Why Do So Many Startups Fail?

(soft piano music)

Hal Weitzman: The media love to focus on CEOs who started companies in their bedrooms and made billions of dollars in a few years before selling out or listing on the stock market. But tech startups that are valued at more than $1 billion dollars are known as unicorns for a reason. The reality for more than two-thirds of entrepreneurs is that their startups will go out of business within the first few years.

So why do so many startups fail, and how do you foster a startup culture without blinding people to the harsh realities of entrepreneurship?

Welcome to The Big Question, the monthly video series from Capital Ideas at Chicago Booth. I’m Hal Weitzman, and with me to discuss the issue is an expert panel.

Scott Meadow is a clinical professor of entrepreneurship at Chicago Booth. He teaches Entrepreneurial Finance and Private Equity and Commercializing Innovation and has been named twice by Businessweek as one of the US’s outstanding entrepreneurial professors. He’s worked as a general partner with four venture-capital and private-equity firms and in 2011, he was awarded the Daley Medal for his services to the venture-capital and private-equity industries in Illinois.

Waverly Deutsch is a clinical professor of entrepreneurship at Chicago Booth. She teaches Building the New Venture and coaches startups at the Polsky Center for Entrepreneurship and Innovation. Her research focuses on the execution challenges entrepreneurs face as they grow their business. She’s also an active angel investor.

And Craig Wortmann is a clinical professor of entrepreneurship at Chicago Booth, where he teaches the class Entrepreneurial Selling, for which he won the 2012 Faculty Excellence Award for teaching. He’s also the founder and CEO of Sales Engine, which helps companies improve their sales performance, and he was previously CEO at two other companies. And he’s the author of the book What’s Your Story?

Panel, welcome to The Big Question.

Waverly Deutsch, let’s start with you. Why do so many startups fail?

Waverly Deutsch: Hal, at its basic core, it’s a numbers game. There are about 6 million employer companies in the US, and every year, about 400,000 people attempt to start a new business. Well, that’s about 8 percent of all companies.

So in an economy that’s only growing at 1 to 2 percent per year, there simply isn’t enough room to absorb all those new companies.

There’s another problem. Very often entrepreneurs choose to start their businesses in industries that have low barriers to entry, low cost of capital, low initial investment. So in 2006, about 35 percent of new startups fell in retail, food services, and accommodations.

Well, those industries only make up 9 percent of the economy. When you’re in an industry that has low barriers to entry, low capital requirements, you’re going to have a lot of competition, which means a lot of those businesses are simply not going to work.

Hal Weitzman: Basic question, is that necessarily a bad thing? I mean, don’t we want businesses to fail in order that the best businesses will be the ones that succeed?

Waverly Deutsch: Absolutely, although there is a cost. So every time a business opens and fails, we lose jobs. So when the business opens, we gain jobs, but when it fails, we lose jobs, and very often that balances out in a way that startups are a net, sort of, zero on the increase of jobs in our economy.

Hal Weitzman: I see, OK. Craig Wortmann, what’s the biggest single mistake that entrepreneurs make?

Craig Wortmann: I think the biggest mistake, Hal, is once they’ve decided to do this . . . so Waverly gives us the numbers behind how businesses get started and what sort of ecosystem they’re coming into. I like to spend time with entrepreneurs thinking about, OK, once you’ve made that decision, that big decision, let’s go, what do you do?

And I think one of the issues that entrepreneurs face is sort of what I refer to as the curse of knowledge, right, what a psychologist would call the curse of knowledge. They’re super passionate, they’re incredibly enthusiastic about their business, but they have no idea how to talk about it.

Hal Weitzman: So they almost know too much.

Craig Wortmann: They know too much. If you think about, you know, who they’re interacting with in those early moments of the company, raising money, talking to folks like Waverly about angel investments, investors, venture-capital firms, that’s a wonderful—and not to mention getting their first customers—that’s a wonderful mix to be in. But what we see one of the common mistakes that entrepreneurs make is the inability to really tightly and concisely communicate: who are they, what’s their value proposition, what are their differentiators, why are they doing this.

It’s a tough time.

Hal Weitzman: Scott Meadow, what do you think is the biggest mistake that entrepreneurs make?

Scott Meadow: Well, from my point of view, it’s a more macro-issue, and it’s how they decide to fund their company. Of course, everybody needs expertise and they need to surround themselves with that, but there’s really three stages. There’s proof of concept, there’s expansion, and there’s exit.

And if you’re pitching a less sophisticated group of investors, like a lot of angel networks, and let’s say that angel network or that angel individual has $200,000 and they are so excited by your idea that they decide to put $180,000 of their $200k in the proof of concept stage. Then when the company moves to the expansion stage, there’s not enough early stage money to support the expansion, which creates a problem because now many of the problems that Craig referred to are front and center with institutional venture capitalists, who have a much different bar in terms of quality in what they invest in.

Hal Weitzman: So this is sort of a structural question, a bottleneck that we talked about in a previous The Big Question. What’s the mistake that entrepreneurs make? Is it not looking ahead to that bottleneck and thinking about the next stage?

Scott Meadow: I think so. It’s easier to get money from people that know less about the industry. I mean, that’s a fact. And from my point of view, I think that you should prepare yourself analytically in terms of notions about the idea and in terms of your human capital, so that even if you’re going after angels, that discussion is really pointed toward institutional investors.

Hal Weitzman: So, in other words, you know how to scale the business from the beginning?

Scott Meadow: From the beginning and you know how to talk to professional investors from the beginning.

Hal Weitzman: Right, OK. Waverly Deutsch.

Waverly Deutsch: So Craig is talking about companies going out raising angel investment, and Scott’s talking about those who are setting their sights on venture investment. That’s about 10 percent of the startups.

There’s a much more fundamental problem with the numbers across the board with the average American entrepreneur, and that is that over half of them don’t think they’re bringing anything innovative to the market. They’re just doing, as a self-employed or a new entrepreneur, what they would do for another company, right. So when you open a store, if there’s no innovation, if you are a plumber and there’s no innovation, if you are a tax preparer and there’s no innovation, there’s no reason for customers to choose you over the established competition. So without innovation, it’s much harder for entrepreneurs to get a foothold.

Hal Weitzman: So is that assessing demand properly? What’s the mistake exactly?

Waverly Deutsch: Well, it’s twofold. One is starting a business based on your own capabilities rather than market needs, and the other is not defining something that you bring to the market that’s different than what the market can get elsewhere. So just being another player in the space.

Hal Weitzman: I see, OK. And from your perspective, you’re coaching people who are trying to start ventures. What is the biggest single thing that they struggle with?

Waverly Deutsch: Falling in love with their idea. So they fall in love with their idea. They think it’s something that’s very valuable for them, and therefore it will be very valuable for many, many, many people. But they can’t quantify that value. They can’t articulate that value. They can’t define the market that that value is for, so they flounder around because they’re in love with an idea.

Hal Weitzman: OK, Craig Wortmann.

Craig Wortmann: And they don’t narrow it. So they think well this would be helpful for parents between 28 and 38 and Russian people and people from, you know, and it’s just . . . it becomes this huge thing. And you know, while that drives passion, enthusiasm, and effort, those are all wonderful things. You know, one of the things we coach people to do is you gotta get more narrow so you can get that early messaging concise and crisp and articulate.

Waverly Deutsch: I just want to add on to what Craig said about this lack of focus. As we know, there are lots and lots of travel apps, sites, etc., and I just gave feedback on a business plan where their market was defined as global travelers who view travel as an essential part of life’s experiences. There are 3.3 billion global travelers, and they could all be our customers.

So that’s just an example of what Craig was talking about, a lack of focus, a lack of narrowing.

Hal Weitzman: Right, OK, they’re like saying, we sell water, and everybody on earth needs to drink it. Yes, Craig Wortmann.

Craig Wortmann: So just trying to pull a couple of these threads together. I thought Scott’s comments about venture and the notion of getting ready to be deeply, you know, have a deep understanding and an analysis of the business. I think that’s a key point. There’s some dissonance, though, here, right, which is how do you, as you come out of time zero as a business, you start, right, you open the doors and you start and you’re trying to figure out who are we, what is the narrow market, how do we talk about it? All that stuff. You don’t necessarily have that deep understanding as you’re trying to achieve what, you know, what we call product-market fit. You’re going through those cycles trying to understand that. You’re gaining understanding, and it’s a tough problem, right, because Scott’s right.

I mean, you know, you can build in badness by raising too much money from angels before you really know the story, but how do you learn the story without going through those cycles—perhaps with those angels, with other folks, with the market itself—to understand how to tell the deeply analytical story to a professional venture investor?

It’s a tough deal.

Scott Meadow: Yeah, so there is a lot of money. And you know, if you’re a talented executive that’s going to excite an institutional venture capitalist, I think you’re going to have to be a person who has sector-specific knowledge, who’s worked in a cash-constrained environment, and has probably made money for a venture-capital firm in the past.

And what we see in the entrepreneurial economy that we currently have is people sort of directly going out to the market without any apprenticeship process. That means I probably wouldn’t have been an investor in Google and I probably wouldn’t have been an investor in Microsoft, even though I went to school with the two guys that started it.

But to me, I think that lack of an apprenticeship stage in terms of the development of the entrepreneur puts much more emphasis on the luck side of things as opposed to the skill side of things.

Hal Weitzman: But you’re saying that companies who . . . it’s easy for startups to get funding, and then they come to a point where it’s much harder to get funding. If they’ve already shown that they can, you know, they can build a business to that point, haven’t they done some of their own apprenticeship?

Scott Meadow: Haven’t they done some of their own apprenticeship?

Hal Weitzman: Well, just by being in the industry, if I can demonstrate that I can sell ice creams, why shouldn’t I be able to go to the next level?

Scott Meadow: Well, because I think some people are very good at starting things and then some people are very good at growing things. Professor Kaplan talks about this in one of his papers. And, you know, it’s important that as a venture capitalist you’re able to make changes at those various stages. You want everybody to be wealthy, but you don’t want them to fail.

Hal Weitzman: Waverly Deutsch.

Waverly Deutsch: Yeah, I have two things to add to what Scott was saying. The first is when he talks about having sector-specific knowledge and industry knowledge and management experience and P&L experience, that runs counter to the stereotype that we see in the press, which sort of says, Drop out of school—Bill Gates, Steve Jobs, right—to be super successful.

You know, what entrepreneurs have to realize is that when they see news articles about these kinds of entrepreneurs, it’s because they’re the exception, not the rule. The data says that successful entrepreneurs have industry experience, have management experience, have P&L experience. So that’s one problem that the American entrepreneur faces is the view of the entrepreneur in the press.

The second thing that Scott touched on that I want to say is: you said, isn’t the early days an apprenticeship? No, it is not an apprenticeship. Because the skill sets that you need to get something from zero to launch are about creating a product and engaging initial customers. The skill sets that you need to get it from launch to a successful company are sales, team building, hiring, people management, customer service. So no, it isn’t an apprenticeship that the investors look at as saying, this person is capable of moving this company to the next level.

Hal Weitzman: Right, but I wonder if that also means conversely that somebody who has all the apprenticeship skills might have never been at the startup phase, so they don’t have the skills to do that bit.

Craig Wortmann?

Craig Wortmann: You know, we have fantastic Booth alums who have started businesses, and they’re self-aware enough to know that they’re sort of a $0– $10 million person, and once they’ve sort of edged up against that and they’ve got product market fit, they’ve got, you know, the version three of the product is hum, and they’re gathering users or they’re getting B2B customers, these are great things and they get bored, frankly, and they want to move on.

The question, you know, one of the questions that we all ask people is where, how do you know thyself? Right, how do you know if you’re a $0–$5 [million] person or a $5 [million]–$100 [million] person?

Scott Meadow: But you know, I think that there’s people with sector-specific knowledge that just don’t have some of these skills that you’re talking about. That’s not necessarily—

Hal Weitzman: The startup skills you mean?

Scott Meadow:The startup skills.

That’s not necessarily negative. You take an example like Tom Stemberg who started Staples. He had worked running a series of grocery stores, but he accessed a gentleman named Leo Kahn, who was a giant retail figure, and brought him on his board. So therefore now as an investor, I look at that and I say sector-specific knowledge, long-term knowledge on growth. That’s a team I want to be involved with.

Hal Weitzman: Waverly Deutsch, do new companies tend to measure the wrong kinds of things? Do they tend to look at, let’s say, users instead of revenues? Is that a classic mistake?

Waverly Deutsch: Boy, Hal, you’re bringing up one of the big controversies in venture capital, and that is the question that I like to call the California business model.

So in California, many companies have been spawned that didn’t worry about a revenue model, that only worried about getting technology on everyone’s phone or getting all the eyeballs to the website. And lately, those have become referred to somewhat as vanity metrics because unless somebody values that audience enough to buy the whole company, it’s very difficult to sustain that as a company because it doesn’t generate its own revenue.

I think entrepreneurs have a bigger problem with metrics around, can I make this product? And they think that that is a success. Do people get excited when they hear about this offering? And in fact, entrepreneurs tend to think that an excited meeting is a closed customer, and it doesn’t happen that way.

So I think, yes, entrepreneurs often do look at the wrong metrics, but part of that is the type of business they start and what they read in the press is important—users over revenue—and part of it is what Craig talked about, sort of a lack of understanding of sort of what are the real dynamics of their business and what are the metrics they need to look at.

Hal Weitzman: I see, but Scott Meadow, there are examples of companies that basically had no revenue, but were still able to exit very successfully.

Craig Wortmann: Yes, I mean I think to understand that, one has to understand the progression. I think startup to what is known as growth equity. And in a growth equity model, there’s really three things that I expect to see: I expect to see a fully-fleshed-out management team, one that can take the company to a liquidity of that. Number two, I expect to see two or three examples of the profit formula working, or what I all the unit model working, and then I want to see something tactical. So do they have nine months of backlog that’s referenceable? If all those things are in place, then in my judgment, they have an outstanding opportunity to be successful.

Hal Weitzman: OK.

Waverly Deutsch: And Hal, I want to take issue with your . . . these companies have successfully exited. Because Twitter is still a company, and it’s still not cash-flow positive.

So when we talk about exit, Scott might be talking about exit for the investor, where the investors make a lot of money, and maybe the founders make a lot of money, but now the shareholders are the average investor on the street, and we’re wondering: Will Twitter become cash-flow positive? Will it become profitable?

So I want to take a little bit of issue with what you said about success. Twitter is an incredibly successful platform, an incredibly successful technology, but I think it remains to be seen whether it’s an incredibly successful company.

Hal Weitzman: Craig Wortmann, your view on these metrics?

Craig Wortmann: I think Waverly said my favorite phrase, which is “vanity metrics.” You know, how many hits did my website get this week? And that doesn’t mean anything. It really doesn’t. That’s looking in the mirror and liking what you see, right.

Then there’s grit, the sort of grit metrics. I mean, one of my favorite things to do with startups, either prelaunch as Waverly outlined, or postlaunch, is to walk into an incubator—like here in Chicago we have 1871—to walk into an incubator and ask an entrepreneur, you know, what are you doing this week on sales? And the answer I often get is very funny and somewhat disconcerting, which, they’ll say, well, you know, we’re using an email system to do a lot of outbound stuff.

Well, that’s another way to measure. I’ve pushed out 20,000 emails, which we know, you know, the conversion rate on those emails is next to nothing, and I always like to ask them: How many conversations have you had with people you don’t know about your company, product, team, etc.? And that’s a hard question to answer. It’s one of the most valuable metrics I know, and you know if it’s true what Waverly said earlier in this conversation, which I think it’s true, which is prelaunch you’re starting to worry about two things. You’re worried about: Can I build this product? And can I have a bunch of conversations with customers?—which, I call that sales. And then postlaunch, sales, which you said.

Then if that’s true, how many conversations are you having? And that doesn’t have to be this conversation like this. That’s ideal. But it can be email conversations, phone conversations, but it’s got to be engaging, and it can’t be with your sister’s cousin. It’s got to be with someone you don’t know.

Hal Weitzman: OK, how important is the founder to a startup? If the founder, you know, has all the energy and the ideas and then the founder leaves, can that be a very damaging thing, Scott Meadow?

Scott Meadow: I would find it disappointing to have a founder leave because I would like to keep that person around to work on the things that they’re good at. They have certain functional areas where they’re very good.

Hal Weitzman: But I’m saying maybe the person was good at starting a business, but not at taking it to the next level.

Scott Meadow: Right, I hear you, and therefore, I have a conversation with every entrepreneur I work with that says, geez, wouldn’t we be better off with Peyton Manning running this business rather than you or I? I mean, I wouldn’t trust myself to manage this business. You’re the person who stands to make the most amount of money. Why don’t we bring in somebody who’s experienced to lead this thing forward?

And there needs to be a lot of frank conversations like that.

Hal Weitzman: And do those frank conversations happen?

Scott Meadow: They definitely happen in the institutional world. I think, you know, people are a little bit more ginger . . . walk a little bit more gingerly when, you know, their main source of income is being a doctor or lawyer, not investing in small companies.

Hal Weitzman: Right, Waverly Deutsch?

Waverly Deutsch: So I think we’re seeing a phenomenon of what I call the bounce-back founder, and I think we’re going to see that more, especially in the tech space but in other industries as well, where Steve Jobs has to get fired or he’s going to kill Apple from a managerial perspective. Because we go from entrepreneurial leadership to needing managerial leadership to needing corporate leadership.

During the managerial phase, he cannot be allowed to continue to run Apple, but once Apple is established as a company, has processes, has middle management, has leaders in the relevant areas of the business, he can be brought back very successfully to be the innovator, the chief of culture, the voice of the company.

And we’ve seen this with Michael Dell. We’ve seen this with Brandon Page. You know, I think we’re going to see a lot of these bounce-back entrepreneurs, where some of those entrepreneurial skills like vision, leadership, and charisma, become important again later in the stage of the company.

Hal Weitzman: OK, fascinating. Craig Wortmann, what’s your view on founders?

Craig Wortmann: I think . . . I want to react to what Waverly said. I think that’s right, and I hope we see. So I’m less bullish, I think, than my colleague is on this bounce-back founder phenomenon ’cause I think, you know, Jobs is obviously the Example A in that I worry about that. It’s really hard to pull off.

You know, I think most entrepreneurs, myself included, are not as self-aware as we should be to know where do we play best. And there’s just a lot that comes up with leaving a company and then coming back. There’s a lot of change that happens.

Hal Weitzman: And again, Waverly, I wonder if we hear too much about the success stories and not enough about the other examples, which presumably don’t make the press.

Waverly Deutsch: Well, let me give you a little local example. So the cofounder-inventor of the company Digital Innovations, which created SkipDr, got his company into the market, left because he wasn’t happy being a managerial CEO, brought in a managerial CEO, stayed on the board, stayed around, as Scott mentioned, and a few years later, the board asked him back in because what the company really needed to do was go back to that second word in their title, Digital Innovations, to innovate again to find new products and to figure out how to get them into the market. And he recently led that company to a successful sale, and that’s not one you’re going to read about in the press.

Hal Weitzman: Scott, can a company do everything right and still fail?

Scott Meadow: Yes, absolutely. And you know, a lot of this is a function of whether or not the company can in fact remain disruptive. So if they start out disruptive from a technological standpoint, by nature, they’re moving established players to the side. Well, those established players, depending on their point of view, could easily invest in competing with them, as opposed to acquiring them. Personally, I think it’s easier to acquire, but not everybody feels that way. So that would be one example.

Hal Weitzman: OK. Waverly Deutsch.

Waverly Deutsch: In the world of high-risk, high-reward entrepreneurship, absolutely founders can do everything right, their investors can do everything right, and it’s a market-timing fit. So I invested in a terrific e-book company that created the largest digital library of off-copyright material in its history in the mid ’90s when we didn’t have e-readers and laptops weighed 15 pounds. So it could be a market-timing fit.

It could be a product issue, where you do everything right, but it turns out that you can’t produce your product at a price the market can bear at this point in time. So a lot of the innovators in the solar industry, even if they’ve done everything right, have failed because the price of electricity is so low that the cost of creating innovative solar energy solutions outweighs the market.

So absolutely, in high-risk, high-reward types of startups founders can do everything right and still fail.

Hal Weitzman: Yeah, Craig Wortmann.

Craig Wortmann: In the app economy and the B2C space, you see this over and over again. Young entrepreneurs or young companies will get started. They’ll ostensibly do everything right, and because the barriers, the technology barriers to entry are very low, there’s a . . . You know, we have a fantastic Booth alum who started a company. He was the first in the space, and the next time he picked his head up and looked around, there were 1,036 competitors, and all very hard to distinguish what the value proposition is the difference. And you can get lost in there, even though he himself and his company are doing exactly the right thing.

Hal Weitzman: Scott Meadow, you talked earlier about, you know, the challenge to get VC, venture-capital funding, is so hard and so many companies fail at that point. For the companies that succeed and get the funding at that point, why do they then go on to fail? What happens there?

Scott Meadow: Well, first of all, these funds have a life, and these lives are generally 10 years. If we take money from the University of Notre Dame, we have to give it back to them at the end of 10 years. So if you invest in a company in, let’s say, year seven, and things go along gingerly, but then all of a sudden there’s a downturn that Waverly was talking about in the public markets or there’s too many of these kinds of companies that have started up, there may actually be no money available among the institutional providers to move the company forward. So funding just dries up at that point.

Waverly Deutsch: And come on, Scott, be honest. Venture capitalists aren’t always perfect pickers. Sometimes they actually back and back extensively ideas that simply don’t have a good product market fit or can’t make traction in the market or are led by the wrong people, and it simply doesn’t work.

Scott Meadow: Absolutely true. Absolutely true. I was on the phone yesterday with somebody trying to raise money for a very innovative concept. They’d put $35 million into the project, and it’s still not ready, which is wonderful for me as an investor because I can say, well, we’ll put $10 million in, but we have to own half the company, and once we make four times our money, then you can start participating.

So yes, yes, just because somebody, you know, has a lot of fancy degrees and one or two funds under their belt, they definitely can slip and fall.

Hal Weitzman: Waverly Deutsch, you’re . . . in the Polsky Center here at Chicago Booth, you train companies. You train entrepreneurs to get their ideas out there. One of the things you’re basically telling me is there are too many startups. So how do you tell these people to keep their idea, keep enthusiastic, but also telling them that the reality is they’re probably going to fail?

Waverly Deutsch: I actually start my class by telling them they’re probably going to fail. There are too many startups in the US for the economy to absorb, but the startups that have the impact on the economy are that top 10 percent of startups where the founders are aiming at growth, are aiming at disruption, are aiming at bringing innovative new value to the market, and we could actually use more of those.

The challenge is finding a way to get the right capital to the right concepts and teams. That’s what we’re trying to build at Booth. If we were just trying to create average entrepreneurs, I would say, don’t take our classes. But our goal is to find the growth entrepreneurs that are capable of succeeding, give them some of the disciplines and structures that we’ve been talking about, match them up with the smart investors. And so we end up with people like Matt Maloney, and Matt Maloney is the CEO of GrubHub.

I think he is sort of a showcase example of what an entrepreneur can do with an MBA education. Not only did he have the grassroots scrappiness of the entrepreneur to start a business in Chicago, but he had the management capabilities and fortitude to take his company public and still be its CEO.

Scott Meadow: Yeah, and if we could trace his success, what you would see is a series of lessons that he took from his education here that allowed him to be successful in what I would suggest is a probably safer launch than most companies because that’s our discipline.

Hal Weitzman: OK, Craig Wortmann, how do you coach young entrepreneurs to keep them enthusiastic but keep them real at the same time?

Craig Wortmann: Knowledge, skill, and discipline, the combination of those three things. You know, the knowledge that, OK, this is a tough place, and I have better than even odds of failing. The knowledge of, as Scott’s talked about, the sector, the industry, the position, the ecosystem. But then I like to really focus on the skills and disciplines. Do you have that grit? Do you have that scrappiness? What skills do you need when it comes to talking to those customers or hiring your first couple of employees? That takes tremendous skill and discipline. It’s not just knowing. It’s not reading a résumé and saying, well, who’s the smartest person in the room. It’s not that at all. It’s whether they can live through this crazy stage and these phases of growth. That’s absolutely key. That’s just critical.

Hal Weitzman: Unfortunately, our time is up. We’ll come back to this discussion another time.

For the moment, my thanks to our panel, Scott Meadow, Waverly Deutsch, and Craig Wortmann.

For more research, analysis, and commentary, visit us online at chicagobooth.edu/capideas, and join us again next time for another The Big Question.

Goodbye.

(soft piano music)