This interesting article underscores my many pointers in my blogs on how NOT to run a startup: http://www.businessinsider.com/startups-that-failed-in-2015-2015-12. From very avoidable mistakes, these 8 startups totaled losses amounting to $400 million. VCs are not the only losers in this game. These losses do suffer economic externalities since 80% of VCs funds are derived from their limited partners: the retirement funds such as CalPers, university endowments such as Harvard or UVa., commercial banks, and other institutional investors. It is not the only bruised egos from the executives from these failed startups, who are discouraged. It can be “everyman” with a retirement fund. Yet I hear from the Silicon Valley startup promoters claiming that it is “OK to fail”, “No need to write a full-fledged business plan”, “Only the young can be creative enough to start a new business”, and so on. As an experienced executive, I always place a company’s paramount priorities to the shareholders/investors. It isn’t appropriate not to execute the due diligence and strategies for a startup company to succeed. Is it appropriate to learn from your mistakes from your investors dime as some people suggest? To believe so, then these same commentators don’t care about the limited partners and their needs to hit their ROIs. I still insist that there are clearly defined recipes to setting up a startup company, investigating a market, preparing a SWOT analysis, writing a business plan; steps that can provide the right arsenal to avoid filing for bankruptcy. Here are the 8 companies described in the article and what I thought could have preempted their demise.
Company: Quirky – lost $185 million. An interesting idea – have people “crowd” vote the kind of product they would like to buy, then build it. One problem – any crowd-suggested manufactured product would never reach the economy of scale to be built profitably. This catastrophic idea reminds me of Professor Milton Friedman, the Chicago Economics professor, providing the example of the $5 pencil vs. $0.05 pencils. Mass production reduces the costs. A common sense rule. Otherwise, every home would have a 3-D printer producing their products at will. For example, Quirky produced 28 set of on-demand speakers that cost about $400k or $14,300 per pair. Not a very profitable model. True business planning requires to include different scenarios that would reveal the true ROI. It would have required to explore the competitive market and note that those which have been successful, those that failed. Then, you set a course to a growing, profitable company. And even with that, the planning must include an alternate marketing strategy when the primary one fails. But it looks like that the VC s which funded this company for almost $200 million did not identify this flaw in Quirky. I guess the investment prerequisite — below the age of 35 founders – was sufficient to invest in any economically ineffectual business idea. The founders were inexperienced in manufacturing. Oh, yes – I forget, most of the financial loss was not their money. Read my previous blogs on how VC firms operate. If Warren Buffet, in his 80’s, proposed a business plan to these guys, he would have been rejected immediately. But, based on his track record and experience, was he capable of losing $200 million?
Company: HomeJoy – lost $40 million. Let’s have house cleaners work for minimum wage, no fiduciary duties as employer without paying FICA, unemployment insurance, or medical insurance. Sort of like Uber but more like portable house cleaners. In the business planning, one must foresee regulatory requirements and hurdles as a risk or barrier to entry. Not having to include that risk means pure cash flow for the parent company with fat margins. But HomeJoy lost that argument that these employees are independent contractors. (Note that Uber is facing the same challenges.) One line item on business planning is to investigate regulatory issues—labor employment law is one, and healthcare industry has the forminable FDA, which contains 15,000 employees. With regard to the latter, I noted that one “smart” physicist is inventing a device that relates to healthcare—his fatal flaw? Not including the regulatory requirements and costs. We’ll see how far that medical device will go. (Theranos, anyone?).
Company: Zirtual – loss $5.5 million. Zirtual hired over 400 employees on the original funding. I guess that spreadsheet modeling is not part of the startup training in NorCal. The cash did’nt catch up to its labor costs. Part of business planning is to see what other companies have had comparable models, how fast they grew and their revenues. For example, an ex-Apple engineer showed me his business projections in 3 years to hit over $1 billion – multiply the number of sensors by the hospitals. I asked a simple business planning analysis – what direct competitors where earning annually? Total: $300 million and they were mature competitors. I asked if he had any healthcare marketing experience. Answer: none. Zirtual, however brilliant they solved this problem, never bother to implement the exercise before or for that matter, the investors saw enthusiastic 20 year-olds, and thought that they could build a business with a software platform. That worked out well, didn’t it?
Company: Secret – lost $35 million. An App that allowed users to post anonymously snippets of text, rumors or confessions, while shared with other people. This CEO bought himself a Ferrari after the closing as a reward for raising this big round. But he forgot to look into the legal implications of what is being posted – cyberbullying, defamatory statements. The Internet should be free for all to communicate, but, obviously, there are legal limitations. Imagine posting a bomb scare on the Internet— the Supreme Court has ruled that the First Amendment has its limitations where other harm is feasible. Now the Europeans are imposing huge fines for digital data and privacy. I realize that lawyers can be expensive, but the founder would have saved $35 million from going to a deep hole by investigating the legal and regulatory risks. Certainly the legal advice would have been cheaper than the Ferrari.
Company: GrooveShark — lost $6 million. Music sharing without paying for royalties. I guess that it didn’t pay to visit Los Angeles to get feedback as to the legal rights to sharing copyrightable music. Again, this is a legal risk that any simple business planning requires to research before implementing a plan.
Company: Rdio – lost $127.5 million, but its IP bought for $75 million, with $52.5 unrecoverable loss. I once asked a Silicon Valley guy to analyze the SWOT – Strength, Weaknesses, Opportunities, and Threats. Why? I wanted this individual to provide me information about the competitive environment, and the worst case scenario. That has been some weeks ago. With the current burn rate, his sensor company will run out of cash in a month. What were Rdio’s potential competitors? Spotify, Apple, Microsoft’s Groove, Google Music. Unless Rdio had something so revolutionary and established licensing agreements with the music industry (already taken by the established players), I could easily expect the Rdio failure. Going back to the sensor company, it has patents, but so many other sensor companies out there. The whole point of the SWOT analysis is to be fairly honest to yourself to see whether you can succeed in spite of the competitive environment.
Company: Leap transit – lost $2.5 million. Leap Transit offered a high end, commuter bus service. Again, it forgot to register itself as a transportation company – I guess that the company’s corporate lawyers failed to inform Leap Transit founder that their job is to set up companies, negotiate term sheets. But had no expertise in registering a company for its services. Again, this is a failure to research the regulatory hurdles. Yes, it is seemingly simple to write an App, hire bus drivers, lease buses. But companies operate in a legal world with many regulations. Regulations for public transportation are all over the place. I guess that the business strategist didn’t have access to Google to look into public transport regulations. Leap Transit received a cease and desist order and then shut its doors.
Now, not every investment by VC firms will be successful. As I stated in an earlier blog, one cannot anticipate every hurdle thrown at a startup. But one can expect the best, and prepare for the worst. I know of one Virginian VC firm invested $100 million on 10 startups, and lost everything in each company. Investments tend to be unpredictable. There is a financial book entitled, “Random Walk Down Wall Street” by Burton Malkiel, a classic which relates that fact that it is difficult to predict the success of any stock, because of the many variations that impact the value. On the other hand, one can reduce the potential pitfalls by marking off each bullet point on Strategy I describe in one of my blogs. If I fail to respond to one bullet point, it increases the chances for failure. That is what Rdio failed to do – investigate every risk in its plan.
Then, given that the company is a startup, one balances the costs of avoiding a strategic risk versus taking it. Interestingly, I had a recent quick chat with a biotech startup co-founder. As co-founder, he finds that his company can’t pay for the substantial patent legal fees that he has to file. I gather that his outside counsel must have related all of those risks (and remember, again, in an earlier blog, that a lawyer earns his living by his/her dedicated time—the more time he spends on a client, the more he earns!) He related to me that filing for the patent was very expensive—he has to file in the U.S., Europe, Brazil, and China. Practically, the whole World. (Also, to file for IP in mainland China, the company must file in every province. I guess his patent lawyer forgot to tell him that.) Their business is at a standstill because they see these filings as costly – and it will be. I told him that it will exceed $150,000. Why? The U.S lawyer will coordinate with foreign counsel. Documents need to be translated. And the filings to be coordinated with foreign counsel, who will require retainers as well. Then the U.S. counsel will require inhouse translators to understand what the foreign documents state. I would first file in the U.S. quickly, and ignore the international filings until there are potential revenues in those markets. But these are technical guys – they can’t tell true value propositions when working with law firms. And this aspect of the business should be the core strategy of the company. I do know of a Southern California company that did file worldwide patents for sports sensors, based on the recommendation of its lawyer over 4 years ago. Total revenues so far? None. As I told the co-founder, too much concern and focus on legal advice, not on the core business and fulfillment of the milestones. For example, hitting your Q3 sales is a milestone as part of the defined Strategy that impresses investors. Delaying or spending too much time on too many legal filings is not a milestone for investors.
There is nothing wrong with founding a startup company. However, it doesn’t pay to invest so much financial and personal capital and face a failure. Or lose the investments from the limited partners. The focus is to prepare a detailed strategic plan that covers the worst case scenarios. In summary, an ounce of prevention is worth a pound of cure: write or prepare a full-fledged business plan, examine all variables that can go wrong. And if you can’t figure that out, then get someone outside of your team who can help you get there.