5 Reasons Why Start-ups Fail

The word start-up has become synonymous with success. Amazon, Uber, Airbnb are all outstanding examples of mega-successful start-ups. But what about those that fail to make it? Why did these start-ups fail to do what they set out to do?

The first reason: Market Problems

One of the first reasons why most start-ups don’t do well is that they cannot read the market properly. Sure the idea could be great but if there is very little to no market market adoption of the product, the company will run into problems quickly.

So how do you recognize this problem? The following symptoms are prominent indicators of this issue:

Lackluster value proposition

Every successful start-up has either had a compelling value proposition or event that prompted customers to commit to buying what they were selling.

A start-up that cannot get this right will not do well. Selling in today’s business market is tough. There are so many options available and customers are more demanding. In fact, sales reps experts have a specific metaphor for this. For a product to sell you’ll have to find a customer segment that either has their “hair on fire” or is in “excruciating pain” and needs immediate relief. In other words, you are either selling a vitamin or a painkiller.

Bad timing

As with anything in life, timing is everything. Some start-ups fail to realize that they are ahead of their market by several years. While the value proposition could be sound, the size of the market will not be able to sustain the growth of the company. Simply put, not enough people will have the money or see the need to purchase the product.

A good example of this is the 1998 Pets.com start-up. Meant to be an ‘Amazon’ for pet owners, the idea failed for several reasons. The business model was unsustainable and expectations of growth were inflated. But aside from these reasons, Pets.com overestimated the number of online customers it could rope in.

The second reason: Business Model Failure

An unrealistic business model will always spell failure for any company. A common reason for start-up failure is the assumption that customers will flock to them because they have an awesome product or service.

While this may happen especially with the first few customers, most start-ups will realize that a lot more effort is required to maintain a steady stream of customers. It is likely to become very expensive to attract and win over customers. The cost of acquiring the customer (CAC) is most likely to be higher than the lifetime value (LTV) that individual customers will bring.

Most companies do not set realistic cost projections when they are considering how to acquire customers. Often, the figure is under forecasted and at times even ignored. This is a grave mistake. A business plan that does not consider this crucial step will not work.

So what should start-ups do to counteract this oversight?

The fundamentals of a successful business model

To avoid this from occurring, the start-up will have to figure out a way to generate more money over the lifetime of their relationship with the customer compared to how much the company spent attracting them.

A great tip to consolidating a successful business model is to focus on these two questions:

Can you find an expandable method of acquiring customers?
Are you able to monetize those customers at a higher figure than what you spent acquiring them?

Simplifying the process when developing your business model will make a world of difference. In addition to this, you can use the following guidelines to assist you in the practical thinking process that you have to engage in.

The CAC / LTV rule and ratio

As we have outlined previously, your CAC has to be lower than the LTV. There is no escaping this rule. The best way to figure out if you’re doing it correctly is to calculate your LTV/CAC ratio. Ideally, this ratio should be 3:1, i.e. the value the customer brings to the business should be at least three times more than what it cost to acquire them. If the ratio is too close, you are pouring out too much money and if it’s too wide e.g. 5:1 you are spending too little and probably losing business in the process.

To figure out this ratio, you’ll need to have accurate numbers for both CAC and LTV.

How to calculate CAC

To calculate CAC, every start-up needs to factor in their total cost of sales and marketing expenditure. This includes expenses like salaries, marketing campaigns, lead generation, and conversion methods as well as travel expenses, among other things.

Once you have these numbers, divide them by the number of new customers gained in a certain period. This is especially easy if the sales cycle is short and you can tie the marketing and sales costs with new customers in the same time frame. If the sales cycle is longer, the best way to get accurate results is to stagger the costs, and the acquired customers to get accurate numbers.

So CAC= sales and marketing costs ➗ new customers.

A good example is, if you spent $1 million in sales and marketing in a given period and acquired 1000 customers, your average CAC will be $1000.

How to calculate LTV

The LTV measures how long an average customer sticks around before they stop buying your service or product. The longer your customer retention, the more valuable they are. To calculate LTV, you will need to account for the gross margin percentage associated with every individual customer.

This is the percentage of profit that is left after you factor in the total cost of operation, support and installation expenses. This is straightforward if the business model is centered on one-time fees. If the start-up has a recurring subscription revenue model, then this figure is calculated by dividing the monthly recurring revenue by the monthly churn rate (monthly number of people who cancel their subscription.)

Capital Efficiency “Rule”

In an ideal world, getting this process right is easy as long as you follow the CAC/LTV rule. The reality that most start-ups face, however, is that certain business functions such as general and admin expenses, product development, and other expenses have to be factored in so that the business becomes profitable.

After considering all these expenses, every start-up that wants to do well needs to utilize capital efficiently. The general rule of thumb is to recover CAC in less than 12 months.

Knowing these numbers goes beyond ensuring capital efficiency. You need to understand the drivers of your business so you can know which levers you can manipulate for growth.

The third reason: Poor Management Team

Problems arise for most start-ups when the management team is either weak or has poor decision-making capabilities. A good management team knows how to avoid business model failure, running out of cash, and delivering a poor product.

Several symptoms often plague a weak management team:

• Weak strategy
• Poor product research and development. Usually evidenced by bad product adoption by the market.
  
• Bad execution that leads to the product being built incorrectly or missing important launch deadlines. Go-to-market execution is also poorly implemented.

Weak team-building capabilities. The wrong people are put in key positions and the whole organization is wrought with people who don’t know what they are doing.

The fourth reason: Running out of money

This is a rampant problem in the start-up community. Running out of cash was one of the causes of the dot.com bubble burst in the late 1990s. Most start-ups fail because they are not generating enough revenue (either via revenue streams or funding) to sustain and grow their business.

A good business strategy to avoid this problem is to understand how much money is left and whether that cash can carry the company to the next successful financing round or to a positive cash flow.

Milestones that every start-up should reach

Understanding that a constant increase in valuation for many start-ups is not possible. If you manage to raise a certain amount of money from a funding round in January, it does not guarantee that your start-up will automatically be worth more at the end of the year.

Valuation increase is rarely linear. Certain key steps have to be achieved. We’ve narrowed down what these milestones would look like for a software start-up. 

Development after the first seed round valuation should be focused on removing as much risk as possible. This could be as simple as hiring a key staff member, building a prototype and testing it out on customers, or overcoming a technical obstacle.

Acquire customer validation. If the product is still in the beta stages, acquiring customer validation early on is a significant step towards increasing valuation. If you have a finished product with no customer validation, it is unlikely that you will see an increase in valuation.

The product is finished and already shipping. Paying customers who are giving positive reviews will likely aid in increasing valuation.

All the first release product or market issues have been ironed out and there are no hiccups. This is a good indicator that the business is starting to gain momentum.

You’ve figured out the CAC/LTV ratio. Once it’s proven that the business model can be monetized and that it can realistically make profit, the road to increased valuation is clearer.

The start-up has expanded well, but additional funding is needed to grow further. This capital might be used for different reasons, such as expanding internationally or injecting more funds into working capital.

How start-ups fail to reach these milestones

What often happens is that the company management fails to achieve the next milestone before they run out of money. While it may still be possible to raise more money, valuation is likely to be lower.

So how should start-ups walk this tightrope?

It’s simple. The most important tool that management has to have is the ability to know when to pause and when to dive in full steam ahead. During the early stages of development, when the business is going through refining the business model, the pace needs to be slow. The focus should be on preserving as much money as they can.

For example, it is counterintuitive to hire a full-service marketing or sales department when the product or service is still being developed. This is a significant waste of precious resources because at this point you have no need for full-blown marketing or sales staff. 

Knowing when to release the purse strings can also be a challenge even for seasoned CEOs because you need to start investing more than what your current revenue income is. If the timing is off it can set you back quite significantly.

Usually, most start-ups need to start investing in certain aspects, like marketing, when the business model has been proven. In other words, you have the green light once it’s been established that the cost to acquire a customer is lower than the lifetime value of the customer.

The fifth reason: Product Issues

The last reason why start-ups fail is that they totally miss the mark when they are developing a product. Failure to identify what the market requires is a big mistake. Other times the product could be great but the execution is mishandled.

It’s fairly common to find that the first product a start-up introduces will not appeal to the market. At best the product will require a bit of tweaking. A good example of this is Uber. When Uber launched it was called Ubercab, the target market was urban city professionals who wouldn’t mind paying extra for the convenience of a black cab. The idea then morphed several years later with the introduction of the cheaper sedan cars that catered to the average person.

Sometimes a complete overhaul of the product is needed. When this happens, it’s evidence that the management did not conduct proper due diligence and completely misread the market.