly lauded.
The trend to raise the largest amount of capital, coupled with an expectation to grow as fast as possible has led to a heightened burn-rate among funded startups. Founders have taken to heart Steve Jobs infamous quote “A lot of times, people don’t know what they want until you show it to them“. This is despite the top reason a startup fails is due to the being no market need for a product. For every US$ 23 billion company like AirBnB, there are 27 imitators that will never catch-on. But their founders refuse to acknowledge it.
The defining factor of a zombie start-up is failure to launch, and stalled growth despite having had access to funding.
Entering ‘zombie-mode’ is historically the most common result for VC-funded startups. Whilst approximately 10% of start-ups succeed and 20–30% fail fast, the zombies generate sufficient revenues to barely maintain operating expenses, end up downsizing, and continue to limp along, barely able to maintain a product, let alone their innovative capacity. Zombie start-ups tend to herd in industries that have lower barriers to entry, and that have already gained significant market traction and investor confidence. They feed off the excitement and positive market sentiment created by other incumbents and competitors in their marketplace, and refuse to die despite having reached the end of their life-cycle. Some get big fast, but fast-paced growth and a lack of demand becomes their albatross. Their burn-rate is higher than average, and they will only admit defeat when the cash runs out. Even then, they are hard to kill off.
Referly was the first startup to be coined a zombie startup in a postmortem by its founder detailing why she believed the online referral for social networks had failed to grow since its graduation from YCombinator in 2013. With $350K left in the bank, Referly founder Daniele Morrile first considered pivoting the technology, before deciding to call it quits, and launching ‘a ‘Bloomberg for start-ups”. More recently, the London-based restaurant delivery start-up Dine In disclosed it had been chronically underfunded since its inception four years ago, had failed to compete with its closest competitor Deliveroo (who received more capital in its seed round than Dine In received in its lifespan) and finally decided to shut down after an aborted sale, and the loss of investor interest in further funding. It also took Shopa, the online shopping social sharing app three years and $11 million in early-stage VC to realize that it’s target users — women- didn’t want their friends to know what they had purchased, and had to close it’s doors.
Recently, Clinkle is the zombie start-up that just won’t die. The mobile wallet-app raised an unprecedented $25 million seed round in 2013 and was the talk of the town, without ever launching a product. In early 2014 the start-up began down-sizing, and several high-profile executives walked out. That was until Clinkle CEO Lucas Duplan was found to be mismanaging $30 of investor capital. Today, Clinkle barely exists, but Duplan just won’t quit, resuscitating Clinkle as a mobile-referral service called Treats. The future is yet unknown for ‘Treats’, but given Duplan’s track-record, it seems investors and consumers will be unlikely to bite despite the founder’s perseverance.
But even start-ups that are considered successful and have gained significant traction, even talks of an IPO, run the risk of running into ‘zombie-mode’ and losing momentum. Spotify rival, Deezer, pulled-out of its IPO last year and has since raised a further $109 million in Series E- hoping to quash concerns about user acquisitions, failure to pierce the US market and its ability to effectively compete against Itunes and Spotify. Similarly, Soundcloud has been hemorrhaging money, and has been dependent on venture capital to remain solvent- spending $64 million to generate an unremarkable $19.5 million in income in 2014- and has once again called for a major cash infusion that leave backers unimpressed.
The rise of zombie start-ups are being fueled by the current start-up culture, in Silicon Valley and beyond. The easing of barriers to entry, strong competition, and investor propensity to finance ideas rather than execution perpetuates the emergence of a herd of startups operating in zombie mode. Having to keep-up with the Jones’ (more successful start-ups) also puts unnecessary pressure in a VC-backed startup. Competing for talent, inflated salaries and having to provide perks and incentives expected by start-up employees lead to costs spiraling out of control. As quoted by Jon Bischke “”.
According to CB Insight’s R.I.P Report, 69% of start-ups raise up to $5 million before failing. The average amount of VC capitalization by failed start-ups is $11.3 million. 71% of dead companies fail less than two years after their last funding round, with the average start-up calling it quits after 20 months. This may seem short, but in a start-up life-cycle this is a strenuously long time to realize that consumers and investors will no longer be knocking at your door. To put it bluntly, if after 15 months a start-up hasn’t received another VC injection or met an interested acquirer, it is all but dead on paper. Despite this, the number of start-ups that have received angel, seed and Series A rounds has increased by 16%.
To top it off, stories of sensational pivots only add fuel to the fire for zombie start-ups. Flower-delivery startup BloomThat recently caught headlines when its founder announced a turn-around after burning more than $550K a month and having only 4 months to live. And BloomThat is the perfect example of the ‘burn’ mentality gripping start-up founders and investors. Investor’s perpetuate the ‘zombie-mode’ life-cycle by avoiding to invest in companies unless they are burning cash. Why? A low burn-rate means the start-up has low financing needs, will move inefficiently and will expensively stagnate. A model best-avoided unless you want to create a zombie from the get-go. A high burn-rate on the other hand is seen as a risky and aggressive strategy, but the best path towards quick execution. Unfortunately, a start-up’s ability to dramatically burn investor’s cash hasn’t yet reaped a scientific formula that is correlated to the start-up’s competence and capability to execute, or even it’s long-term potential. If so, 29% of failed VC-backed start-ups wouldn’t disclose that the reason they failed is because they ran out of cash. Dubiously, only 8% of start-ups cite burn-out as a cause for their failure.
For the cynics among us, zombie start-ups have enabled the formation of a new professional niche in Silicon Valley. Much like the Dr. Frankenstein’s of our age, a new breed of founders, technocrats and investors have made it their business to rescue ailing startups, an example being Tech-Rx, Silicon Valley’s first turnaround shop. Such affectionately known ‘start-up fixers’ get approached by the zombies of Silicon Valley, and dependent on the talent, attitude, financials- and most importantly- the landscape for a potential buyer, inject up to $5 million in capital. The cost? 50% in common stock, 20% saved for new management, and 30% for existing shareholders and investors. The winners? The ‘start-up fixers’, who can be set to make between 3x to 5x return in a two to five year time-frame. The runner-ups? Investors, who are likely to get their money back. A company like Tech-Rx does not disclose its investments in zombie start-ups due to the fear it will raise negative market signals, and VC’s not wishing to openly discuss investments that have gone south. And for the zombies? Perhaps a failure would have been better, as their IP and startup is more than likely to be sold off to the highest bidder.
As the current tech-bubble implodes, and more start-ups find it difficult to raise further rounds of VC capital and exit opportunities, the population of zombie-startups will be on the rise. And unlike what Gallup or Brooking’s Institute may have you believe, start-up death rates in the US aren’t on the rise- they are actually declining at the same rate than start-up births. It is not the lack of birth-rates that will kill entrepreneurship, but the lack of death’s among zombie startup’s which will prove extremely harmful to the startup ecosystem. When zombie’s refuse to die, they siphon away capital from new start-ups, reduce investor confidence, and have the potential of creating a negative spillover on an sub-industry as a whole, hindering the birth and innovative fervor of potential growth-start-ups. Put simply, they not only contribute disproportionately to job destruction, but cripple innovation. And the symptoms have been spreading, as Silicon Valley is bracing itself for a record-number of layoffs in its start-ups.
So how should we deal with a zombie start-up? Founder teams need to remember that the health of a startup is not measured by frivolous metrics such as staff perks, free food and open-plan offices. Retaining talent is one thing, going bust because of them is another. Founders should be much more willing to either pivot, sell their IP, or be acquihired when they still have the chance and have traction in their network. Surviving no matter what is no badge of honour, but a recipe for missed opportunities. Exitround.com, a ‘match-making service for start-ups open to acquisition’ does just what it says on the label, and anonymously matches flailing start-ups to potential buyers. BandPage wasacquired by YouTube this year for $8 million, and although this is much less than the reported $27.6 it raised in Series B and C rounds, it successfully pivoted away from its Facebook-dependent model to receive a new lease of life.
What needs to change, is the association that VC’s have created of burn-rate and growth. Growth for growth’s sake is a recipe for disaster, as the majority of start-ups cannot handle fast-paced growth, and either lose the market, fail to launch, or fail to deliver a product that consumers actually want. Uber should not be a benchmark for start-ups, but an exception that has yet to confirm the rule.
However, we have to hope that the heyday of over-selling good ideas as big ideas, and fostering the birth of ‘on-demand’ start-ups is coming to a close. As tech capital crunches, perhaps investors will realize that those supposed ‘game-changers’ have done little in terms of technology and innovation, and can now focus on supporting the emergence of a new breed of innovators, not zombies.
Tatjana de Kerros-Budkov is the author of “The Startup Illusion” — the blog that believes that entrepreneurship is more than just a buzzword.