The table above, lifted from an earlier report, triggers my memory why I immediately left as an advisor to an early NYC startup introduced to me in January of this year. When the NYC startup’s CEO demonstrated his Pitchdeck in a video conference call, he left out the spreadsheet which would help me understand why the company sought $10 million indicating a valuation of $30 million, even though the startup had no website, no traction, no corporate entity, and no employees. Later on, that valuation was so wrong. I demanded to review the financials, which I received a couple of weeks later. Once received, I was shocked as to the utter simplicity and peculiar, erroneous assumptions, almost as if the CFO had no financial management experience whatsoever. And this table understated why the reasons startups fail caused by the weaknesses in spreadsheets and unrealistic financial projections.
Let’s look at the 2nd largest cause of failure: Number 2: “Ran out of cash.” Not enough funding scenarios come about when not enough capital is being raised or, most likely, the company didn’t anticipate the expenses (or the “burn rate”) it would go through. Why the second scenario is most frequent? The management team doesn’t know how to run a business (lack of experience), hired the wrong CFO (which I attribute to the CEO’s lack of experience as well). Going back to the NYC company, I had exchanged numerous emails criticizing the spreadsheet. I discovered that this supposedly “experienced” CFO had lumped many line items, and, in so doing, he failed to account the many expenses it takes to run a company in NYC. Besides lumping all salaries in on line item, the CFO also covered all G&A expenses into one number, $124,000. So, when I had requested a breakdown, the CFO simply replied that he didn’t see the point of details.
Let’s look at salaries as part of why I demanded a breakdown. In the CFO’s version, he estimated a 3% additional costs above the salaries. He explained to me that the 3% represented some Delaware tax. Considering that the company was not incorporated in any state, I thought that his assumption was absurd. By this wrong assumption, he revealed to me that he never was accountable for labor costs, although he claimed to be a financial director of medical institution. In the U.S., when one includes unemployment tax, benefits, and the like, every CFO should anticipate that, for every dollar being spent for salaries, he should add anywhere from 23% to 25%. (By the way, in other countries, this factor changes, even as high as 100%!) And, since a couple team members are located outside of NYC, the CFO should have added relocation costs anywhere in the vicinity of $25k to $35k for each employee. Since he lumped up all salaries to less than $1 million, he should have added $250k to $280k to labor costs. Not an insignificant amount.
Since he lumped G&A in $124k, he also grossly underestimated rental costs in NYC. With a few minutes of Internet research, one can get the average costs per square foot in NYC. Multiply that by the number of employees for the first year (6 in his business plan) and the 150 sq. feet office requirement per employee, then you get your annual office leasing costs. That estimate alone would boil down to $120k annually. And we have not included the required office insurance, utilities, moving costs, furniture, electronic equipment, etc., all required to populate an office.
And let’s add legal costs alone, also included in the G&A, to close down a deal for a NYC startup without the legal infrastructure. To have outside counsel draft a negotiable instrument, $7k; to create corporation, bylaws, securities – $3k-$4k; to draft stock option program, $10k-$15k; to draft or negotiate a term sheet, $3k; draft employment agreements, $1k-$2k; miscellaneous, $3k. We take the worst case scenario – $30k for the budget. And lest we forget, the company must pay for opposing counsel fees representing the investor, who normally charges $1,000 an hour – a possible $50k. Overall I would anticipate that the first year’s legal costs – unless handled by inside counsel – will total about $80k.
We can already estimate that the projected costs versus actual costs are several hundred percent off. I am estimating that the G&A should be closer to $500k not $124k. This gross error only raises more reasons why startups fail – Number 3: “Not the right team”, the wrong team members. I question whether this CFO has the right expertise for his role. And, since the business plan included an attorney as General Counsel, I ask why that attorney was not aware of the potential expenses. Maybe he/she lacks the appropriate experience in handling startups.
These line item errors come cascading down to why many startups fail: Number 7, “Need/Lack Business Model” – this NYC startup failed to have an appropriate business model. That leads to another problem – erroneous product pricing, and, to very experienced investors, these investors would simply pass the deal since the company cannot determine its cost model.
Then, comes the clincher: in well drafted investment documents, it is fairly common for investors to be awarded greater percentage of the company when the startup company fails to hit major milestones – whether in its projected revenues or in its financial performance (to wit, controlling expenses.) So when the startup hits the double whammy – not hitting its sales, and its expenses skyrocketing beyond projected models, clauses will kick in reducing the equity amount for the founders and management team and transferring that equity to the investors. There is a saying on Wall Street, “under-promise and over-deliver”, for this very reason. Here I would foresee the founders and investors bickering about who said what and when, which leads to Number 12, “Disharmont (Sic) on Team/Investors”. And when this friction accelerates, key team members leave and other investors shy away from investing in this company—in other words, the slow “kiss of death.”
In conclusion, I used a real, actual example of how a NYC startup would fail, even before it starts. And through this startup, I show that the failures can be combined into one large percentage to gauge how startups fail. In a previous blog, I do refer to the fact that companies live and die on how they build their spreadsheets. But this table shows how large a percentage related to failures can be attributed to that financial modeling failure — over 50%.