Mind the Flags

It’s highly likely that anyone starting up a new business is something of an optimist. In fact, recent surveys (1) suggest that 4 out of 5 small business leaders are optimistic about the future of their business. However, the evidence suggests that many of these leaders (and their employees and supporters) will be disappointed. An Australian Government report on small businesses (2) showed that after 3 years only one-third (31%) of Australian start-ups had sales exceeding their costs, with another third (34%) still trying, and a large third (35%) shut down. The authors indicated “it appears unlikely that more than 50% will ever reach operational status”.    

Given the many thousands of new businesses that start up every month in Australia, this represents a lot of optimists finding out that real life isn’t going as well as they had hoped.

Unfortunately, in business as in every walk of life, it appears that the fact that someone thinks they are going to go well, doesn’t mean that they will. There is a phenomenon known in psychology as the Dunning-Kruger effect (3), where those with low ability think they are more capable than they really are, while  those who truly are more competent tend to underestimate their ability. As an aside, this is the legitimate reason why performance self -assessments need to be supported by some objective outcome measurements. Basically, you can’t tell the idiots from the star performers, based only on what they tell you about themselves.

It seems that the Dunning-Kruger effect applies also to start-ups and the people who lead them. There is a gap between perception and reality that catches out a lot of new businesses. 

So – how can one tell whether or not a new business is likely to succeed rather than fail? While every person and therefore every business is somewhat different, there do seem to be a number of basic indicators (let’s call them “Green Flags”) which suggest that a new start-up is more likely to justify the confidence of the founders than the rest. Through observation I suggest that 5 “flags” are especially important:

1. A business model that makes sense.  Now, this might sound too basic, but I have seen and heard founders of new businesses start with a great new idea, for which they cannot explain how they will make enough money to justify their effort or cover their costs. Although venture capitalists seem to favour rapid growth rather than profitability in the early stages of a start-up, at some point the business model must break even, and then provide a reasonable return on investment. 

If you can’t work out where the return is coming from, and the founder cannot explain it simply, then in my book it doesn’t pass this first test. Not only does the business need to know that it is going to make money (eventually), it should also aim to do so in ways that leverage the real world’s corporate and tech giants, not defy them. 

In other words, it’s a lot safer if you are setting out to trade on Amazon than planning to set up a competing online service to it. The same is true with regard to the human factor: if you expect people to change their behaviour for your business model to work, there has to be a simplicity and ease of use to it  – and a huge incentive in terms of value or convenience to the consumer  – for them to do so. 

Uber is the poster-child for this value-add to consumers, although it has not yet turned a net profit, even at enormous scale. If your business offers something genuinely new and valuable, especially for other (larger) businesses, then a more complex delivery is not necessarily a sign of a weak business model. It does, however, make a clean execution of the business model even more important. 

1. The track record of the founders and leaders of the business.  In a fast-growing, cash-consuming, non-earning new business, having someone on board who knows some of the things that must be done in these early stages, and the things that should not be done, is a huge advantage. 

The reason why so many successful entrepreneurs have prior start-ups in their career history  – often relative failures, sometimes more than one  – is that this has given them the experience to know what to do, and in what sequence, in their later successful businesses. If you are learning as you go for the first time, a start-up can be an expensive classroom experience. 

I am especially wary of those who have spotted a need in their current (large business) environment, and then quit to build something to address that perceived opportunity. Without any prior experience in setting up a successful business from scratch, and often only a hazy understanding of how things will work financially (see Flag 1 above) – these are the start-ups most likely to struggle. 

That doesn’t mean complete novices cannot succeed in their first business. It’s just a lot harder, and usually takes a lot longer than anyone expects at the outset. 

1. Realistic execution plans, and patient backers. You might think that the backers of a new start-up would always demand to see a detailed plan for how the new business is going to build capability, market share, and earn money. However, too often this “plan” is only a financial cashflow projection that is laid over simple calendar start and end points, with many of the intervening points left vague and “TBC when we have raised our next round of money”. 

Understanding what needs to be done in practical terms  – people, processes, premises, products or services, customers – should not be left to aspirational and high-level targets. Although no plan can possibly predict everything that is going to happen, without a good understanding of the way the business will be built it is even harder to know what needs to be done to manage the inevitable risks and issues that arise as the business grows. 

I believe that every scale-up of a new business is a learning opportunity for those involved. The execution plan, which allows some room for failure and rework, is a key tool to ensure this learning can be captured and communicated well across the business, and to its backers. It has to be updated constantly, with a good audit trail of the changes made to assumptions, so that there is no misunderstanding about the flight path of the business. 

I have seen start-ups struggle because the plan has not allowed for the reality of the execution effort, or alternatively, the financial projections have assumed “perfection” in the delivery, which inevitably means disappointment in all but the rarest of cases (where everything works perfectly at first go). 

This “Green Flag” also means that the financial plan needs to be adjusted in flight as the ramp-up of the business proceeds, and this is where the financial backers of the business need to be patient and trusting in the team, relying on points 1 and 2 above for comfort. If the execution plan is sound and well-delivered then the backers will eventually get their return, although it may not always be when they originally expected it.

1. Have enough cash to get through the “valley of death”.  The journey to success for a start-up often has a heavy focus on raising investment funds along the way, which are needed to support the operation as it grows. 

However, the real sign of sustainable success is when the business gets to a positive operating cashflow  – more cash coming in than is going out in operating expenses and cost of goods sold. This means that the business must have funds or access to funds to allow it to survive the nerve-wracking period going from start-up to sustainable operation  – the “valley of death”. So called because so many businesses run out of money and die before they reach self-sustainability, despite a good idea and competent execution. Their bleached carcasses are then picked over by one of their erstwhile partners or even customers, hoping to pick up their IP (intellectual property) or other valuable assets for a song. 

Having enough cash in this case, means having a good understanding of how long it will take the start-up to earn money. Especially when dealing in a B2B (business to business) marketplace, start-ups can often be wildly optimistic about how long a large corporate customer will take to pass over a cheque to the new business. Many assume decision making and then payment follow at the same speed as the start-up works  – in days. 

The reality is that the processes that lead to cash being paid out can take not days, nor weeks, but many months to complete their circuits within a big business. Understanding this, and preparing sufficient resources to survive through this period, is critical for success.

1. Aligning the “walking assets” of the business to its eventual success.  The final green flag is not always easily seen from outside the business. However, when you see key members of staff leave quickly through the early stages of start-up growth it often hints at the fact that the founders and owners have not locked in their key team members. 

Emotionally, it often seems hard for a new business owner to give away equity or substantial long-term success incentives to keep their key staff. They simply can’t bring themselves to do it. However, the cost of not doing this is usually far less than the cost of rebuilding the resource, and the organisational knowledge that can be lost, when key team members depart. 

If there is nothing much beyond personal loyalty or pride in their work to keep them onboard the business, the pressure on everyone at an early stage start-up is high enough for staff to get burned out and decide they can do better elsewhere. Hopefully, if the backers of and advisors to the business are on the ball, this is something that gets addressed alongside the development of the realistic execution plan. 

Even in a high-tech start-up, business is built with people, and it’s important to get this right in the early stages. Putting it simply: an employee incentive or share ownership scheme (ESOP) may be the last thing a founder wants to spend his or her time building, but perhaps it should be one of the first.

Of course, there will be many other factors affecting the path to success of the business. But with these 5 “Green Flags” in place, I am optimistic that any start-up is likely to be one of the minority that succeed, not the remainder that struggle or fail.