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.