Why Start-Ups Fail: Part Two

Last May, Silicon Valley HR start-up Zenefits was being called a “unicorn” and sending its top salespeople to Vegas for a bacchanal to rival The Wolf of Wall Street. My, how things have changed. Over the last several weeks, as news of compliance failures and employees run amok (between all the sex and drinking in the office, the place was, ironically, an HR nightmare) has surfaced, it’s become clear that Zenefits’ spectacular growth has also been, at least in the short term, its undoing. Last week I discussed several common reasons start-ups like this one suffer, and today I want to explore a few others.

Uncoordinated Transformations

A new firm can maintain healthy expansion only to the extent that its internal mechanisms are seamlessly coordinated. The problems of coordination—such as with the rapid addition of new locations and employees (both huge issues for Zenefits, which added a satellite office and hired hundreds of underqualified new employees over the past year)—are directly proportional to the rate of growth. An organization’s capacity to digest new elements depends on a complex set of organizational processes. It’s difficult to add employees and customers at an extremely fast rate without diminishing the quality of output or running out of cash. Failure to define processes for recruitment, selection, motivation, control systems, and development of values within the organizational culture creates chaos rather than providing the kind of transformation that will allow a new business to thrive. Ultimately, these issues can crush any hope of sustainability. Each person who began with the firm must change as the organization does, entailing a shift that can feel profound. The days of ad hoc management disappear, and managers must learn how to work at a strategically higher and faster level and to define the principles that will govern decisions such as who should be hired and fired. They must learn, quickly, how to create new structures so the company can spend serious money while taking bigger risks for bigger returns. And they often must learn to let go of traditions and established practices in favor of more professional norms. Beer pong at the office might be fine for a company of five, but it’s not hard to imagine why that won’t work for a company of one thousand.

The Fantasy That There’s a Map

Sustainable growth for any entrepreneurial venture requires moving methodically through a series of developmental stages. In one analysis of entrepreneurial growth patterns, 51 percent of the companies progressed sequentially through the expected stages. They followed a traditional linear pattern of development and growth. That’s good news. But the other side of this equation is the bad news: Did firms in the 49 percent that skipped the traditional stages of development one might assume to be necessary end up spiraling out of control and failing? With nearly half the successfully scaled firms not following any model that explains or predicts growth stages, it stands to reason that models accepted and used in the past may be poor predictors of how an organization might successfully scale in the future. A slew of “growth stage models” exists, but most are based on anecdotal observations rather than rigorous research. Warp-speed growth doesn’t follow a tidy linear progression. Analysis of successfully scaled organizations reveals that the stages or patterns of development vary. There is no universal road map that guides scaling. Only the road map that results from managing a unique, comprehensive vision can predict whether a scaled firm will sustain itself.

The Struggle to Maintain the Family

Watching a start-up scale without an adequate vision is a familiar scene: As the need for processes and values takes center stage, old rules disappear, time becomes woefully scarce, work life and personal life merge, and corporate gestures that used to mean one thing suddenly mean the opposite. A warm family atmosphere where everyone knew one another and virtually everything was transparent becomes an environment where silence replaces the easy, informal communications. To compensate for that silence—which is often both unintentional and inevitable—a plethora of ad hoc processes are set in place. Reporting systems, budgets, and performance reviews—often inconsistent in their implementation—attempt to direct employee behavior. When the easy, informal communications channels begin to fade and are replaced by more formal chains of command and departmental silos, people begin to feel overlooked, if not abandoned, by upper management. As the firm launches, the environment feels intimate. Everyone knows who is getting married, having babies, caring for a sick parent. But the venture has to get bigger, add more systems, and implement more controls. What used to happen spontaneously now happens systematically. Through email and voicemail, perhaps even with stringent reporting structures and weekly meetings, everyone may know everyone else’s business—but they no longer know everyone else’s name. The venture that begins as a team or family becomes an impersonal company as it scales. People within will likely remain strangers to one another in spite of the desire and hard work by some to keep the memory and spirit of the family alive. Often, the people who left a big corporation to become part of a start-up realize the firm is evolving into something all-too familiar and distasteful. It will be fascinating to see what Zenefits’ remaining employees do now that the party, quite literally, is over.

Facing the Enemy

If we step back and consider these organizational perils, a picture emerges of the firm’s biggest enemy to survival: its own executive management team. It may be a founding entrepreneur, a COO hired to “bring discipline” to the original vision, or the entire team. These hardworking people have enormous responsibilities for managing the liability of newness, coordinating organizational transformations, and determining which growing pains to address at different times. If correct and timely actions are not taken to address these issues, the team will probably fail at one or another goal. And when they do, there is the probability—however unintended and well meaning—of holding someone or something else accountable.

Why Start-Ups Fail

As beleaguered software company Zenefits continues its spectacular fall from grace with news last week that they are laying off 250 employees, it begs the question: How do these start-ups fall so far so fast? This isn’t the first time a tech start-up has turned toxic seemingly overnight; the stories are myriad and go back to cautionary tales from over a decade ago with companies like Friendster, Napster, WebTV, and others. So why doesn’t Silicon Valley seem to ever learn? How does the Vegas-like atmosphere continue as though nothing’s ever gone wrong? The most comprehensive analysis to date of start-up failure has been done by the Startup Genome Project. Premature Scaling—a project coauthored by Berkeley and Stanford faculty members with Steve Blank—used ten start-up accelerators as contributors and analyzed 3,200 high-growth web/mobile start-ups. They found that within three years, 92 percent of start-ups failed. Of those that failed, 74 percent failed due to premature scaling.

Premature scaling leads to either spending money on marketing, hiring, and other resources before you find a working business model (you acquire users for less than the revenue they bring) or in general spending too fast while failing to secure further financing.

Most start-ups that survive the first few years remain small, but smallness is acceptable only in the rare cases when an entrepreneur or parent organization has patient investors not demanding a significant return in a relatively short period of time; this is almost never the case in today’s high-stakes VC climate. For the overwhelming majority of firms funded by outsiders, staying small is a death knell, indicating that while the organization hasn’t failed yet, it has slim prospects of providing the return originally expected by both the VCs and the founder. In industries like tech, being small is considered as good as being dead.

“There are a hundred reasons for success and a thousand reasons for failure,” a VC once said to me with a sigh the day after he shuttered one of his portfolio companies. I disagree. The reasons for most of the failures I’ve studied may have a thousand variations, but they share a small number of interrelated root causes. And absent a comprehensive vision, there is no way to combat them.

The “I’m Right, the World’s Wrong” Mind-Set

Entrepreneurs of failed start-ups have a tendency to blame others for business problems rather than holding themselves accountable. This is ironic, as these are often the same leaders who like to project the sense of being in control of everything. Nonetheless, they more frequently attribute failure of their own ventures to external factors, such as competitive market conditions and financing problems. This is in contrast to the VCs who fund them, who more frequently attribute failure to internal factors, particularly management inadequacies.

These same entrepreneurs often attribute the poor performance of other firms to internal factors, yet assign their own troubles to external causes over 85 percent of the time. This difference between the lack of accountability entrepreneurs take for failure and what they are actually responsible for can profoundly affect which solutions are pursued when a venture starts to go down. If the assessment points to issues outside the organization, then why bother changing organizational components under management’s control? Some entrepreneurs also seem to think that attributing their problems to external factors is the best strategy for negotiating with a VC. If they can convince the VC that their firm’s problems come from the outside, then the VC will be more likely to help them ride out the storm. But this often backfires. The entrepreneur who blames external factors is often seen as delusional or unwilling to take responsibility by the VC. This chain of passing the buck can hasten the venture’s demise and lead to an unfortunate self-fulfilling prophecy: when the entrepreneur wrongly blames external factors for the firm’s problems, one crucial external factor—the VC capital—may become its ultimate problem if it stops flowing in.

The Liability of Newness

The most appealing, and perhaps least daring, explanation for failing to scale up and remain sustainable is to attribute it to a phenomenon known as the liability of newness. The risks of newness result from a wide variety of sources, but we almost instinctively point to the invention itself—a new product or service. As we saw with Zenefits, for example, it’s easy to imagine how such an unprecedented approach to manage benefits for small businesses could contribute to the climate of “no rules apply” that has been so disastrous for them. It follows that a company doing something so outside the box would bear some outsize risk just by nature of its products.

And although common sense would indicate that failure is higher for pioneers than for late followers (which is true), it would also lead us to believe intuitively that the causes underlying the liability of newness would be the failure for a new product or service to reach and appeal to its intended audience (which is false). Actually, the risks arising from newness appear to result from a much wider variety of sources that are not weighted on product or market share issues, as most believe. Of course new industries and innovative products take more time to refine, but the ultimate failure of these companies is still most likely to be organizational.

Research again leads us back to senior management as the key factor behind the liability of newness. Zenefits had a great product, as many in the HR field have claimed. But in the process of a major scale up, such as we saw with them, management too often pays little attention to the need for a consciously developed organizational culture. They often create structures that support current—but not future—needs and ignore conflicts regarding evolving and emerging roles within the organization. Most important, management often lacks clarity for how the organization’s vision relates to people’s roles and behaviors. In an overwhelming number of cases, no vision has ever been articulated. It’s reduced to the immature denominator of “get big fast.”

Executive management teams tend to have an outward focus—they’re consumed with ensuring that the new product or service is accepted and gains increasing levels of market share. But the liability of newness blindsides them. They fail to pay sufficient attention to what’s going on within the house. This phenomenon further compounds entrepreneurs’ “I’m Right, the World’s Wrong” tendency to avoid accountability for acknowledging and managing strategic issues within the firm.

What Comes Before a Fall: Lessons from the Growth and Crash of Zenefits

If you have even a passing interest in the tech industry and start-up culture, you’ve certainly heard about the unfolding crisis at formerly golden start-up Zenefits. The company—a producer of web-based software to help small businesses manage their human resources operations—made big news last year when they raised $500 million in one round of funding, at a valuation of $4 billion. The growth of the company over the past couple of years has been astronomical: they went from a total of fifteen employees at the end of 2013 to a reported sixteen hundred late last year. Perhaps unsurprisingly, the growth has caused some serious issues, and CEO and founder Parker Conrad was asked to step down two weeks ago amid scandalous reports of employees being encouraged to cheat on their insurance broker licensing exams (even being given software to help them do so), overimbibing during the workday from company-provided kegs, and having sex in the stairwells of the office building.

Conrad’s resignation from the company allegedly brought tears of relief—not sadness—from beleaguered employees, many of whom are wholly unqualified for the work they’ve been asked to do (a reported 80 percent of Zenefits’ Washington transactions were claimed to be unlicensed). Strangely for a technology company, Zenefits seems to have attempted to solve its woes by adding even more employees to fix problems manually, rather than fully debugging systems when breakdowns took place.

Some of the details of Zenefits’ (and Conrad’s) downfall may be shocking—drinking on the job as a company norm, disregard for regulations in a company that handles something as sensitive as health insurance—but to anyone accustomed to working with entrepreneurs, especially those operating in the high-stakes pressure cooker of Silicon Valley, this outcome is anything but a surprise.

Certainly Zenefits’ rise and crash was helped along by the trend of outrageous VC funding for Silicon Valley start-ups, but the heart of their problems is nothing new. This is simply what happens when there is not an effective, embedded vision at the crucial juncture where scaling meets speed. Zenefits began as a Software as a Service company devoted to helping small businesses combat the onerous red tape of HR issues, health coverage in particular. An honorable enough mission. But as they scaled with lightning speed, they began taking on businesses with hundreds of employees, long before they were equipped with the culture necessary for handling them and the organization’s scaling to that level. Growth became the only imperative, at the cost of quality, employee morale, and even lawful practices.

The current climate in Silicon Valley prizes the “get big fast” mentality, but it’s worth asking, is growth always the ultimate goal? David Packard, the cofounder of Hewlett-Packard (HP), wrote in his memoirs that over the years he and Bill Hewlett had “speculated many times about the optimum size of a company.” They “did not believe that growth was important for its own sake” but eventually concluded that “continuous growth was essential” for the company to remain competitive. One reason growth was a matter of survival was because HP “depended on attracting high-caliber people” who wanted to “align their careers only with a company that offered ample opportunity for personal growth and progress.” Growth for the sake of attracting and keeping great people would become a factor for virtually all firms in technology-driven fields. When the firm introduced “the HP way” in 1957—essentially a manifesto for its future—it emphasized growth “as a measure of strength and a requirement for survival.” While Carly Fiorina trash-talked the original culture and called it an adorable artifact of an older time, she was no paragon of leadership during her tenure there, and the company suffered under her watch.

Most companies understand that growth is essential for survival for the very reasons Packard put so succinctly above. But few know how to reconcile the need for growth with the external and internal pressures to grow very quickly—especially with a group of big-time venture capitalists breathing down one’s neck. Building any large and sustainable corporation requires a considerable organizational transformation rather than a predictable set of linear stages. Building it quickly diminishes the odds that it can weather the growing pains of that transformation, as we can see so clearly in Zenefits’ unraveling. “More businesses die from indigestion than from starvation,” Packard said.

Start-ups are not just large businesses in miniature, and their trajectories do not necessarily point to either size or longevity. Rather than relying on opportunistic adaptation to exploit niche opportunities, their existence depends much more on formulating and implementing ambitious strategies that prepare the firm for the longer term. Put another way, the transition of a fledgling business into a large, well-established corporation requires nothing less than a series of fundamental yet relatively seamless transformations, nearly impossible to pull off in a period of eighteen months or so as Zenefits attempted to do.

Well-articulated visions guide these transformations so they are not experienced as traumatic surprises. Unfortunately, there are relatively few exceptional entrepreneurs with the capacity to conceptualize, articulate, and relentlessly manage with a vision and survive the steep challenges wedded to accelerated growth.

Maybe—just maybe—there’s a degree of maturity, insight, and future focus that’s not just about EBITA growth. Zuckerberg got that in his twenties, and he turned Facebook into a growth machine. The Google guys got it too, in their youth. They were smart enough to turn the reins over to Eric Schmidt, who would successfully guide the firm’s growth.

But perhaps the real lack of maturity rests with shortsighted venture capital firms and boards. They’re the ones who drove the wild growth and then kept Mr. Conrad in place until the shooting star was crashing back to Earth.