You are not the only entrepreneur who worries over “why startups fail.” Did you know that 90% of startup businesses fail? It is unfortunate but true. Numerous startups have already died down with their business idea in the first few years. While only a few manage to succeed, the majority fail.
If you plan on starting a business, this news should not discourage you. Instead, we hope you feel motivated to do what 90% of startups fail to do. To achieve that, you first have to know why startups fail. That way, you can learn from those experiences and avoid accidents along your way. It is usually not just one factor, but several reasons that prevent success. This guide will unpack the most common reasons why startups fail that every entrepreneur should know.
Why startups fail: the most common reasons
1. Lack of market need
If no one will buy what you sell, your business is bound to fail. Often, companies run into the problem of little or no market for the product they have built. You can recognize the situation from the following signs:
When there is no good enough reason for the buyer to purchase the product
Sometimes there is no compelling enough value proposition or exciting scenario to cause the buyer to invest in the product.
Being ahead of your time might not be a blessing in the startup world. Instead, it could be a reason why startups fail. If you are ahead of your market by a few years, that means you have a disconnect with the buyer. They may not be ready for your particular product at this stage. Before gaining great success and becoming the most lucrative corporation in the 2000s, Apple was responsible for some of the most catastrophic product failures in the history of the world. Before its introduction in 1983, the Apple Lisa had been in development for nearly three years and cost over $50 million. It was developed as a sophisticated personal computer with a graphical user interface for corporate users.
Although the computer cost $9,995, which is equivalent to an estimated $25,000 today, many customers found the pricing too costly. Apple terminated the Lisa in 1985 after only selling 100,000 units in two years of manufacture. Probably, it was too early in the 80s for consumers to invest money in personal computers with a high price tag.
2. When you are too optimistic
A positive attitude is good, but it should not give you false hope or stand in the way of your success. One of the most common causes why startups fail is that entrepreneurs wrongly presume that they will easily attract customers. An exciting website, product, or service, does not guarantee a permanent clientele. Sure, It may work with the first few customers. However, with the emerging rivals and consumers’ requirements constantly changing, it soon becomes an expensive task to acquire customers after that. In most cases, the cost of acquiring the customer (CAC) is notably higher than the lifetime value of that customer (LTV).
The rule of the game is that you have to win your customers for less money than they will produce in value of the lifetime of your relationship with them. Yet, most entrepreneurs fail to figure out a realistic customer acquisition cost. They do not put enough thought into this critical number. These entrepreneurs fail to recognize that their business model may not work as they do not see that CAC will be higher than LTV.
The Essence of a Business Model
It is essential to focus on what matters in your business model. To do that, you have to ask yourself the following two questions:
- Is it possible to find a scalable way to attract customers?
- If yes, can you then monetize those customers at a significantly higher level than your cost of acquisition?
Did you find answers to the questions? You see, when you break it down into simpler terms, it is straightforward and less complicated.
Next up, look at the following rules regarding the business model. They are not as complex as they sound, rather more like simple guidelines. How it goes: CAC (Cost of Acquiring a Customer) should be less than LTV (Lifetime Value of a Customer.) But please keep in mind that the entire business model is not just about these two.
To calculate CAC, you have to take the entire cost of your sales and marketing functions. Here you should include salaries, lead generation, marketing programs, travel, etc. Then you have to divide that by the number of customers you closed within that time. For example, suppose your total sales and marketing spend in Q1 was $1m, and you closed 1000 customers. In this case, you spend $1000 on average to earn a customer.
Next, to find out the LTV, consider the gross margin associated with the customer over their lifetime. It should include net of all installation, support, and operational expenses. It is pretty easy for businesses with one-time fees. However, suppose your company has recurring revenue. Then you can calculate this by considering the regular monthly income and dividing that by the churn rate per month.
Most businesses have other functions like G&A and Product Development that are extra expenses more than marketing and sales and delivering the product for a profitable business. So you will need CAC to be significantly less than LTV. For SaaS businesses, it seems that multiple is about three to break even and that to be profitable and generate the money needed to grow. An ideal LTV to CAC ratio should be 3:1. You can test these numbers for real by getting feedback from the community on their experiences.
The Rule Around Capital Efficiency
To have a capital-efficient business, it is also advisable to recover the expenses of acquiring your customers in under a year. Banks and wireless carriers break this rule, but that is because they can afford to do so. They have access to cheap capital, whereas you do not. So let us get back to the rule, which is; Recover CAC in less than 12 months.
3. Wrong management team
In the end, the wrong management team would become one of the top causes that leaves everyone pondering about “why startups fail.” You can never expect weak management to take your business to the top. Only a good management team will be smart enough to avoid Reasons 4 and 5, whereas weak management teams make mistakes in multiple areas such as:
Their strategy is weak
They would develop a product that no one wants. This situation happens when the management has not done enough work to validate the ideas before and during production.
They are usually poor at execution
As a result, the product may not get built correctly and/or on time.
They will create weak teams under them
Only a strong management team can make a strong team of players. The weak ones hire below their skills to make themselves look good. This wrong team can be a recipe for disaster. If the cooperation between the employees does not work, if the skillset is not there, the startup business does not stand a chance either. Before you know it, the rest of the company will end up as weak as the management, and poor execution will be rampant.
4. Running out of Money
Lack of capital resources is another unfortunate reason why startups fail. A perfect example here is the drone company Airways, which had to close its bulkheads again recently. The company desperately looked for financiers for around a year and a half. However, things did not work in their favor. Eventually, the company ran out of money and had to quit. Airway’s goal was to be a pioneer in commercial drones.
Unfortunately, the market did not grow as fast as Airware anticipated. Besides, there were long development cycles and missing software features that Airway’s competitors already had on offer. When Caterpillar withdrew as one of the largest financiers, the company lacked the financial resources to place itself successfully on the market. Around 120 employees were out of a job after the business had burned $118 million in cash.
It is essential to know how much cash is left. The CEO should also understand if the company has enough money to drive the business to a milestone that can provide successful financing or positive cash flow.
Milestones to Raise cash
You cannot expect the valuations of a startup to change linearly over time. Just because it was a year since you raised your series A round does not mean that you are now worth more. Instead, companies need to reach important milestones to increase in valuation. To understand the rules further, take a look at the following example regarding a software company:
1. Progress from Seed round valuation
Here, the goal is to remove a significant element of risk. It could be hiring a key team member, proving that you can overcome some technical obstacle, or developing a prototype and getting customer feedback.
2. Product in Beta test, with customer validation
It is essential to realize that if there is no customer validation to the finished product yet, do not expect the valuation to increase much. Note that the customer validation part is the key here.
The product is shipping, and early customers have already paid for it. They are using it in production, and the reactions are positive.
Product/Market fit issues, like some missing features, have been eliminated for the most part. You are starting to see early indications of the business beginning to elevate.
5. Business model
The business model is now proven. At this point, it is clear how to acquire customers, and also data shows that you can scale this process. The cost for earning customers is low enough, and the available data shows that the startup can be profitable because monetization from each customer goes beyond this cost.
The business has scaled well but requires more funding to accelerate expansion further. This capital might expand internationally, accelerate growth in a land grab market situation, or fund working capital needs as the business grows.
How things can go south
Things can go wrong when the management fails to reach the next milestone before cash runs out. It can cause the startup to run out of money and also fail to raise additional funds. Although sometimes it could still be possible to raise cash, the valuation will be lower.
When to hit the Accelerator Pedal
Knowledge of regulating the accelerator pedal is essential to avoid failures. And the task is up to the company’s CEO, who’s in the driving seat, to do the right thing at the right time. Suppose the product is still developing in the early stages of a business. At this point, you must focus on saving money by lightly setting the pedal. It is not the right time to hire lots of sales and marketing people if the startup is still working on the product to the point where it meets the market need. If a company makes this mistake, it will result in a fast burn and frustration.
Later, there comes a time when you should press the accelerator pedal down hard- as hard as the capital resources available to your company permit. That is when statistics finally indicate the cost to attract a customer (and you can maintain this cost as you grow) and monetize those customers at a significantly higher rate than CAC. It could be three times higher as a rough starting point. And it should also indicate that you can recover CAC in under a year.
Of course, knowing how to react when they reach this point can be tricky for first-time CEOs. So far, they have been maniacally guarding every penny of the company’s cash and holding back as much as possible. At this point, they have to change their ways. Suddenly they have to throw a switch and start investing aggressively ahead of income. It could involve hiring multiple salespeople monthly or spending considerable sums on search engine marketing (SEM). That switch can be very counterintuitive.
5. Why startups fail: product problems
Companies fail when they cannot create a product that meets the market need. Sometimes it can either be because of execution. Or else it can be more of a strategic problem, which is failure to achieve Product/Market fit.
Usually, the first product that a startup introduces will not completely meet what the market requires. If you are lucky, it will only take a few revisions until the product is the right fit. In some cases, the product will be way off base and may force you to go back to square one and completely alter the original idea. This unfortunate situation is a classic indication of an incompetent team. It implies that they did not validate their ideas with customers before and during development.
6. Getting outcompeted
Another reason why startups fail is when stronger competitors overtake them. Most businesses end up with no choice but to quit when they face competition. Take Wesabe, for instance. It was a failed online personal financial management service outdone by Mint. Mint saw the weaknesses of Wesabe’s MVP and waited to introduce the platform until they had developed a better solution. It gave Mint a competitive edge. While Wesabe was comparatively more powerful and offered more functions, it was more difficult to operate.
7. Costs and pricing
A business should present a high enough price to cover costs but low enough to acquire customers. Unfortunately, many startups fail to do so, which prevents their success. The perfect example to explain this is Delight. The business had the idea to develop a new type of mobile analysis: visual analysis. They decided their most expensive monthly plan was going to be $300. Their customers had higher expectations for this price point. Add to that the poorly chosen billing model.
The company calculated the cost according to the number of recording credits. Their customers did not influence the duration of the recordings, so most of them were being careful when using up the credits. It would have made more sense if Delight based pricing models on the accumulated length of recordings. Also, it would have increased the number of subscriptions.
Now that you understand the reasons “why startups fail,” it’s essential to address any mistakes you may have made. Today’s markets are very competitive, which means you must have a sound business strategy and a management team to survive and thrive in this environment. Please refer to our blog for further helpful articles on raising funding for startups to ensure that you do not run out of money in the future. Even if you fail once, it does not always follow that you will fall again. Nonetheless, repeating the same mistakes will almost certainly fail.