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Failure Modes

November 19, 2009

The conventional wisdom about the venture capital business is that 1 of 10 investments “really” make money; 2 or 3 of them do “ok;” 2 or 3 return the money invested and the rest fail. The reality over the past few years is much worse – more like 60-70% of venture-backed startups fail to return at least the capital invested. Why do these companies fail?

While every situation differs, I think there are some key diseases that plague startups and while some of them manage to recover, most, unfortunately, are doomed to at least mediocrity, if not complete failure when they contract the symptoms.

What follows below is a list of the top ten eleven recurring themes I have noticed and some context around them. You’ll note that of six of these relate to the team, which shouldn’t be a big surprise to anyone.

Let me know what you think of my list – whether you agree or disagree, or if there are any I am missing.

1. Don Quixote Syndrome: Solution looking for a Problem. While there are several derivations of this theme, the basic thrust is that an entrepreneur sees an emerging problem and develops a solution in anticipation. But the problem never arises. Or it only applies to a small population (the tip of the Iceberg with nothing below the surface). Or it’s more of a “nuisance” than a problem and those affected aren’t willing to pay much for it to be fixed.

This is the most prevalent and most dangerous failure mode I have seen. It’s the most prevailing condition because in essence it’s what most ground-breaking companies need to attempt to do – see a market before it arrives. Admitting one may have been wrong about the opportunity in the first place is heresy and puts the company in instant peril – few entrepreneurs or their VCs are brave enough to do it.

2.  Overshot the Threshold of Adequacy – Companies over-engineer the initial product because they want to impress customers and blow the socks off their competition – instead of aiming for the threshold of adequacy level at which customers would buy immediately, which is usually far lower than the design point.

This almost always means that schedules are missed. By a lot. And the competitors that figured out what customers need (rather than would like to have) won. By a lot

3. Number 19 – If it’s a good idea for Sequoia to fund, why not start a competitor. Or another. Or another. etc etc etc …This is a phenomenon fueled by the overabundance of venture capital, which has resulted in too many companies pursuing the same niche idea.

The lack of differentiation caused by too many competitors gives rise to two outcomes; (1) a huge disparity between #1 and the pack, or (2) prolonged gestation periods for the winners to emerge. I have high expectations that a fall-out in my industry, where coincidentally the #19 phenomenon is in full swing, will halt the spread.

4. Underestimated the Status Quo – No one ever got fired for buying from IBM. Or Cisco. Or Microsoft. Or Broadcom. Startups often underestimate the power of incumbency and stature, overestimating the importance of innovation.

While choosing the “right” initial customers can help companies avoid this situation becoming fatal, I have seen too many companies go on a singular elephant hunting strategy, only to find few to none will buy. And then they run out of money.

5. It’s the Team Stupid #1- Founders hire close friends because they can trust them, not because they have the right experiences or are qualified for the job. And then these execs perform poorly, causing intense resentment with the rest of the team, and are left in their roles too long because their removal would be too emotionally scarring for the founders.

6. It’s the Team Stupid #2 – Founders hire executives recommended by their VCs/Board because they feel pressured, not because they have the right experiences or are qualified for the job or fit with the culture of the company. And then these execs perform poorly, cause resentment with the team, and are left in their roles too long because their removal would be too politically risky for the c24 pxompany leadership. This situation is exacerbated when the recruited executive is the CEO.

7.  It’s the Team Stupid #3 – Founders hire individuals recruited via a (high priced) search firm, because they seem to have the right experiences, are qualified for the job appear to fit with the culture of the company. And then these execs perform poorly, cause resentment with the team, and are left in their roles too long because the leadership (both company and Board level) wants to believe with just a little more time, things will work out. They don’t.

These first three variants of the team problems aren’t always fatal; but in my experience the fatality index is directly correlated to the length of time the poor performer is left in his/her position. Left for too long, a potential star company slinks into mediocrity.

Conversely, if dealt with swiftly and decisively, these situations can actually improve the morale and culture of a company, and help propel them toward success.

I remember a prime example from own operational career: a guy who started the same day I did at Chipcom in 1989, was clearly not a fit with the culture. He had a young family and needed to be home with them early evenings and weekends. At that point, the engineering team was working non-stop and his absence was notable. Menachem Abraham, our co-founder and VP of Engineering, recognized this issue quickly, and fired that person less than two weeks into his tenure. And the team cheered, not because the fellow was a bad guy, but because he was the wrong guy for the role and we were all working for the future value of the stock. It was a delicate situation given the small size of the company, but because of his swift action, Menachem actually enhanced the culture of Chipcom – he walked the talk of the team demonstrating commitment to performance.

8. It’s the Team Stupid #4 – This is the most lethal variety and unfortunately, one of the most prevalent. The founders are strong technical people with little business experience. They trust the VCs/Board to help them recruit a business-focused CEO and he/she in turn, assembles an executive team.

But if the CEO hired is the wrong one, which they often are and prove to be a weak player, the die may be irrevocably cast – as the old adage that “A” players hire other “A’s” and “B” players hire “Cs” and “Ds” is usually dead on. And no matter how terrific the idea, a mediocre team rarely if ever wins.

9.  Poisoned Founding Team – The worst situation is when a founding team is at war with each other, rather than the competition. I haven’t seen it often, but when it happened it was devastating. And nasty. And relentless.

I believe a primary cause is found in teams that don’t know each other well enough prior to starting a company – and find that as they get to know one another, they really don’t like what they learn. Familiarity breeds contempt, I guess. A secondary cause arises when a founding team hires a CEO or key senior executive they never really supported – and seek to undermine the individual to prove their point. Both poison the culture from the outset, and I have not yet seen an antidote.

See this great piece by Naval at Venture Hacks on choosing co-founders wisely.

10. The Hero Effort (a/k/a Pushing the Gas Pedal to Oblivion) – This is a disorder that seems specific to first time CEOs. The CEO is determined to prove to his/her board that they are more than capable of handing every aspect of their business without any help -and then (1) things start getting out of hand in the areas they have less expertise and therefore ”feel” for the business (eg a Sales focused CEO dealing with finance issues) so they dive-in deep, (2) while ignoring the areas in which they have great expertise (eg Sales), (3) they delay talking with their board about it for fear they may be seen as weak, (4) the no-context-area continues to worsen, and even worse, the context-area starts to falter, and then (5) the company runs out of money suddenly.

11. Sales Learning Curve Misunderstood. Mark Leslie, founder and CEO of Veritas, coined this term and characterized the affliction incredibly well. Leslie.pdf The essence of the situation is simple: in anticipation of on-time product release and readiness, plus great and immediate success in selling, the company hires a very experienced VP of Sales, who builds the team out nationally (and internationally) with sales execs and support staff. With the full support of the VCs/Board of course.

Variant #1 – primarily direct sales model: The product is late. And the 1.0 version isn’t really ready to be bought because it’s missing key features. So the sales team sells nothing, but costs plenty, and the company runs out of money before it has referenceable customers.

Variant #2 – indirect or web-based/lead-gen sales model. The team hired doesn’t really know how to drive this new type of approach, because, let’s face it – it’s new. So they follow everything they read about it, buy Marketo, create SEO/SEM strategies – and the company runs out of money before it has referenceable customers.

There are many more failure modes than listed – these are simply the ones I have noticed most often. As I mention above, many are not fatal, if identified early and dealt with quickly. But the toughest thing for entrepreneurs and their VCs to do isn’t noticing the phenomenon; it’s reacting to it properly.

The right course of action could be pushing the reset button to find/execute on a new team or path or it could be pushing the coin return button. I have both espoused and heard the gamut of rationales for not taking action – “it would be premature”, “we’re just a quarter away”, “it’s a signal of panic”, “competitors would pounce”, “team would revolt”, etc etc. IMO, these are all BS. It all comes down to ego and the basic human tendency toward conflict-aversion. And CEOs, founders, VCs and external board members are all culprits.

If these failure modes don’t prove fatal, they certainly keep companies from becoming great.

A couple of PS’:

  1. The failure to act is often the result of denial. We were fortunate this past summer to have Professor Richard Tedlow from Harvard Business School, meet with our CEOs and founders to discuss his new book, “Denial: Why Business Leaders Fail to Look Facts in the Face—and What to Do About It,” which will be released in March 2010. This is a fascinating analysis of how great leaders stare at irrefutable evidence and make the wrong choices that sink their companies (and some who make the right ones)
  2. Coincidentally, Peter Levine, a friend and great entrepreneur who teaches a class at Sloan, recently emailed me asking for ideas of the “Typical Mistakes Entrepreneurs Make,” as this is the topic of a class he’ll be leading in November. Hopefully he’ll post his slides and notes from the session.

ADDED 11/23/09 – Peter Levine’s great slides from his class on entrepreneur’s mistakes.avoidable mistakes_final.pptx

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