Why do most Venture Capital Funded Start-ups shut down?
9 out of 10 start-ups fail but what is surprising is that 75% of VC-backed start-ups fail because we assume that VC firms are seasoned investors with experience, expertise, and resources to evaluate the potential of the start-ups before funding. This post will provide the main reasons why most venture capital-funded start-ups shut down.
When we study the Business Employment Dynamics report from the Bureau of Labor that tracks survival rates for private companies from 1994 to 2021, we infer that 20% of private firms close shops in the first year and the failure rate increases to 50% at the end of 5 years. From our experience, start-ups fail for two main reasons: poor financial planning capabilities and a lack of product-market fit.
In our experience working with a few start-up founders, we saw founders struggle with the financial planning function, which is pivotal to running a business. As a result, they have challenges managing cash flow and are thus unable to act quickly according to business needs. Therefore, it is no wonder that some start-ups confront severe cash flow issues. Thus, from a corporate finance professional point of view, more than just the quantum of cash inflows and outflows, the timing of the cash flows will differentiate a surviving enterprise from a dying.
Another significant reason we opined is that many start-ups fail to focus on solving problems confronting customers. There seems to be insufficient product-market fit validation, and we have observed start-up founders ignoring customer needs either deliberately or unknowingly. And when the product hits the market and doesn’t meet customer needs, it is hidden under the often-false premise that “the customer doesn’t know what he needs.”
Path to profitability for money-losing firms?
In our view, based on our study above, if start-ups intend to get profitable, they may consider the following points:
- Perception — When a start-up receives funding from VC/PE firms, it does not imply an outright market validation or product-market fit. It just implies that a firm managing someone else’s money is willing to place a bet on the start-up.
- Constant Validation — A start-up is a work in progress. So, in our view, founders need to constantly evaluate the product-market fit and its alignment with customer expectations; and be ready to adapt whenever a pivot is necessary.
- Prudence: Securing funding is the first step and not the end. However, as raising funds is an arduous process, we have observed that sometimes founders get ecstatic about receiving funds and miss out on the necessity of employing funds optimally. For instance, Grab shares tumbled 37% after posting a $1.1 billion quarterly loss. This share decline is because they spent money on incentives to attract drivers and offered food delivery promotions to induce people to dine out. The shareholders felt that Grab’s decision to employ funds on incentives/promotions is not optimal and does not add value.
- Financial Planning Support — Sound financial planning is a sine qua non to running a successful business. Thus, hiring the right CFO who understands the importance of proper cash flow management is critical in a start-up’s development. As mentioned earlier, our view is that managing cash flow timings fundamentally affects a start-up’s survival.
- Growth vs. Profitability — When founders receive a new round of funding, sometimes we observe that to overgrow, they burn cash without realizing that rapid growth can pose problems if it does not accompany a path to profitability. For instance, Fast, which enabled retailers to offer one-click login and checkout options, closed operations in April 2022 because the firm’s burn rate exceeded its revenue growth rate.
Of course, there are many other reasons why a start-up can fail. However, paying some attention to the two highlighted reasons may allow more founders to escape that dreaded 90% band.