Why do many Venture Capital Funded Start-ups shut down?

We all know that most start-ups shot down at some point. What is surprising is that 75% of VC-backed start-ups fail ⁽¹⁾ because we assume that VC firms are seasoned investors with experience, expertise, and resources to evaluate the potential of the start-ups before funding. When we studied the Business Employment Dynamics report ⁽²⁾ from the United States Bureau of Labor website, which tracks survival rates for private companies from 1994 to 2021, we infer that 20% of private firms close shop in the first year, and this failure rate increases to 50% at the end of 5 years. Relating this correlation to start-ups and drawing from our experience, start-ups fail for two main reasons: poor financial planning capabilities and a lack of product-market fit.

From our experience working with a number of start-up founders, we have seen 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 to business needs. Therefore, it is no wonder that some start-ups face severe cash flow issues during their operations. From a corporate finance professional point of view, more than just the quantum of cash inflows and outflows, the timing of the cash flows often differentiates a surviving enterprise from a dying one.

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:

1. 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 means that a firm managing someone else’s money is willing to place a bet on the start-up.
2. 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.
3. Prudence: Securing funding is a first step and not the end goal. However, as raising funds is an arduous process, we have observed that sometimes founders get ecstatic upon receiving funds and miss out on the necessity of employing funds optimally.
4. 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 to a start-up’s development. As mentioned earlier, our view is that management of cash flows timings fundamentally affects a start-up’s survival.
5. Growth vs. Profitability – When founders receive a new round of funding, sometimes we observe that to grow quickly, 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 ⁽³⁾.

Of course, there are many other reasons why a start-up can fail. However, paying some attention to the above highlighted reasons may allow more founders to escape that dreaded 75% band.

References:

1. Chernev, B. (28^th March 2022). What Percentage of Startups Fail? [30+ Stats for 2022]. Review42.com. https://review42.com/resources/what-percentage-of-startups-fail/
2. U.S. Bureau of Labor Statistics, Table 7. Survival of Private Sector Establishments by Opening Year (n.d.). U.S. Bureau of Labor Statistics, from https://www.bls.gov/bdm/us_age_naics_00_table7.txt
3. Wilhelm, A, Azevedo, M.A. (6^th April 2022). Fast shuts doors after slow growth, high burn precluded fundraising options. Techcrunch.com. https://techcrunch.com/2022/04/05/fast-shuts-doors-after-slow-growth-high-burn-precluded-fundraising-options/#:~:text=Fast%2C%20a%20startup%20that%20provided,and%20its%20fundraising%20options%20limited.