What causes startup failure? You may have seen my response to this – I say we don’t know because we can’t get good data – but I like what David Rose says here:
Since a startup is a new business that doesn’t yet exist, the default outcome is for it to fail. Everything has to go right for it to succeed!
David knows. He’s a super angel investor, founder and Chairman Emeritus of New York Angels, and founder of gust.com. I’m quoting from his Quora answer to why startups fail.
On the other hand, when startups are conceived around need, giving value, solving problems, offering something people want or need enough to pay for, then the odds of failure go down. I bet David would agree with that one. He’s been involved in, founded, and invested in dozens of startups that didn’t fail.
I will add, though, that a good look at this data reveals mostly what is already common knowledge. Startups fail for lack of market need, running out of cash, team problems, competition, pricing, poor product, and so forth. There’s no surprises there.
By the way, notice that the various causes here add up to a lot more than 100%. That makes sense to me because it’s no hard to really identify causes.
And also, please notice how much of those failures are about failing to do something people need and want. If I add up the totals for no market need, get outcompeted, poor product, ignore customers, and product mistimed, that’s 105%.
Shane was referring there to a post on startup equity I did a while back, highlighting the problems that happen all too often as founders fail to define their own functions and ownership, in writing, in time. The situation I described was a hypothetical. Here’s a quick summary of that post for you:
Parker comes up with a great idea for an iPhone application, and works on it for three months in spare time. … develops sketches and designs…
About three months into it, Parker has spent maybe 10 to 20 hours on it so far. [enter Leslie, programmer] … Leslie is excited, which rekindles Parker’s excitement. They agree to be partners in a new business based on this initial iPhone application.
Four months go by. Leslie … gets into the code … discovers Parker’s initial idea isn’t quite possible … revises the idea radically, makes it practical and develops a prototype. Parker meets with him three times, they talk, she accepts his changes begrudgingly. At this point Parker’s total hours have gone from 15 to 25, but Leslie has worked a lot, probably 120 hours, on the programming. … [they] … take the prototype to Terry, who has been through a failed startup, has a business education and is looking for a startup to do again … Terry does a business plan and networks with local business development groups to find angel investors. They win an opportunity to present to an angel investment group. Another three months have gone by. Parker has now put in more like 40 hours, Leslie 250 hours, and Terry 120 hours. Leslie wants to quit a current job and work full-time on the new thing but needs to get paid. Parker doesn’t want to quit a current job but wants to stay involved; she’s not quite sure how. Terry wants to lead the new company as soon as he can get financing.
I asked three questions at the end of the post. I asked, but didn’t answer them:
How would you suggest that Parker, Leslie and Terry divide up the 100 percent ownership of the company now, before they go to the angel investors. Who owns how much?What do you think of the management team here?
Leslie and Terry both want to work full-time on the business when there’s money to pay them. What titles should they take? How much salary?
How much of the company should these three offer to the seed investor for $250,000?
Pre-money Valuation
It was relatively easy to answer the third for Shane. I put it into a tweet:
@diffily so pre-money is just math. $500K = 50% left for founders, $1M leaves 75%. On that one, Founders get what they can negotiate.
“Pre-money” means the valuation for the transaction with the initial seed round investors. To clarify, “post-money” would be the valuation after new investment funds are received. So if “pre-money” was $750K, then the angel investors’ $250K would buy 33.3% of the shares and the founders would end up with 66.7% of a business values post-money at $1 million.
I can’t get more specific than that without filling in some value judgments about the relative value of the application, the presumed product-market fit, and the credibility of the team. If all three factors are positive, then I’d suggest starting the negotiation with a valuation of $1 million. That would give the angels 25% ownership and the founders 75%. That leaves enough equity for future rounds. Otherwise, if the deal isn’t that stellar, then the three founders would have to go down to $750K or even $500K, hoping to get some angel investment to develop traction and increase the valuation later.
For the sake of explaining dilution, I’m going to go with the $750K valuation for the discussion on dilution below.
Startup Equity
Shane then asked the much harder question:
@Timberry Thx so much. A lot ask – but what rough breakdown for Parker, Leslie & Terry wud you say is equitable? No worries if u’d rather not!
Keep in mind that I just made these people up and imagined an unspecified iPhone app without describing what it does for whom. In the real world it would take a lot more of understanding who these three people are and how credible their real skills. Here’s what I think:
First, Parker can’t have much equity because she hasn’t done that much. Her initial idea didn’t work. She has put in only 40 of the 410 hours (less than 10%) and her hours weren’t all that useful. Still, she was the originator, she came up with the market need, and she set the wheels in motion. So she should stay involved as long as she wants. However – also very important – Parker doesn’t even want a full-time job. I’d ask her to take 10% of the pre-investment 100% shared by the founders. And I’d give her a seat on the three-person early board of directors, with the assumption that she’s going to go off to make room for investors.
With Terry and Leslie, I’d put Terry in charge and at the top of the business, with a title like CEO or President or some such; and Leslie should be the technology/product development lead, reporting to Terry. I’d want both of them to take minimum possible full-time salaries as soon as possible, Terry’s a bit more than Leslie’s. Their salaries should be a compromise, enough to support them and their families, but less than market value because they have to keep the burn rate low. And I’d want to get their salaries up to their market value as soon as possible. In a real company, if it’s going to make it, the people it depends on get paid.
I’d want Leslie to take 50% of the founders’ 100%, and Terry 40%, bringing the total, including Parker’s 10%, to 100%.
Why? Obviously I’m making some assumptions on the unknowns. I assume that Terry has a credible background in startups and holds up as lead founder. I assume Leslie has a credible background in tech and can run the technology, even as the business grows. I assume Parker has knowledge and experience beyond just the idea, and can contribute to the business even if not an employee. I assume all three are there for the long term.
I confess to some bias here too. I don’t believe the original idea has much value without ongoing contribution. I do believe in product-driven businesses, and technology-driven businesses, which is why I end up giving Leslie more equity than Terry. And I assume Terry’s MBA is a healthy number of years in the past, which means (to me) that it has been tempered in the field and has more value.
Valuation and Dilution
After angel investors put in $250K, they own one third of the shares. Usually the legal work is done with preferred shares and more subtlety, but, for purpose of illustration, let’s assume this is all done with common shares and the total founders’ shares, before the angel investment are 1,000. That’s a small number because startup attorneys usually write up the original corporate documents with more shares, such as 10 million instead of the 1,000 I’m showing. I’m using these simple numbers because it shows how the founders are diluted when the angel investors join the ownership. Each of the founders retains the founder shares he or she has, but the additional shares mean that they end up owning less of the company than they did before the deal.
Do you recognize this question: “Do I start two businesses at one or just one at a time?” I received it over the weekend from my ask-me form on my website. And I have two completely contradictory answers and then an explanation.
First, the question (leaving out parts of it that would identify the person asking it):
I am about to start a business called [omitted] a digital marketing agency. But I also want to start another one, a mining research consultancy company called [omitted]. I am passionate about both but just wondering if I should start both at the same time or start one then use the profit from the first one to start the second one.
Before I answer, I have to enjoy the optimism there. How nice to be wondering whether to fund the second success with profits from the first.
My answer: Focus. It’s going to take a lot of work to start up either one of these. Don’t dilute your efforts. Choose one. It’s going to be harder than you think. Do a business plan for it, then execute, and review and revise the plan constantly.
The contradiction: I’m right now doing exactly the opposite of what I recommend. I’m working on a social media business and a mobile apps business, both of which I’m doing with co-founders, without staff, and without outside investment.
The explanation: It’s dumb, but I get up in the morning, like the idea, and I can’t resist. I have patient co-founders.
So I’m hypocritical, yes. Do what I say, not what I do.
Please, entrepreneurs, this is important. Please don’t give away ownership in your startup, ever, except to partners who offer permanent help and value to the business, and will be there forever. That’s team members working the business, investors, or strategic partners with long-term commitments you can’t live without. Separate ownership, which is critical, and should never be given away easily; from credit and kind words, which are easy to give away.
I’ve seen this so many times. People give percentages away to their lawyers, their graphic artists, their friends, and their relatives, but for no good reason. Then what happens is if the business makes it a year or two into actual business, suddenly those once-naive founders realize they are doing business with partners, who own part of their company, who don’t work, don’t care, criticize, and drag the decision-making processes. Pay the fees. Don’t save starting costs by giving the business away.
Giving a piece of your new business isn’t liking buying a round of drinks at a table, but sometimes people treat that as if it were. But the truth is that you only have 100 percentage points to give away. The best ownership structure is 100 percent you. If however you need resources, key people and investment, then you need those percentage points to trade them for absolutely critical long-term relationships, or money. Not to make your cousin happy. Not to save on attorney fees.
I recently dealt with an entrepreneur who was grateful for a ton of help, including written content, received from a good friend. He was trying to figure out how much of the company to give that friend as a reward. But the friend wasn’t going to be involved in the future, had taken another job, and wasn’t even asking.
Don’t give her a piece of your business, I said. Pay her fairly. And if you can’t afford to pay her now, write up a bonus or a percent of sales that you’ll give later if you make the sales. Everybody wins. And you own your whole company. You don’t give away a piece of it in gratitude for somebody who won’t be a permanent part of it. He took my advice and gave her money now and a promise of money later, but not ownership. Both sides of that were delighted with that arrangement.
What brings this to mind is this question I received over the weekend in my ask-me form on my timberry.com website:
I’m 19. I have been avidly working through ideas for an amazing product. I’ve gone through lots and I eventually stumbled upon one that my mom loves so much that she wants to be a part of my business. Great news, but my issue now is that I’m willing to list my mom as a founder and now she wants me to add my stepfather as a founder as well. I feel like people are fishing for credit and titles that they have not yet earned. I’m not willing to appease anyone for the sake of it. How can I build a successful business alongside my family?
Kid, you’ve got this one right and your mom and stepdad have it wrong. Read the post here. Family or not, ownership in your business is about actual contributions to your business. You say you’re “willing to list” your mom as a founder. But this isn’t like the acknowledgements at the beginning of a book; this is ownership in the business. List, sure; stocks and shares, no.
Titles and credits are nice but ownership should be reserved for people who are going to actively contribute either money or long-term help. List them as advisors and give them credit on your website but give them ownership in proportion to the work, contribution, or money. This is business.
It’s not about taxes or any public policy, or economic statistics, or red tape. The right time to start your new business is …
When you think you can…
When you’re pretty sure people will buy what you want to sell…
When you understand the market… You know why people might make purchasing decisions, and where. That doesn’t mean, by the way, that you necessarily have some fancy expensive market research full of numbers and charts. It does mean that you understand the market.
When you have reasonable educated guesses about the basic numbers … You don’t have to correctly estimate future sales, by the way — nobody does — but you can’t have no idea. And you ought to have to have some reasonable estimate of real costs. Don’t forget your rent, overhead, and what you pay yourself.
When you have the resources you need…
When you’re not betting your life or your important relationships on business success.
What’s the secret to success in entrepreneurship? Passion? Persistence? Doing what you like? Maybe it’s having a great business plan? I’ve written here that empathy might be the most important. But that’s a generalization too. What do you think?
Here’s the problem with that: there are no general rules. Scratch under the surface of entrepreneurship and you’ll find lots of people willing to put forth one characteristic or another. You can find examples for anything.
The people who strike off on their own are by definition people who split off from the group to do something different. So they don’t come in flocks, Generalizations don’t apply. I know people who fell in love with technology, a market, doing something they like to do, or even one or two who set out from the beginning with the specific goal of making millions of dollars. And I know people who started their own business mainly to be independent, set their own hours. I know people who did it just to prove that they were right when they said it could be done.
What reminded me of this was Susan Solivic’s What is Your Motivation? on Up and Running a few weeks ago. Writing about what makes people start companies, she suggests there are lots of different reasons.
For startups, patents are nice to have, but not if you trust them to really protect you. In that they’re like umbrellas. Good protection in a drizzle. False confidence in a downpour.
I write that because I’ve read about 50 real startup business plans in the last two months, and I’ve gone through at least two dozen pitch presentations, and I think it needs to be said.
Patents are usually better than nothing. I like it when a startup has a patent portfolio already issued, but also promises to keep trade secrets very tight and has a budget for patent defense. I like it more when they have a letter from a patent attorney talking about coverage and defensibility of the patents.
I hate it when the startup says a patent has been applied for, or there is a provisional patent, and says (or implies) that therefore their business is defensible.
Having a patent doesn’t mean much anymore. A provisional patent, less. And having applied for a patent, even less. The world of high tech is littered with fallen companies that were smashed to bits by a large company getting around, or violating, their patents. It happens all the time.
Sometimes I feel better with a strong trade secrets policy, a fast ramp-up, and great marketing, which I think offer the best real protection against copycats.
I suspect that the patent system is broken. Some bad patents that should never have been issued feed the coffers of patent trolls. And good patents are hard to find, slow to get, and hard to enforce. Sure, they’re good to have. But don’t trust ’em.
We all forget too easily: the best startup funding is sales. Sure, angel investment, friends and family, SBA loans, all of those options are necessary for most startups. But sales is better.
If you can, find the early customers. Give them a deal, make them important, work with them to optimize their needs; but make a sale.
Even if you need to go out and find investment — and I speak now as an actual angel investor — there’s almost nothing as convincing as actual sales. People are spending money. It makes a new business proposal far more credible.
True, not all businesses can do that. But a lot of them can. And, as we write about business plans and seeking investment and all, we forget the real sweet spot: finance growth by making the sales.
After angel investors put in $250K, they own one third of the shares. Usually the legal work is done with preferred shares and more subtlety, but, for purpose of illustration, let’s assume this is all done with common shares and the total founders’ shares, before the angel investment are 1,000. That’s a small number because startup attorneys usually write up the original corporate documents with more shares, such as 10 million instead of the 1,000 I’m showing. I’m using these simple numbers because it shows how the founders are diluted when the angel investors join the ownership. Each of the founders retains the founder shares he or she has, but the additional shares mean that they end up owning less of the company than they did before the deal.
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