Why Startups Fail and How to Avoid the Pitfalls of Premature Scaling
The 2012 Startup Genome analysis, which investigated 650 Internet startups, found that “premature scaling is the most common reason for startups to perform poorly and lose the battle early on by getting ahead of themselves”. Similarly, a complementary report on 3200 high growth startups revealed that “74% of high growth internet startups fail due to premature scaling”. Premature scaling, thus, is a startup killer. But what, exactly, is premature scaling? And how can you prevent it from leading to the death of your company? In this article I’ll provide detailed answers to these two questions as well as outline various key strategies for successfully growing your business.
Repeatable and Scalable Business Models
Entrepreneur Steve Blank defines a startup as “an organization formed to search for a repeatable and scalable business model”.
Expanding on this definition, I recently pointed out that:
“The creation of a repeatable and scalable business model is the point in the start-up lifecycle where a new venture finds ways to consistently acquire new customers for less money than the revenue they are expected to bring in, thereby generating (the potential for) profit.”
In the startup world, a wannabe company becomes a “real business” once it develops the ability to acquire customers quickly and at a cost that’s lower than the revenue that such customers generate.
The formation of a repeatable and scalable business model is essential to a startup’s vitality precisely because it opens up the possibility for a startup to accomplish its central objective, i.e., to grow and scale exponentially.
Achieving such a business model is, therefore, the ultimate goal of a startup.
Your company reaches this defining point when it secures the following 3 key developments:
- Your customer acquisition cost (CAC) — i.e., the total cost of convincing a potential customer to buy a product or service — is lower than the lifetime value of customer (LTV) metric — i.e., the revenue that a customer is expected to generate during his/her lifetime;
- You operate in accordance with economies of scale — i.e., a situation in which the more customers you have, the cheaper the cost of your product become — such that your CAC/LTV ratio decreases with growth; and
- Your business model keeps replicating itself, i.e., you continue to successfully acquire customers without exhausting your customer acquisition channels.
Serial entrepreneur turned VC David Skok suggests that SaaS startups ought to pursue and institute a minimum 3 to 1 LTV to CAC ratio, i.e., the revenue that your average customer brings in should be at least 3x higher than the cost it takes to acquire him/her in the first place:
This 3:1 ratio seems to be the general consensus for most startups.
6 Stages of Startup Development
The above-mentioned Startup Genome project found that startups generally pass through 6 milestone-based stages of development.
Specifically, startups typically progress through stages of Discovery, Validation, Efficiency, Scale, Sustainment, and Conservation.
The first 3 stages — i.e., Discovery, Validation, and Efficiency — encapsulate the period during which time a startup validates the core assumptions of it main business ideas and product.
Let’s look at the first 3 stages in a bit more detail:
- Discovery stage: focus = ensuring that the primary customer pain that the startup intends to solve is a) substantial enough to fuel the growth of a new company and b) monetizable to the point where the business can eventually turn a profit and scale. In other words, finding a problem/solution fit is the most important concern.
- Validation stage: focus = achieving a product/market fit. Product/market fit means creating an in-demand product that satisfies the needs of a market that is large enough for your startup to grow into a full-scale business down the road. As I’ve discussed previously, as a founder you must be “absolutely sure that a market actually exists for the solution you intend to offer — otherwise, your startup won’t ever earn the money it needs to [scale or to] do [any] good in the world”.
- Efficiency stage: focus = optimizing the business model so that the startup can eventually become profitable. This ultimately involves developing a repeatable and scalable business model.
In general, once a startup has successfully progressed through these 3 stages it’s then time to start spending money aggressively so as to expand and scale operations:
My experience as an entrepreneur and now as a co-founder of a successful digital apps startup leads me to believe that successful companies are distinguished from the vast majority of all other wannabe businesses that ultimately fail by the former’s commitment to remaining hyper frugal with their spending throughout the beginning 3 stages of the startup lifecycle.
Because the Appster blog already contains lots of helpful content (1, 2, 3, 4, 5, 6, 7) detailing ways to scale a startup, i.e., the 4th stage mentioned in the Startup Genome report, I’ll leave discussion of that phase for another time.
I’ll also postpone addressing the 5th and 6th stages, i.e., sustainment and conservation, because I’d like to take a closer look at the dangers associated with premature scaling, which typically occurs earlier in the startup lifecycle.
What Is Premature Scaling?
In simple terms, premature scaling refers to an effort to grow your business at a rate faster than you can afford to sustain.
Or, as I recently explained:
“Premature scaling is an attempt to massively expand and grow your new company before you have successfully hammered out the intricate details of a repeatable and scalable business model.
Failing to nail down the specifics of your CAC and LTV can facilitate premature scaling and, thus, cause startup failure”.
Startups that fail because of premature scaling share one or more of the following characteristics in common:
- They build and try to scale products before having adequately tested and validated their problem/solution fit. A Startup Genome analysis of 3200 high growth startups found that 80% of successful startups focus on discovering problem spaces (i.e., uncovering a problem/solution fit in the market) during the first 3 stages of the lifecycle rather than concentrating on customer acquisition tactics.
- They overspend on customer acquisition efforts before successfully establishing a solid product/market alignment. Failed startups have a tendency to try and overcompensate for their absence of product/market fit by spending lots of money on public relations and marketing strategies. This is an example of what might be called the entrepreneur’s vision fallacy wherein an entrepreneur builds a “revolutionary” product that’s “guaranteed to succeed” and tries to convince her customers to buy it rather than intentionally building something that her extensive research and testing prove customers actually want.
- They hire too many people too early (including expensive “consultants” who might add little if any concrete value to the businesses), raise too much money resulting in a loss of financial discipline (i.e., a dedication to efficiency), and/or try to generate high earnings at the cost of every other aspect of growing a company.
The following Appster infographic outlines the major focal points, business actions and strategies, and approximate time scales for each of the 4 broad phases involved in building a startup:
Establishing a Problem/Solution Fit
As venture capitalist and billionaire Vinod Khosla once put it, “if there is no problem, there is no solution, and no reason for a company to exist … Nobody will pay you to solve a non-problem”.
Successfully establishing a problem/solution fit requires discovering and thoroughly understanding a customer pain so significant that sufficient numbers of people not only recognize its existence but are willing to pay good money for its solution.
On a pain scale of 1–5, a monetizable pain is a 4 or 5, i.e., it needs to be addressed now.
Discovering a problem/solution fit is an indispensable part of building a successful startup.
Because every single entrepreneurial activity is ultimately predicated upon the capacity to create something that people are willing to purchase but such a purchase will never materialize unless your creation effectively solves one or more of your customer’s pressing pains.
How can a startup validate what it believes to be its monetizable customer pain?
I’ve written on this topic before. Here are the most important points to keep in mind.
In order to test your pain hypothesis you need to:
- Find a sample of customers;
- Survey them in person or online;
- Evaluate the results; and
- Do more testing.
Acquiring as much valid insight as possible requires attaining brutal honesty from your focus group.
Rather than eagerly pitching specific ideas to your participants and trying to sell them your particular pain hypothesis, you should ask open-ended questions intended to allow respondents to speak freely and openly.
It’s also important to avoid priming your audience by ensuring that you don’t explicitly tell your participants that you’re working on a business idea.
Rather, you should pose questions like:
- What is the most difficult aspect of x [i.e., some given problem]?
- Tell me more about x. What happened the last time x occurred?
- Why was that experience so problematic or unenjoyable?
- What solutions, if any, are you currently using to address this problem? What do you find unsatisfactory about them? How do they need to be changed?
Be sure to use all the offline and online resources available to you to locate potential customers and gather this kind of intimate focus group feedback.
Try your existing email lists, online forums/message boards, social networking and micro-networking sites, Reddit, Linkedin, Quora, and Meetup.com.
Go to Starbucks and offer passersby free coffee in return for an opinion.
You can also consider utilizing personalized, thoughtful, and intelligently targeted outbound marketing in the form of cold emailing.
Finally, you can apply the “$100 test”:
“List all the features you are considering implementing into the final version of your product and ask your customers, ‘If you had only $100 to invest in one or more features of this product, how would you invest your money? Which features would you invest in?’ Naturally, customers will select the ones about which they care the most thus providing you with data with which to distinguish necessary from superfluous features of your product.”
Determining a Product/Market Fit
Marc Andreessen, partner at VC firm Andreessen Horowitz, insists that a startup’s success ultimately rests on finding alignment between a healthy market and an in-demand product:
“In a great market — a market with lots of real potential customers — the market pulls product out of the startup.
When you get right down to it, you can ignore almost everything else besides the market.
A successful startup is thus one that has reached product/market fit.
You see a surprising number of startups that have nearly all aspects of operations completely buttoned down and yet they’re actually heading straight off a cliff due to not ever finding product/market.”
Marc’s essential claim here, then, is that founders are destined to fail if they don’t perform their due diligence by ensuring that a genuine product/market fit develops and flourishes over time.
Growth hacker Sean Ellis argues that once a startup develops a working prototype and subjects it to beta testing, the business can begin measuring its product/market fit by asking its beta users to answer the following simple yet important survey questions:
How would you feel if you could no longer use product x?
- Very disappointed
- Somewhat disappointed
- Not disappointed (it isn’t really that useful)
- N/A — I no longer use product x
Ellis’ famous survey, which has been tested on hundreds of startups, is based on his belief that:
“The best way to think about product market fit is that the product should be a ‘must have’. People have too many choices today to settle for a nice-to-have. So what makes something a must have? Essentially it needs to be both valuable and difficult to replace. The various survey questions are intended to function as leading indicators of it being a ‘must have’.”
Essentially, if more than 40% of your beta testers indicate that they’d be “very disappointed” if they were unable to continue using your product then, arguably, your startup has achieved a solid product/market fit.
If you’d like to learn more about the thinking behind, and the usefulness of, Ellis’ test then consider watching the following on-stage talk delivered by Ellis himself.
At this point, having successfully traversed the first 3 or 4 key stages of building a startup, it’s time to move onto developing economies of scale, generating greater revenue, and expanding your operations.
As we’ve already provided lots of detailed and comprehensive content on different methods for scaling startups, I encourage you to visit the Appster blog to continue reading about this topic.
Originally published at Appsterhq.