Why do service start ups fail

Startups have been the hyped-up success story of the past decade, with a few new companies not just hitting it big, but changing the face of business in the process. But for every successful startup, countless others fail, sometimes mysteriously and often unnoticed.

I was asked by some of my readers to write an article on what are the common reasons for failure of start up companies that offer services and below are a few reasons I could think of based on my observations. However, this article represents my opinion with contributions from some good friends regarding the finance part. Rreaders’ valuable contributions are welcome.

1. The market

A major reason for failure of companies, is that there is little or no market for the product that they have built. Here are some common symptoms:

• There is not a compelling enough value proposition, or compelling event, to cause the buyer to actually commit to purchasing. A good sales representative will tell you that to get an order in present market conditions, you need to find buyers that have their “hair on fire”, or are “in extreme pain”.   You also hear people talking about whether a product is a Vitamin (nice to have), or an Aspirin (must have).
• The market timing is wrong. You could be ahead of your market by a few years, and they are not ready for your particular solution at this stage.
• The market size of people that have pain, and have funds is simply not large enough

1. Business model

Many entrepreneurs are too optimistic about how easy it will be to acquire customers. They assume that because they will build an interesting web site, product, or service, that customers will beat a path to their door. That may happen with the first few customers, but after that, it rapidly becomes an expensive task to attract and win customers, and in many cases the cost of acquiring the customer (CAC) is actually higher than the lifetime value of that customer (LTV).

The observation that you have to be able to acquire your customers for less money than they will generate in value of the lifetime of your relationship with them is stunningly obvious. Yet despite that, the vast majority of entrepreneurs fail to pay adequate attention to figuring out a realistic cost of customer acquisition.

So what should be a good business model?

A simple way to gauge your business model is look at these two questions:

• Can you find a scalable way to acquire customers
• Can you then monetize those customers at a significantly higher level than your cost of acquisition

These are the hard and fast rules. Now, the guideline:

• CAC must be less than LTV

CAC = Cost of Acquiring a Customer
LTV = Lifetime Value of a Customer

To compute CAC, you should take the entire cost of your sales and marketing functions, (including salaries, marketing programs, lead generation, travel, etc.) and divide it by the number of customers that you closed during that period of time. So for example, if your total sales and marketing spend in Q1 was $1m, and you closed 1000 customers, then your average cost to acquire a customer (CAC) is $1,000.

To compute LTV, you will want to look at the gross margin associated with the customer (net of all installation, support, and operational expenses) over their lifetime. For businesses with one time fees, this is pretty simple. For businesses that have recurring subscription revenue, this is computed by taking the monthly recurring revenue, and dividing that by the monthly churn rate.

Also, unless you have surplus capital, which is rarely the case, recover CAC in less than 12 months

1. The management team

An incredibly common problem that causes startups to fail is a weak management team. A good management team will be smart enough to avoid Reasons 2, 4, and 5.  Weak management teams make mistakes in multiple areas:

• They are often weak on strategy, building a service model that no-one wants to buy as they failed to do enough work to validate the ideas before and during development. This can carry through to poorly thought through go-to-market strategies.
• They are usually poor at execution, which leads to issues with the service not getting operational correctly or on time, and the go-to market execution will be poorly implemented.
• They will build weak teams below them. There is the well proven saying: A players hire A players, and B players only get to hire C players (because B players don’t want to work for other B players). So the rest of the company will end up as weak, and poor execution will be rampant.

1. The ‘C’ factor

A fourth major reason that startups fail is because they ran out of cash. A key job of the CEO is to understand how much cash is left and whether that will carry the company to a milestone that can lead to a successful financing, or to cash flow positive.

What goes wrong

What frequently goes wrong, and leads to a company running out of cash, and unable to raise more, is that management failed to achieve the next milestone before cash ran out. Many times it is still possible to raise cash, but the valuation will be significantly lower.

When to hit Accelerator Pedal

One of a CEO’s most important jobs is knowing how to regulate the accelerator pedal. In the early stages of a business, while the niche services are being developed, and the business model refined, the pedal needs to be set very lightly to conserve cash. There is no point hiring lots of marketing people if the company is still in the process of finishing the service to the point where it really meets the market need. This is a really common mistake, and will just result in a fast burn, and lots of frustration.

However, on the flip side of this coin, there comes a time when it finally becomes apparent that the business model has been proven, and that is the time when the accelerator pedal should be pressed down hard. As hard as the capital resources available to the company permit. By “business model has been proven”, I mean that the data is available that conclusively shows the cost to acquire a customer, (and that this cost can be maintained as you scale), and that you are able to monetize those customers at a rate which is significantly higher than CAC (as a rough starting point, three times higher). And that CAC can be recovered in under 12 months.

For first time CEOs, knowing how to react when they reach this point can be tough. Up until now they have maniacally guarded every penny of the company’s cash, and held back spending. Suddenly they need to throw a switch, and start investing aggressively ahead of revenue. This may involve hiring multiple sales people per month, or spending considerable sums on SEM. That switch can be very counterintuitive.

1. Issues with the final offering

Another reason that companies fail is because they fail to develop a service that meets the market need. This can either be due to simple execution. Or it can be a far more strategic problem, which is a failure to achieve Service/Market fit.

Most of the time the first service that a startup brings to market won’t meet the market need. Of course, there are exceptions. In the best cases, it will take a few revisions to get the service/market fit right. In the worst cases, the service will not be in tune with customer needs, and a complete re-think is required. If this happens it is a clear indication of a team that didn’t do the work to get out and validate their ideas with customers before, and during, development.

Finally, no matter how good the advice from experts, they inevitably contradict one another and also contradict success stories.  Actually the complexity of predicting the success of the startup is so incredibly high that actually no matter what rationale people place on why they back a particular company, it is their ‘gut instinct’ that actually makes the choice. Then once decisions are made, both the fundamental attribution error and survivor bias kicks in causing us to look at the patterns between successful companies and not the conditions that helped them be successful or the companies who were just like them but failed.

To sum it up, unfortunately, there are really only a very small handful of companies that do get true viral customer acquisition, and the rest are forced to work very hard, and find other means to get each customer. Unless the entrepreneur is really sure they will get true viral growth, they should plan for the costs of acquiring each customer, and figure out how they can finance the capital requirements of the business, and also at some future stage create a monetization strategy that will result in each customer being profitable to them.