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Beyond the Pitch

The Heartbreak of Category Three

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In the early days of a startup, the excitement is palpable and optimism reigns. The founder’s energy infuses the organization. Each new hire brings new ideas and new energy to the team. Product releases and new customers fuel the enthusiasm. The influx of new investment validates that the business is on the right track.

Then, one of three things will happen:

The company continues its impressive growth, fueled by a growing team, great new products, new customers, and excited new investors. Additional funding comes easily. Eventually, there’s a successful exit, or maybe even an IPO. Let’s call these cases Category One.

Or, the company fails, crashing and burning like a satellite hitting the atmosphere disintegrating in a ball of flames. The team disperses. The founder feels terrible, but learns from the experience and, after a few months of reflection and, possibly grief counseling, may even try to start up another company. Let’s name these cases Category Two.

And then there’s the third possibility, which we’ll call Category Three. Things get really tough. The company fights to survive. Somehow, through force of will, it keeps on going. Growing revenue is a slog. New investment dries up. Existing investors become agitated, cynical, or completely disengaged. Rounds of cost-cutting, layoffs, and reduced pay create internal angst.

In the best case, Category Three leads to re-tooling the product and some improvements in marketing that lead to some slow progress on the sales side. Often, however, a Category Three company is really just a zombie, undead, but not really alive either.

How do you know that you are in Category Three?

No business, even if it’s a fabulously successful Category One, will always perform up to all expectations and forecasts, but when the business is headed toward Category Three, there will be shrill warning signs, almost always starting with a revenue shortfall.

  • Deals aren’t moving through the pipeline to closure. The cycle takes longer, possibly requiring different expertise than the business plan anticipated.
  • The company misses its revenue forecasts continuously.
  • The customers you are able to sign up are unhappy and don’t stay.

The ultimate reality check, however, is when the business starts running out of cash. Cash doesn’t lie. If the end of the cash runway is in sight without any reasonable prospect of extending it with new sales or new investment in the business, your choice is to either throw in the towel (Category Two) or find some way to extend the runway and stay in the game.

If there is at least some path to extend the life of the business, that scenario puts you right into Category Three.

Category Three always begins with a revenue problem

It seems like it should be easy to understand why potential customers don’t want to buy your product, but it’s not.

Is the product just not what the market is looking for? Did you miscalculate the overall need for the product in the first place? Or is the concept good, but the execution poor? Is the user interface unappealing or difficult to understand? Does the product have a steep learning curve? Are the training materials inadequate? Does the product fail to address certain key customer needs? Is it priced wrong?

Or maybe the problem isn’t the product. Have you really found a cost-effective means of marketing?  Maybe you underestimated how much time and money it would take to give your marketing a chance to succeed. Or perhaps your sales approach is wrong, or your sales team just isn’t very good.

It can be very difficult to determine the real answer to these questions in the real-time pain of Category Three. Unfortunately, any or all of these issues can produce the same effect: weak revenue.

Can cost-cutting buy enough time to find and fix the cause of the revenue shortfall?

If you’re facing the end of the cash runway, and you can’t fix the problem with more revenue, you are down to just two options: raise new investment or cut expenses.

Sometimes you can go back to the well with your investors, but if the business hasn’t been meeting milestones, don’t be surprised if the response to that is “no.” That leaves cost-cutting as the only tool to extend the company’s life.

Cost-cutting will be painful. It always means employee reductions, often releasing people whose skills are essential to the business. And even then, the cuts will only extend the runway for a limited amount of time. You can’t cost-cut your way to profitability when there’s a fundamental problem with the product or the business model.

Keeping key team members and stakeholders engaged while you work your way out of Category Three

“These are the times that try men’s souls.” Thomas Paine

There is nothing fun about a startup that has missed its growth plans and laid off half the staff.

In the mire of Category Three, everyone will be asked to work even harder than they did before, with less help and less hope. Fatigue becomes corrosive to morale. There is plenty of fatigue to go around—team member fatigue, board fatigue, investor fatigue and, especially, founder’s fatigue. The pressures on the company’s leaders are immense.

Category Three creates enormous stress on the CEO’s relationships with employees, investors, and even family and friends. You may even come to resent the remaining employees who (in your rattled state) are not working hard enough or worrying enough; the investors who refuse to put up any more money; the customers who still won’t buy your product, and even your spouse for not understanding that the company’s success is the-most-important-thing-in-the-world.

I can tell you from personal experience that it is very difficult to present an optimistic face to employees, customers, board members and investors when you’re battling through Category Three. But that’s what a good leader must do. Any CEO can ring the bell at the NYSE to celebrate the IPO, but it takes a genuine leader to keep a team together while managing through the desperate times of Category Three.

When to persevere; when to throw in the towel?

Sometimes passage through Category Three is relatively quick; but when it’s quick, it usually doesn’t end well.

If the company lacks any reasonable prospect of revenue from new sales or cash from a new investment, notify investors, create a shut-down plan to sell any remaining assets, communicate as rapidly and humanely as possible to employees, and don’t waste more money or time.

However, if there are reasonable possibilities to extend the runway and stay in the game, entrepreneurs owe it to their investors, employees, strategic partners, customers, and to themselves, to tackle a plan to turn things around.

With staff, salary, and expense cuts, it’s possible to stretch out the company’s existence for a surprisingly long time. Some Category Three companies endure for years.

The question becomes: What is the difference between perseverance (good) and delusional behavior (bad)? If there is an easy answer to this question, I don’t have it.

Ending a startup feels like a failure and a betrayal of the team members and investors who you convinced to become involved in the first place. But continuing the effort when there is no reasonable prospect of success isn’t the right answer either.

In my career, I’ve only been deeply involved in one Category One company. Everything went right. Getting customers and investors was easy, and everyone walked away very happy. I’ve been deeply involved in a couple of Category Two companies, and yes, we crashed and burned. Every other company I have been deeply involved with spent at least some time in Category Three.

Of my Category Three experiences, several companies took years of hard work that never produced any positive results. It was lots of painful and ultimately fruitless effort. I’m still dealing with the emotional scars.

But several of these businesses actually made it through Category Three and produced very successful results for everyone. The most enjoyable, rewarding experiences of my business career—and the deepest relationships I have with business partners—have been in Category Three companies that stuck it out and succeeded.

The Category Threes made me a better entrepreneur, a better investor, and a better manager.

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