Book Review: Why Startups Fail
I was the Managing Director at Techstars NYC between 2014 and 2018 and invested in 104 startups through two funds. The first fund has 13.74x TVPI (a multiple of the distributed capital plus future value) and 1.69x DPI (a multiple of the distributed capital), and the second has 5.37x TVPI and 1.16x DPI. Both funds, although early, have already returned all capital to investors with very significant upside.
However, here's the thing. Of the 104 companies that I backed, 34 failed. In other words, 33% of the companies I invested in are no longer operating. I have been exceptionally lucky with this portfolio, but I've experienced significant failure alongside my success.
Failure is inextricably linked to entrepreneurship.
The strong suit of the US entrepreneurial community is its ability to accept and embrace failure, and, more importantly, to learn from it.
Learning from failure is exactly the subject of the recent book written by Dr. Tom Eisenmann.
Dr. Eisenmann spent more than two decades as a Professor of Business Administration at Harvard Business School (HBS) and a faculty co-chair of the Arthur Rock Center for Entrepreneurship.
Over the years, Professor Eisenmann has been instrumental in contributing to the HBS curriculum and several generations of HBS founders as they have built 19 unicorns including Stitch Fix, Cloudflare, Oscar Heath and Zynga.
I've been lucky to participate in the HBS and Arthur Rock Center community over the last several years as a part of their Startup Bootcamp, a VC, and a Coach in residence. There is an incredible support system to help students lift their startups off the ground. It is not surprising that HBS and Harvard are in the lead.
Why Startups Fail
Paul Graham of YC is credited for saying that startups don't die from homicide but, instead, from suicide. Startups fail not because of competition but because of internal conflict and bad decisions.
Among the top causes for failure I've experienced are founder conflict, lack of founder market fit, lack of customer demand and bad market timing.
Professor Eisenmann's book is the fruit of a self-conducted, multi-year study analyzing the reasons why startups fail. Why Startups Fail zooms in on both early and later stage failure with a fresh, systematic approach to ultimately help founders avoid these issues in the future.
The Early Stage Failure
The book begins with the so-called Diamond-and-Square framework, a foundational tool used at HBS for thinking about startups.
This framework can assesses risk by focusing both on people involved - Founders, Investors, Team and Partners - as well as the Idea, Execution and its Potential. Eisenmann argues that a promising startup demands the dynamic alignment of all 8 pieces.
Armed with the framework, the book lays out 3 cases for early stage failure:
Good Idea, Bad Bedfellows
False Starts
False Promises
Good Idea, Bad Bedfellows
Professor Eisenmann explains that people are the most common cause for failure. In 'Good Idea, Bad Bedfellows', he highlights and documents how lack of founder-market-fit, founder conflict and the lack of clarity of who is in charge can lead to failure. These early dynamics can cause undercapitalization and the involvement of the wrong investors. Eisenmann stresses the importance of funder fit and ensuring that the investor is the right one for the business. He notes how obsession with venture capital as the only viable source of funding can lead to failure.
False Starts
This chapter focuses on startups that fail from neglecting to find the right customer. The problem with MVPs - which I've written about here - is that the founders don't get the viability right. Similarly, Eisenmann argues that startups encouraged by the fail-fast culture keep pivoting without finding the right customer. Even worse, the founders will often possess an 'I will build it, they will come' mentality. Lacking understanding of customer pain points is another common reason why startups fail. This chapter highlights how failures such as low growth and limited revenue potential are both due to limited customer demand.
The conclusion is clear - lack of clarity around the customer problem, in combination with a hard-headed founder who isn't self-reflective, causes failure. Customer discovery is absolutely critical in order to avoid this. This is especially important for the founders who don't have strong founder market fit and venturing into a new industry. The chapter ends with dozens of helpful tips and tools to help the founders avoid the false starts.
False Positives
A startup that has had early success can still fail. In 'False Positives', Professor Eisenmann documents the failure that results from premature scaling and mistaking early success for a larger opportunity. This is a difficult failure to forecast, particularly within a culture which encourages going fast and pouring gasoline on the fire. When a startup doesn't have strong infrastructure in place on the product and operations side, and, more importantly, doesn't prove repeatable demand and growth engine, the scaling is likely premature.
The Later Stage Failure
My second startup failed after 6 years and I can personally attest to how painful later stage failure can be.
In the second part of the book, Professor Eisenmann dissects later stage failure. He specifically zooms in on why it is difficult to scale by expanding vertically, by launching more products, and geographically. To analyze later stage failure, Eisenmann proposes a 'Six S's' framework:
Speed - how quickly can the startup build their brand, tap into network effects and economies of scale and saturate their market?
Scope - how well will the management make an expansion decision - to grow geographically, to launch new products or to expand vertically - and can the startup grow successfully by making acquisitions?
Series X - fast growth is usually at odds with profitability and startups are constantly hungry for more capital as they scale. Can the startup attract the right growth stage investors? Can the startup do a smooth CEO transition?
Staff - early startups are built by generalists, but later stage startups need specialists. How do you create a foundation for a successful transition, particularly for the management team and the CEO?
Structure - early stage startups are wonderfully chaotic, but later stage startups need structure. These transitions are tricky and, when done incorrectly, can lead to failure.
Shared Values - last but not least, it is essential to hone culture. Locking down the startup's true north is critical for communication, making decisions, better HR practices and, ultimately, scaling the business.
Speed Trap
Hyper growth can lead to a failure even for the most promising startups. In this chapter Eisenmann documents the failure of Fab.com. Its early traction attracted not only a lot of capital, but also a lot of competition. Fab didn't pay close enough attention to the CAC to LTV ratio, and was overspending on customers at the expense of long term revenues. The company also had a hard time hiring and implementing management structure. A combination of rapid growth and a lack of focus and internal alignment led to a failure.
Eisenmann argues that the CAC/LTV ratio is a critical factor in assessing whether or not it is the right time to scale. Without strong LTV the startup is running a risk of unsustainable growth. He recognizes a fatal pattern when an increase in CAC leads to a reality check as the insiders and downstream investors aren't willing to write the next check.
Help Wanted
Next, the book tackles the ability to secure capital and hire an appropriate management team as crucial variables determining a startup's failure or success. The capital problem is a dilemma as downstream investors always weigh the risk-reward opportunities. Even when startup is growing, the question is: is it growing fast enough to warrant more capital infusion? Is the price of the round and the stage risk map onto the expected upside?
Another risk is building out the management team. Given the sheer amount of successful later stage startups, unicorns and decacorns, the competition for quality talent, especially in the bay area and other startup hotbeds is fierce. Hiring is expensive and difficult, but while "distracting" is key to scale. Without a proper management team in place, the startup will not be able to create the right systems, processes and scaling levers.
Cascading Miracles
The last later stage failure is due to what Eisenmann deems "Cascading Miracles": when too many things need to come together. It is what Josh Kopelman, a Midas List VC and Founder of First Round capital, wrote about in this blog post. Success is dependent on too many variables, and when any one of them doesn't play out the startup fails.
How to Fail
The third part of the book is dedicated to handling failure. Eisenmann highlights the signs that failure is coming - things aren't going well and founders are starting to explore a new business model, trying to raise capital from new investors, trying to raise a bridge round, trying to sell the business, and trying to reduce the burn.
When all else fails, the founders are faced with the decision to shut down the business. The decision is not easy - I know it well myself - as the founders have developed attachment to the business and the idea. It is hard to admit to yourself that you are failing. In a typical scenario, the founder's grit and ego cause him/her to be unwilling to give up. Eisenmann provides a rational and empathetic framework for helping the founders make a difficult decision.
The book ends on a fresh and optimistic note describing how the founders bounce back from a failure. Eisenmann highlights the recovery from a failure and what the founders who failed are up to now. Again, this very much resonated with me - after the failure of my second startup I got a job as a Managing Director at Techstars, which turned out to be an incredible opportunity and my foray into the world of venture.
Professor Eisenmann wrote a smart, clear and concise book that both early stage and later stage founders can learn from. I highly recommend you checking it out.
