5 Reasons Startups Fail

By David Skok from “For Entrepreneurs”)

Reason 2: Business Model Failure

As outlined in the introduction to Business Models section, after spending time with hundreds of startups, I realized that one of the most common causes of failure in the startup world is that entrepreneurs are too optimistic about how easy it will be to acquire customers. They assume that because they will build an interesting web site, product, or service, that customers will beat a path to their door. That may happen with the first few customers, but after that, it rapidly becomes an expensive task to attract and win customers, and in many cases the cost of acquiring the customer (CAC) is actually higher than the lifetime value of that customer (LTV).

The observation that you have to be able to acquire your customers for less money than they will generate in value of the lifetime of your relationship with them is stunningly obvious. Yet despite that, I see the vast majority of entrepreneurs failing to pay adequate attention to figuring out a realistic cost of customer acquisition. A very large number of the business plans that I see as a venture capitalist have no thought given to this critical number, and as I work through the topic with the entrepreneur, they often begin to realize that their business model may not work because CAC will be greater than LTV.

The Essence of a Business Model

As outlined in the Business Models introduction, a simple way to focus on what matters in your business model is look at these two questions:
⦁ Can you find a scalable way to acquire customers?
⦁ Can you then monetize those customers at a significantly higher level than your cost of acquisition?
Thinking about things in such simple terms can be very helpful. I have also developed two “rules” around the business model, which are less hard and fast “rules, but more guidelines. These are outlined below:

The CAC / LTV “Rule”
The rule is extremely simple:

⦁ CAC must be less than LTV
CAC = Cost of Acquiring a Customer
LTV = Lifetime Value of a Customer

To compute CAC, you should take the entire cost of your sales and marketing functions, (including salaries, marketing programs, lead generation, travel, etc.) and divide it by the number of customers that you closed during that period of time. So, for example, if your total sales and marketing spend in Q1 was $1m, and you closed 1000 customers, then your average cost to acquire a customer (CAC) is $1,000.

To compute LTV, you will want to look at the gross margin associated with the customer (net of all installation, support, and operational expenses) over their lifetime. For businesses with one-time fees, this is pretty simple. For businesses that have recurring subscription revenue, this is computed by taking the monthly recurring revenue, and dividing that by the monthly churn rate.
Because most businesses have a series of other functions such as G&A, and Product Development that are additional expenses beyond sales and marketing, and delivering the product, for a profitable business, you will want CAC to be less than LTV by some significant multiple. For SaaS businesses, it seems that to break even, that multiple is around three, and that to be really profitable and generate the cash needed to grow, the number may need to be closer to five. But here I am interested in getting feedback from the community on their experiences to test these numbers.

The Capital Efficiency “Rule”

If you would like to have a capital efficient business, I believe it is also important to recover the cost of acquiring your customers in under 12 months. Wireless carriers and banks break this rule, but they have the luxury of access to cheap capital. So, stated simply, the “rule” is:

⦁ Recover CAC in less than 12 months

Reason 3: Poor Management Team

An incredibly common problem that causes startups to fail is a weak management team. A good management team will be smart enough to avoid Reasons 2, 4, and 5.  Weak management teams make mistakes in multiple areas:
⦁ They are often weak on strategy, building a product that no-one wants to buy as they failed to do enough work to validate the ideas before and during development. This can carry through to poorly thought through go-to-market strategies.
⦁ They are usually poor at execution, which leads to issues with the product not getting built correctly or on time, and the go-to market execution will be poorly implemented.
⦁ They will build weak teams below them. There is the well proven saying: A players hire A players, and B players only get to hire C players (because B players don’t want to work for other B players). So, the rest of the company will end up as weak, and poor execution will be rampant.
⦁ etc.