CHAPTER EIGHT
Five Fatal Mistakes of Start-Ups
The most common venture killers are avoidable.
ALTHOUGH RELIABLE STATISTICS ARE LACKING, IT HAS been estimated that, on average, fifty thousand companies a year are seed- or angel-funded in the United States. A few thousand of them are funded by professional venture capitalists. Of those started each year, a few hundred will produce great returns for their investors, and a few have the capacity to greatly impact the commercial world. Many others will succeed in becoming financially rewarding—but without realizing their dream.
Many reasons explain the failure of start-ups. There are unavoidable events that can kill start-ups, and then there are avoidable mistakes. Unavoidable events might include the loss of a key founder, or an unexpected government action that eliminates the need for the product. Such events are rare in our experience. Instead, avoidable mistakes are the common venture killers.
In broad terms we group avoidable mistakes into five categories: failing to know your customer, keeping the wrong CEO, mismanaging finances, being overconfident, and failing to anticipate future industry developments. If you spot these mistakes in time, you can fix them, but start-ups have very little room for error.
Fatal Mistake 1: Failing to Know Your Customer
Value propositions and business plans, no matter how carefully crafted, make assumptions about customers and their buying behavior. But these assumptions are at best hypotheses. You may have talked with and gained assurance from many customers, but talking isn’t sufficient. As we discussed in chapter 1, it’s essential that your leadership team has deep domain knowledge and experience with customers and their ecosystem. One unfortunate example is the fate of an SRI spin-out called PacketHop.
On September 11, 2001, when the Twin Towers were attacked, 343 firefighters died. One reason so many died was that, due to the fire, all communications, including the internet, had failed between firefighters at the base of the buildings and those who were running up the stairs to save thousands of lives. They never received the call to come back down.
Researchers at SRI reasoned that they could develop another way of maintaining communications: by creating a wireless network that hopped from handheld device to handheld device as the firefighters were running up the tower. Effectively, a local version of the internet would be running up the stairs with them. That is where the name PacketHop came from.
Much of the technology—known as mobile ad hoc networking—had been developed under government funding for an entirely different purpose, but it would apply here, too. PacketHop had an outstanding team, top investors (the Mayfield Fund and US Venture Partners), and in principle a large potential public safety market with a major pain point. Conversations with potential customers confirmed their interest. The government had also indicated that billions of dollars would be invested in upgrading the equipment to allow firefighters and other first responders to communicate seamlessly.
Motorola effectively owned the existing market for devices and had made the devices and software closed systems, making it difficult or impossible to implement interoperability between any devices except those made by Motorola. PacketHop proposed a software system that would work with a multitude of hardware devices, including the emerging smartphones, breaking the stranglehold Motorola had on the market. PacketHop would disrupt the legacy market and create a new, open, lower-cost system. This was a great vision.
But the emergency responders—PacketHop’s initial target customers—were naturally conservative and reluctant to move from a well-known brand like Motorola to a start-up’s product, even if it would be superior. No matter how much value there was in creating this new, seamless, low-cost product, the customers were dedicated to maintaining what had been long-standing relationships developed over many years. Each community, each group of first responders, each town budget official would need to approve the expense. The sales cycle proved to be so lengthy that go-to-market costs were going to be very high. A few high-profile cities were willing to do proofs-of-concept, but it was a very different decision to buy an entirely new solution.
Beyond these primary problems, the federal government funds allocated to help solve this problem went to the states, and the states funded the communities according to their needs. The need for a new type of communications was often deemed a lower priority than, say, a new fire truck.
Because of the inability to close sales, PacketHop missed its milestones, and the venture capitalists were not willing to continue funding. The investors agreed that this was a great technology that could help make a major impact on the world, and they graciously agreed to license back the technology to SRI in the hope that we could deploy it in the future.
We followed our framework in chapter 2 and identified a major market pain point, talked with many customers, and built an outstanding value proposition. What did we do wrong? The team did not have sufficient domain knowledge of the customer and their ecosystem to fully grasp either the reluctance and difficulty they would have to adopt a new system or the priorities that they would place on using their government funding.
Fatal Mistake 2: Keeping the Wrong CEO
If you’re a CEO, you need to understand your own talents and limitations. Although you’ve created a great company, you may or may not have the skills to manage it in all the stages of its growth. This self-knowledge potentially determines the success or failure of the company as well as your own financial reward. If you transition the company to another CEO, it is almost never considered a failure. On the contrary, you will still have your vested stock and will retain the value you’ve created. The company will continue to succeed and grow. You may also take another role, such as a board member or adviser. You will be respected and appreciated for your capabilities and will likely be offered future roles as CEO of companies at the stage for which you’re most suited. We know many great CEOs who are best suited for early-stage companies, who are happiest in that environment, and who have no intention to be the CEO who grows the company to the larger stages, which involve for them a less interesting and less exciting role.
The primary point of CEO failure occurs most often in the transition from the freewheeling atmosphere of an early-stage start-up to a larger and more structured organization. Working in a company that feels like one happy family is great, but it has its limits, which are quickly reached with growth. Some entrepreneurs are skilled in developing a business vision, but when it comes to execution, they simply do not have the talent needed to manage a growing team in the face of growing obstacles.
If this is the problem that besets your company, the symptoms will become evident to your investors. The company will miss milestones without executives having sufficient understanding of the reasons. Employee morale will begin to deteriorate, and good people will leave. The team will look to you for guidance and actions that point the business in the right direction. What will be evident is a lack of direction. Lacking dynamic leadership, the enthusiasm of the early days is replaced by a loss of confidence in management. Such conditions, if they persist, are extremely dangerous. Persistent declining morale results in declining productivity and the departure of the best people, beginning a spiral into business failure.
Rarely do CEOs acknowledge their own inability to deal with events. In that case it’s the board’s role to act; in fact the most important role of the board is to hire and fire the CEO. If the CEO is not right for the position, time and funds are being spent on misdirected plans and products.
The responsibility of the board of directors is to act to determine the root causes of the problem and to address them. If leadership dysfunction is the problem, failure to address it is probably the single most important cause of venture failure.
Fatal Mistake 3: Mismanaging Finances
If you walk into a start-up and you see a lavish environment, turn around and walk away.
Start-ups often spend more than they earn, but running out of money without the ability to raise more capital is the ultimate killer. As we’ve mentioned, the two most important metrics of any venture are the amount of cash available and the monthly burn rate. If you’re within three to six months of running out of cash, you’re in extreme danger.
When you first raised your funds, you convinced investors and your own team that you had a major opportunity and were building a venture that would achieve success. Investors insist on identifying milestones of achievement, and they are willing to fund the venture through the achievement of those milestones. For example, angel or seed investors often fund the venture through formation of the team and product development. Series A investors will fund product and market development to revenue, and so on. As a result, the challenge is to achieve these milestones with the funds provided. Failure to manage cash to meet the agreed-to milestones can make it impossible to find new sources of capital.
Here are some common ways that ventures waste money.
Hiring Staff Prematurely
A common error is to hire too quickly before you’ve properly evaluated your needs for skills and productivity. In the haste to get revenues flowing, hiring errors are common, particularly if you confuse the sales and marketing functions. The most common early overhiring occurs in the sales operation, when you hire personnel too far in advance of having products to sell. Eventually you will need a strong sales organization, but in the early years you need market development people who have the technical expertise to work with potential customers.
We have seen companies set up sales offices and staff them with expensive people, only to discover that these people produce no value because products are not ready at that point. Such was the case at Licom. This company introduced a family of new communications equipment products that underwent an extensive period of testing with a few major carriers. The proper role of the marketing was to assess the market readiness of such products, and the salespeople, who lacked technical sophistication, were redundant. They were paid with salary and commissions, and, when sales did not materialize some months into their tenure, they resigned, having wasted money and time without generating any value—something that was predictable from the start.
Keep Only the Best
Most early-stage ventures have an aura of informality, and most don’t formally monitor employee performance. In a start-up with a small number of employees who have worked together in the past, they share knowledge and mutual trust that help get difficult projects done. But if that informality continues too long as the company grows, less competent people are free to do serious damage. As teams of strangers must learn to work together, ventures must institute formal performance review processes. People trusted with management responsibilities (perhaps for the first time) must receive training. No one is going to like this, but it probably must happen sooner than you think.
Poor Product Management
Poor coordination between marketing and product development makes it difficult to complete products. Worse, if you select the wrong first product—by targeting the wrong customers—you waste time and money. The product won’t be available as anticipated because of misjudgment of product features, unexpected technology issues, or time needed to complete products.
Sometimes the difficulty in getting products to market comes from a belief that “it’s not good enough,” leading to constant (and wasteful) engineering iterations without good reason. Frequently, this problem is caused by the demands of one or two customers that deflect attention from broader market needs.
The Wrong Partners
As noted earlier, young companies with exciting new technologies find many opportunities to work with established corporations. Whatever the outcome of such relationships, they involve a great deal of attention by management. Sometimes this comes at the expense of more productive work as the relationships distract you from more promising activities.
Erroneous Cost Accounting of Products
We’ve talked about the importance of clear financial thinking, but we mention it again because it’s crucial and often ignored. In the search for revenues, but in the absence of honest cost accounting, ventures end up subsidizing customers while believing that they’re building a customer base.
You might think running a business without clear cost accounting is so ridiculous that it couldn’t happen. But it can and does. One example is a software company that came to us seeking funding. The company had excellent products and annual revenues of $100 million. It was noteworthy, however, for its inability to be profitable even as its revenues grew by 30 percent per year. Annual operating losses exceeded $20 million, and these losses increased with increasing revenues. How could such a promising company do so poorly financially?
The reason was erroneous accounting, as became obvious when we looked closely at cost accounting. Although the gross profit margin was 80 percent (quite reasonable for a software company), the actual product costs were about 110 percent of the sale price. The reason? Each sale involved a huge amount of customized engineering and services to install the product and train the customer in its use. These costs were hidden under the heading of “marketing” or R&D costs and were reported as such to the board of directors.
It was clear that the company had an unsustainable business model, because the products were being sold at a loss and most of the engineering was devoted to customer installation support and not product development. The investors were unaware. As revenues grew, so did the losses. It was clear they had to change the pricing structure or they would go out of business.
Fatal Mistake 4: Being Overconfident
When a company—or any institution or individual—becomes arrogant, overconfident, and complacent, it is most likely to fail. It’s almost as if nature planned it that way, to kill them off and make room for the next generation.
If you think things are going great, why bother to change? Because an organization with this mind-set tends to become static and bureaucratic, with employees paying more attention to internal structure, position, and politics than to serving the customer.
Early, rapid success is a good thing, but not if it leads to overconfidence. Often it causes ventures to neglect the competition or changing market needs. Teams begin to feel they are invincible, setting up the company for unpleasant surprises as competition emerges from unexpected sources. Overconfident ventures may avoid developing new products for fear that they will negatively impact existing products—or because information from the field says no new products are needed. As a result, only marginal product improvements are the order of the day.
The solution? Stay paranoid! Perpetual paranoia needs to dominate a business as it runs harder and harder to gain its market position.
Fatal Mistake 5: Failing to Anticipate Future Industry Developments
A business cannot escape the impact the environment has on it. Anticipating future industry developments (good or bad) does not mean that the team needs to be gifted with prophetic powers. It does mean that the team must learn of historical trends likely to impact their venture. Such trends include the commoditization of products once considered proprietary, the consolidation of vendors, the growing importance of industry product and service standards, and, of course, the impact of new technologies that may be nascent when the venture is launched but that could become giant factors faster than anticipated. We consider these in turn.
Products Become Commodities Creating Intense Price Pressure
Successful products and services that address big markets invite competition. The key element in business planning is to plan an evolutionary path forward that keeps a competitive edge.
Certain market sectors are particularly vulnerable to price competition. Consider solar cells. There is no doubt that solar cells provide a clear value proposition as an alternative to energy generated by fossil fuels, for well-known reasons. But the cost of cells is a key factor in the value proposition, and many start-ups have been focused on manufacturing solar cells using new technologies that promised to dramatically reduce their cost. The underlying assumption is that the scale of manufacturing and the cost-reduction curves are predictable.
What these plans often don’t consider is what happens when cost reductions don’t materialize or competitors emerge with lower-cost factories or sponsors (such as governmental agencies) willing to subsidize loss-making factories.
Rapid Industry Consolidation Threatens Niche Companies
A small niche player in a big market needs to have an aggressive business plan to survive and create value. You must either grow with the market opportunity that was the basis of your venture, or die sooner or later unless sold. Some companies fail to understand the market dynamics and end up stranded when more-aggressive competitors copy their original value proposition but do it more cheaply and perhaps better.
The history of technology companies is that of relentless consolidation driven by the cost of developing new products of ever greater sophistication, along with the need for broad marketing.1 Launching a new venture means anticipating the impact of business size on competitive positioning. At some point (as we discuss in chapter 9), a company must make one of these choices:
- Acquire or merge with others to enhance its market position.
- Be acquired by others who are committed and have the capital resources and management to become consolidators.
- Execute an IPO on its own at some time during its development to get the capital to fund aggressive growth.
Industry Standards Obsolete Products
Young companies have limited resources to devote to new products. Once you’re launched along a certain track, any significant deviations require new skills, resources, and money. For example, Licom entered the market for telecommunications equipment in the 1980s with one standard, and found its products obsoleted overnight when a new standard came in and the Licom products were no longer compliant.
The point is not that standards change, but that the management of the company did not anticipate the emergence of a new standard. In fact the change had been under discussion in industry organizations, but the team did not believe that it would be adapted rapidly. That misjudgment cost them the company. It did not have the resources to start over again, nor did the investors have confidence enough to refinance the company.
Failure to React to New Technologies
In the dynamic industrial world, many businesses fail to adapt rapidly enough to new circumstances, and they pay the price: oblivion. Rather than discuss such sad histories, we present the story of a company that successfully reinvented itself, adapting to the new realities created by the emergence of the internet as a universal communications medium.
BEA Systems rapidly transformed into a leading provider of internet infrastructure software technology because of bold actions by its management and lead investor. Had it failed to transform itself, it would have languished as a niche software vendor in a declining market. Instead, BEA became a multibillion-dollar industry leader.
BEA was founded in 1995 to develop software products that would greatly improve the performance of corporate computer systems connected by private communications networks. The company was an instant success. By dint of excellent marketing, improved products (based on acquired Bell Laboratories technology), and successful early customer implementations, BEA built its revenues much faster than anticipated. In a classic snowball effect, the more customers achieved success with the software, the more others became convinced of the benefits of distributed computing systems. Only two years after its launch, the company executed its IPO on NASDAQ. One year later it reached a market capitalization of $1 billion.
But even though others within BEA foresaw a great future for the company in doing more of the same, Alfred Chuang, its head of technology, sensed trouble ahead. The internet was coming of age. Its power and reach were daunting. Chuang saw the internet as both a threat to BEA’s current product strategy—which was based on selling products for enterprise networked computers—and an unprecedented, once-in-a-lifetime opportunity. Whereas others within and outside BEA thought it too risky to invest heavily in the new medium, Chuang thought the bigger risk was failing to exploit the internet’s commercial potential. There were many questions about the suitability for this commercial use.
By 1997, it became apparent to Chuang that the internet was the ideal global interactive data communications medium, linking millions of people, and that it had the capacity to become a key platform for business applications. Chuang commented, “There was just one problem: it needed a great deal of new software technology (and access to industry standards) to realize its potential, which promised to be quite complex.”2 Instead of linking hundreds or thousands of enterprise users, the internet would need to support millions of people worldwide trying to execute transactions at the same time. And, of course, the security of the transactions was vital, so the technology had to address that requirement from the start. If the internet ever became an important enabler of business transactions, then companies would increasingly move their operations to the internet, and demand for BEA’s current products would decline.
Most people connected with BEA considered the new product direction to be a turning away from success, but Chuang went ahead. In 1997, BEA launched a new internet-based software development project independent of its current product development organization. But progress was too slow. Chuang became convinced that it was essential to acquire a company that already had a team of people with the right experience.
In the internet frenzy of the time, a number of start-ups had begun the development of software targeting online business applications. Of all the companies BEA considered, WebLogic, founded in September 1995, was the most attractive. WebLogic had completed an initial product that generated about $40,000 in revenues in 1997 from trial sales. Designed from the start as software geared to internet-based transactions, this product consisted of software that ran on a middle-tier computer, called a web server, to connect the database and related applications on the corporate side, and browser-based software on the client computers. The web server allowed users to execute online transactions in real time.
It was just the system BEA had been looking for. But the price demanded by the founders of WebLogic was outrageous: $150 million. This represented about 15 percent of the public stock value of BEA at the time.
By that time, Chuang had convinced BEA’s management team that internet-based technology represented the future of the company, and the team agreed that WebLogic’s product met the requirements. BEA had three choices: convince BEA’s board of directors that the deal was worth doing despite the high price; find another start-up that was willing to sell itself for a lower price; or continue internal development in the hopes of launching a finished product before a host of others beat it to the market.
The management team chose the first option, but convincing the members of a public company’s board to give away so much of the company to an unproven start-up is never easy, especially when things look to be progressing extremely well with the existing product strategy. To prudent people, it was far from obvious that the internet would rapidly develop into a powerful business driver. Most board members felt that there was ample time to develop a competitive product internally. The most vocal critic of the internet strategy was a well-known software industry executive. Bill Janeway, the lead director from Warburg Pincus, describes the conflict.
The former head of worldwide operations of Sun Microsystems—and a powerfully supportive presence on the board since the launch—assured Alfred and [CEO] Bill [Coleman] that they were insane to propose such a transaction. She added me to that assessment when I supported them. But Alfred’s deep analysis of both the market and the technology prevailed, especially because Warburg Pincus, by far the larger stockholder, was committed to the deal.3
The influence of Janeway was critical in helping convince the independent board members that the acquisition of WebLogic, though risky, was essential to the future of BEA. The board of directors eventually agreed, and the deal was done.
Once the decision was made, Chuang kept management of the WebLogic team independent of other BEA activities. He felt that he could not risk smothering its entrepreneurial energy.
This is not to say that such endeavors come free of dissent among employees as well. Those who are committed to the existing businesses may feel that they’re losing ground to new people and new products in which they have no stake. Managing such internal change can be just as challenging as developing a new strategy. At BEA, Chuang managed this process well by taking a number of steps. First, he ensured that existing products were gradually changed to enable their use in the new applications. Second, to ensure that the product offerings and customer base were exposed to the proper mix of new and old products, the company made Chuang head of the sales force in addition to his technology responsibilities. This step was also important to retain the most talented staff.
The results were spectacular. The internet did become a powerful enabler of real-time transactions, starting with online retailing. These applications were enabled by the BEA software that evolved from the WebLogic product.
Thanks to clever marketing, in addition to product quality, the WebLogic products were quickly at the disposal of thousands of software developers, who tailored their capabilities to the many applications that surfaced to support web-based transactions. As applications proliferated, BEA’s revenues increased dramatically.
Within only five quarters, WebLogic-related annual revenue exceeded $100 million, and BEA was established as the undisputed leader in the new web-based server software market. In fact, in 2001 more than one million independent software developers were generating web-based application software that depended upon the BEA platform.
The company’s value reflected its spectacular growth. By 2004, BEA’s annual revenues exceeded $1 billion, and it began to attract the attention of large companies as an acquisition target. Chuang eventually became CEO of the company. In 2008, Oracle acquired BEA for $8.5 billion. Of course, none of this would have succeeded without an extraordinary management team, especially cofounders Bill Coleman and Ed Scott, or without a brilliant lead investor like Bill Janeway.
BEA ranks as one of the most successful venture capital–backed start-ups in history. Had BEA continued to focus on the original software market, it most likely would have gone out of business. That market was decimated by the internet.
When a venture has executed well, and skillfully avoided the fatal errors we described in this chapter, it has positioned itself for growth and success. At this point, it’s near certain that major companies will begin courting the venture and proposing acquisition. Going IPO becomes a possibility, as well as many other approaches to continuing or accelerating growth. The next chapter will help you in making those decisions.