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Warning Signs of Troubles Ahead
CBInsights looked into 101 stories, and listed the top twenty reasons they found that startups had not succeeded. Let’s take a look at the top three reasons and the implications for things to watch out for.
No Market Need (42%)
By far the number one reason startups don’t make it is lack of demand for the product. This is nearly completely avoidable if a startup is following lean startup principles. With this approach, the team should have really strong validation about what customers want and are willing to pay for before they build the product. If you are not conversant in lean startup methodology, read the book that launched the movement: The Lean Startup, by Eric Ries. (There is even a 58-page summary ebook version for Kindle on Amazon.com for less than $3!)
How to avoid this scenario. In addition to making sure the startup you are thinking of investing in is following “lean” techniques, look at the customer traction very closely for validation that there are paying customers (a.k.a a market) for the product. To be clear, they may not have paying customers yet, or even customers, or even a product. But they should have talked to lots of potential customers to understand their needs and pain points deeply and validate that the features the entrepreneurs have in mind will be seen as valuable.
Ran Out of Cash (29%)
Some might argue that running out of cash is not the reason a company failed, but a symptom of another problem, like a lack of paying customers. That might be true for a company that has already raised its first round and cannot convince investors to put in more money. What is relevant to this discussion is that fundraising takes time and is best achieved when a company is making good progress and has hit its milestone goals promised in the prior round.
How to avoid this scenario. Make sure that the company is raising enough money to reach its next key milestone and will have a minimum of 12–18 months of runway. Keeping in touch with your investments’ cash burn rate and bank balance can help a lot, so negotiate for information rights at a minimum, and ideally observer rights to board meetings. The company should start looking for its next round no later than when it still has at least four months of cash in the bank.
This can be a bit of a catch-all. Was there a functional gap in the team, like marketing or engineering leadership? Were the key founders not all fully committed? Did someone leave when the going got tough? Did they not work well together? Did they lack domain expertise?
How to avoid this scenario. We talked a lot about the importance of the startup team in Evaluating Opportunities, and beat the drum again in Business Due Diligence for Angel Investments. If you’ve taken steps to evaluate the team and are not convinced that this team is uniquely suited to achieve success in their market, this might not be the right investment.
The best hope to avoid a complete failure of a startup you have invested in is to stay informed and keep up-to-date on how the company is doing. A good startup CEO will send out regular communications to the investors. This should cover good news, bad news, and how the investors can help the company. If you are getting these reports, you should definitely read them, and you should have an idea of whether the company is executing well, when it is thinking about raising another round, whether the company is struggling to fill a key slot on the executive team, or failing to land key customers.
If you are not getting updates, be proactive in reaching out to the CEO or the lead investor in your financing round or other investors in the round who may be connected to the company.
Negotiating for information rights and board observer rights can be really useful, because being informed of problems early gives you the best opportunity to do something about it before the company runs out of runway.