Failing Startup? Here are the best VC practices to handle the situation

Statistically, 90% of new startups fail. 75% of venture-backed startups fail. Under 50% of businesses make it to their 5th year. The odds are not in favor for entrepreneurs, but this is the exact prey that VCs hunt for. The nature of a VC firm is high risk = high reward, low risk = low reward. So the 90% failure rate does not scare VCs away to the same extent the 10% success rate attracts them. The life of a VC is full of failures and a few really huge successes, but you don’t always hear about these failures as you do the successes. 

Sometimes, the failure of a startup is inevitable, maybe because of the embedded structure, marketing issues, cash flow issues, or simply it isn’t a good idea and proves to attract no significant demographics. Here are some of the top reasons most startups fail:

VCs don’t always see this coming, and although statistically the failure rate decreases for VC-backed startups, the risk still stands sky high at 75% chance of failure even with funding and backing. Some ways that VCs can reduce risk is through the obvious portfolio or sector diversification efforts, investing at low valuations, investing via preferred stock so they have seniority when liquidation occurs (which entails investing in different valuations and stages of a company’s development and structure), time diversification, etc.

But what do venture capitalists do when it becomes clear a startup won't provide desired returns? 

When VC has a feeling of a startup underperforming, it usually comes down to these conclusions:

  1. The startup is going to crash and burn.

  2. The startup is not indicating growth at the rate expected, but with changes and fixes, it has potential to get on track and become favorable.

  3. The startup is not going to die, but it’s not on track for growth either.

Let’s examine each of the above three cases.

Case 1: Crash and burn.

In some cases companies would spectacularly fail even after raising loads of funding and forming a strong management team. However sometimes, there is nothing a VC can do in that case because the circumstances are beyond the VCs control. Let's take the example of the company Aereo, founded in 2012 and became defunct in 2014 -  They had an $8 USD service where the users can view live and time-shifted streams of over-the-air television on Internet-connected devices. They assigned an antenna to each user. They were sued for infringing upon the rights of copyright holders and had to close down. In this case, due to legal issues, the VC had to take the step down. In other cases, the startup may run out of money without achieving the milestone or even worse - not being able to add a single new customer over a year. What can VC do? Nothing.

In a backup strategy, the VC may help the CEO proceed with a sale of the company but still it's the CEO’s decision and responsibility to sell, and that is if it even sells.

Case 2: The startup is not growing but problems are temporary.

The startup is not able to grow at the expected rate and it could be that certain setbacks have lead to this, for example - maybe they did not hire a CTO in time, and the engineering team was poorly managed, leading to a delay in key technology upgrades. In this case if a VC has expertise in this area then they will provide guidance. However, it is up to the management team to accept or not accept that guidance, depending on how the board of directors is structured.

Case 3 : The startup is stagnant. 

These “walking dead” companies prove to be consistently performing and operating, however it is clear they will not create any significant value or growth. This is basically a failure in the eyes of a VC. These are the worst kind of companies because they are an absolute time suck and sometimes, it’s better off liquidating this company. Remember that the goal of VC is to find big time winners AKA “Unicorns” which bring upon lucrative exit opportunities, especially in order to balance out the rest of the portfolio - which consist of many walking dead companies as discussed here. VCs are not in that business to get 1.5X return or create basic profitable companies. They are in the business to capture a large market as fast as possible; a high risk and high reward scenario. Case 3 is the worst of all three because depending on the VC they may spend a lot more time with these companies for a mediocre return, in hopes that it will turn into a high growth potential investment. Time is money. So, it can be tricky, but as a VC, it is important to see this coming early on,  and take action before the opportunity cost eats you alive, leaving less time for the VC to source better deals, causing the VC to become blind to more promising portfolio companies and inhibit fund success.