With the high risk associated with startup investments, and failure of 9 out of 10 startups, it is almost certain that active startup investors will experience a failed investment at some point or another. What lessons can be learned from failed portfolio companies and potentially applied to future investments? In this blog, learn more about why startups fail and learning from failed startups as a startup investor.

Learning From Failed Startups

When taking a look at why startups fail, there are typically specific themes that can lead to the startup shutting its doors.

Market Misalignment and Lack of Validation

Crunchbase found that lack of market need is the second top reason why startups fail. This may stem from reliance on anecdotal evidence instead of finding true product-market fit through rigorous market research. A startup may be attempting to solve a non-existent problem, misjudging timing of market entrance, or seeking to target too niche of a market to be sustainable.

Financial Mismanagement

Financial mismanagement is another top reason why a startup can fail. It may have run out of capital too quickly, or was unable to secure additional funding. Unsustainable cash burn rates and an over-reliance on raising new capital can lead to problems. Additionally, premature scaling or overly aggressive marketing can mask operational inefficiencies like customer acquisition cost exceeding lifetime value.

Leadership and Team Deficiencies

The capabilities of the founding team are important for any startup, and having a team that is not well suited to manage the business can also lead to failure. From co-founder disputes, poor strategic decisions, inability to pivot, or gaps in operational expertise can lead to challenges.

Operational Scaling Failure

Having troubles scaling a startup can also lead to issues that may cause a startup to fail. If demand exceeds supply and a startup is unable to scale efficiently to meet demand, even a product with product-market fit can fail. Supply chain breakdowns, technological infrastructure limitations, or inadequate organizational processes can all play a role in causing a startup to not meet demand.

Applying Learnings to New Investments

Once investors have learned why startups can fail, it is important to understand why their existing investment failed. By understanding what caused their portfolio company to fail, they may be able to apply their learnings when researching new opportunities.

Enhanced Due Diligence Frameworks

Due diligence efforts should extend beyond just taking a look at financial projects and pitch narratives. Investors should conduct thorough due diligence, independently verifying facts and figures that are claimed by the startup. Assess product-market fit, founding team capabilities, startup moat, competitive advantage, competitors, and industry to gain a wholehearted understanding of the startup.

Focus on Sustainable Unit Economics

Revenue growth should be analyzed through the lens of sustainability. Key metrics like lifetime value, customer acquisition cost, gross margins, and break-even point should all be scrutinized. A business model that requires perpetual capital raising in order to continue operations can be risky.

Portfolio Diversification

Recognizing that a high percentage of startups fail, investors should diversify their portfolios to help mitigate this risk across a wide range of industries, stages, geographical locations, and other factors.

Final Thoughts

Failed investments are an inescapable part of startup investing due to the inherently risky nature of startup investments. However, by understanding the reasons why a portfolio company failed can allow for investors to apply those learnings to future investments, refining their due diligence process and apply diversification principles.

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The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.

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