In the world of venture capital investments in startups, success stories are often celebrated, but there is also the less-explored area—the stories of startups that, despite securing substantial funding, faced unfavorable exits or untimely demise. Frequently, these failures not only result in financial losses but also pose a reputational risk for both startup founders and venture capitalists. The question arises: does the responsibility lie with venture capitalists for misjudging the investment, or do the startups fail in managing or mishandling the venture capital funds? Perhaps both parties contribute to the narratives of these failures.
A professor of entrepreneurship at Harvard Business School highlights the challenging odds of launching a business: Two-thirds of start-ups never show a positive return. He identifies two crucial causes: 1) Bad bedfellows, where entities beyond the founders, such as employees, strategic partners, and investors, can significantly contribute to a firm’s demise, and 2) False starts, emphasizing the importance of researching customer needs before testing products (Eisenmann, Why Start-ups Fail, 2021). In alignment with this perspective, CBInsights identifies three major causes of startup failure: 1) No market need, 2) Running out of cash, and 3) Not having the right team. What insights can we glean from startup failures to enhance the process of building successful startups and making informed VC investments?
My in-depth exploration of this topic unravels common threads, extraordinary causes, and valuable lessons beneficial for both venture capitalists and startups alike.
Return to fundamentals
In 2021, British used car company Cazoo entered the New York Stock Exchange with a staggering valuation of $8 billion, securing its position as one of Europe’s top-valued tech firms. However, Cazoo’s unicorn status has dwindled significantly. With a share price plummeting by 99% since its IPO, the company’s current market capitalization is a mere $83 million (Sifted). Similar stories befell WeWork, once valued at $47 billion (CNBC), and as of November 6, 2023 WeWork filed for Chapter 11 bankruptcy and its stock plunge to 84 cents per share, resulting in a valuation of $44.5 million (Forbes). Additional instances of startups encountering similar setbacks are outlined in this compilation of 278 of the most significant and expensive startup failures of all time (CBInsights).
What factors led to such unfavorable outcomes? These are the startup companies that secured substantial funding but ultimately faced failure or experienced undesirable exits, and even ending up in asset sales or acquisitions for amounts lower than the total funding raised. The Covid-19 pandemic may have played an important role in 2022, alongside other things (CBInsights). Yet, post-pandemic, the reasons for failure are probably more multifaceted. Can we distill the most common causes and use them as a foundational guide for evaluating investments and making well-informed decisions over time?
Apart from exceptional reasons such as financial fraud and lawsuits, there are fairly common reasons for the failure of startups. The first reason is the inability to generate sustainable revenue because there is no market need for the product. Before anything else, startups need to prove that they have good product-market fit and paying customers. Mark Zuckerberg argued that ‘the most important thing that an entrepreneur should do is pick something they care about, work on it, but don’t actually commit to turning it into a company until it’s working.’ CNBC MakeIt conducted a poll to almost 500 founders and asked what they wished they’d done differently when starting their own businesses. The findings revealed that 58% of the founders expressed a desire to have conducted more extensive market research before the launch. Similarly, an equal percentage indicated a wish for having crafted a stronger business plan.
Two other major reasons are lack of financing or investors (47%) and running out of cash (44%) (CNBC MakeIt). Running out of cash can be the result of poor financial planning or again indicate a lack of available funding. And finally, not having the right team is a decisive factor for failure (Eisenmann, Why Start-ups Fail, 2021) (CBInsights).
The dilemma of VC funding
VC funding operates on dual fronts. For new startups without access to stock markets and lacking sufficient cash flow for taking debt, venture capital plays a crucial role. This relationship fosters a mutually beneficial scenario wherein startups obtain essential capital, and investors acquire equity in promising ventures. VC funding can accelerate growth, offering early-stage startups the capital needed to bootstrap operations, along with mentorship and networking services to facilitate talent acquisition and overall growth and expansion.
Conversely, VC involvement often entails a substantial stake in startups’ equity, potentially leading to a loss of creative control as investors seek immediate returns. The pressure for hyper-growth imposed by VCs can inadvertently harm companies by prioritizing short-term gains, potentially jeopardizing the long-term soundness of the business. VCs might exert pressure that steers companies toward premature exits rather than pursuing enduring, long-term growth strategies that emphasize innovation, investments in research and development, and sustainable growth.
What Can We Learn?
- The gradual organic growth of start-ups, reasonable scaling and bootstrapping are not a bad idea.
- Avoid False Starts. Entrepreneurs should passionately engage with an idea, work on it, but refrain from committing to transforming it into a company until proven viability.
- While VC funding accelerates growth, it can be a double-edged sword. Rapid capital injection should align with a solid product-market fit and existing customer base to avoid illusory growth.
- Prioritize a sound and robust financial foundation. Revisit fundamental business principles, ensuring the presence of paying customers capable of generating healthy cash flow.
- Resist the temptation to follow VC herd behavior blindly. Evaluate investment decisions independently, considering the unique strengths and challenges of each opportunity.
- Due diligence should be diligent. Conduct thorough due diligence before making investment commitments.
