Natural Selection Among Startups

Originally published on Substack — March 16th, 2022

Starting a company isn't that hard. You fill out some forms to incorporate. But that's about the last easy thing you'll do. Building a company that lasts the test of time is default one of the hardest things to succeed at. Only 50% of companies make it to their fifth birthday. Consistently only ~10% of companies survive past 10 years.

No one starts a business hoping that it dies. Founders pour their heart and soul into a company hoping to delight users and make a difference in the lives of customers. No one wants that thing to fail. But burying your head in the sand about mortality rates only increases the likelihood of falling victim to known causes of death.

I've written before about a tweet that Harry Stebbings deleted. It was a hot take, but I think there is a lot to be learned from his insight:

If you haven't acknowledged yet that the world of tech and startups is changing? You're in for a rude awakening. Public tech companies have, in many cases, seen 60%+ of their market cap wiped out in a few months. Private companies are seeing investors pull back from high valuations. Over the next 6-12 months you'll see down rounds, layoffs, and companies shut down.

The best time to start thinking about how to manage a startup through a downturn is 6 months before the correction. The second best time is now.

Before Harry deleted his tweet about natural selection in startups he got some pushback on the concept being insensitive. But I think this is akin to burying your head in the sand about the reality of death. Every founder lives with the looming threat of death for their company whether they like it or not. The difference is whether they acknowledge it.

Anyone who believes there isn't a sort of natural element to what companies survive and which ones die, just look at Quibi. There is no better example in recent history of a company doing everything possible to force an idea into existence that wasn't meant to survive. Quibi was like a pair of dolphins adopting a dog and bringing it home. It was never going to work out well.

You don't survive just because you were able to raise billions of dollars. Or because you've done something successful before. There is a natural wave to what can and can't succeed. Some companies defy odds of what people believe will naturally succeed or fail, but that's because the skeptics are wrong. Not because there isn't a natural curve to which companies survive, thrive, or die.

The amount of capital has exploded from $75B to $200B+ of dry powder in venture just over the last few years. This overabundance of capital has led to a bloated marketplace for businesses attempting to solve any given problem and could ultimately lead to worse solutions because no one early-stage company has adequate resources to solve the problem, and there are too many mouths to feed with too few customers.

Companies that probably don't have a good enough idea, a good enough product, a good enough team, or a big enough market have been able to access exorbitant amounts of capital. A balance sheet flush with cash can hide a multitude of sins. There is a spectrum where on one end all the resources accrues to one player and results in a monopoly. On the other? Everyone has access to resources to justify living longer than the quality of their output probably justifies. But that is going to change as markets correct.

In talking to people about natural selection in building startups I've seen an interesting counter-position of two theories: (1) the Red Queen hypothesis, and (2) the Lindy Effect.

Named after a quote from the Red Queen in Through The Looking Glass. "It takes all the running you can do, to keep in the same place." In evolutionary biology the idea is that no species has more right to survive just because they've been around for a long time.

Nassim Taleb explains a similar idea in his book The Black Swan:

We often point out "startup survival rates" like I did at the top of this article (e.g. 50% live 5 years; 10% live to 10 years). But does living longer automatically mean they’re entitled to succeed?

The "non-perishable" idea is key. The Lindy effect applies to things that do not have an "unavoidable expiration date" A human being has an unavoidable expiration date because they never last longer than ~100 years or so. Perishable things are more likely to die the longer they survive.

Are startups non-perishable? There are companies like Kongo Gumi that have been around since 578 AD. So given we have companies that have been around for 1,400 years and still kicking it's safe to argue companies are less perishable than humans.

Once we start dealing in centuries as a time-frame, the data starts to get thinner and thinner. "The prevailing theory, though unconfirmed, is that only about a half a percent (0.5%) of all companies have what it takes to last 100 years. They’re so rare it’s difficult to calculate just how rare they are."

So is a startup a non-perishable thing that demonstrates its right to survive by its longevity? Or is it more like a living organism that can fall victim to any of a variety of causes of death at any time regardless of how long it's lasted?

Take GE as an example. The company was founded in 1892 and has operated for 129 years. Not only was GE a big part of the Dow Jones average; it was literally one of the original 12 companies listed when the Dow was created. Any company that can survive 129 years is likely doing something right, no?

No. GE is on an infamous list of companies that have been remove from the Dow along with names like Sears, AT&T, and General Motors. The company peaked in 2008 with $180B+ of revenue and have fallen dramatically since then.

Extinction for a company can come at any time. Whether its a sudden death (Quibi) or a languishing decent (GE). I think it's fair to say that a company is more of a natural thing that is always at the precipice of death. Acknowledging the potential for death is the first step in building a business that can defy the odds and not only survive, but thrive, for as long as possible.

Before diving into the nitty gritty of survival its important to note that survival is as much a mindset as it is any strategy or execution.

This feels like a painfully obvious idea. "Of course I want to survive." But look no further than how people live their actual lives. If a startup fails? You pick yourself up and try something different. If you actually die? Game over. No do-overs. So do you exercise? Eat healthy? Avoid stress? Not likely. So acknowledging the role that mindset plays in survival is a pretty important step.

Trying to build a company is difficult. But there can be a lot of dopamine-esque hits that keep you going. Splashy press release? Crushing it. Stellar new hire? New funding round? Making the cover of a business magazine? It's all up and up. The fight for survival typically comes without any of that. The willpower required to survive will come at the time when giving up would feel much much easier.

The will to survive is something that has to be deliberately established even when everything looks hell bent on your destruction. Survival also isn't something you can just turn on. It’s a learned behavior. You're best prepared for success if you build survival into the culture of your company so survival is a natural response when / if the time comes.

Warren Buffett and others have famously articulated the idea that "time in the market is more important than timing the market." This is about survival. Luca Dellanna, in his book 'Ergodicity,' explained it this way:

No startup is assured survival. Especially in the earliest days. But anything a company can do to increase their odds of survival give you an outsized opportunity to succeed.

In everything I've written about venture and startups the thing I return to most often is this idea of "improving the odds of success." Bryce Roberts pointed to "improved odds" as the number one product founders want to buy from investors. Firms like Homebrew claim 'improved odds' as a core focus of their investing efforts. There is no better way to improve your odds of success than by improving your odds of survival. These are some of the most common "causes of death" people point to for startups.

Paul Graham points to starting a company without a co-founder as the first thing on his list of 18 Things That Kill Startups. "What's wrong with having one founder? To start with, it's a vote of no confidence. It probably means the founder couldn't talk any of [their] friends into starting the company with [them]."

On the other hand some data points to solo founded teams as having a higher likelihood of survival. One study found that "solo founders are twice as likely to succeed in business [than teams with] co-founders."

There are a lot of ways to think about the ideal founder dynamics. They're likely as unique as what works best for someone deciding who to marry, or whether to get married at all. The same answer won't be right for everyone but if you land on the wrong answer for you things will always get messy.

You choose what "survival" has to look like. You can determine the necessary quality of life for your business. Whether survival means a lifestyle business or a multi-billion dollar outcome. I've written before about the decision you're making when you decide to raise venture capital. Part of that decision is defining what survival means for you.

Paul Graham wrote an awesome essay about one of they key questions he asks of any startup. Is your startup default alive? Or default dead?

After reviewing 100+ startup post-mortems CB Insights compiled a list of the most common causes of death. 38% of failures (the largest portion) pointed to running out of cash or failing to raise new capital. Effective cash management can be a pretty boring part of running a business but it will ultimately dictate whether or not a company will survive those game-changing first 5 years.

In times of plenty people will often point to relying on investors to help support their capital needs to chase ambitious goals. Few founders will say out loud "we're relying on investors to save us," but when you start saying it out loud it should set off serious alarms.

Across both enterprise and consumer businesses one of the most telling aspects of long-term potential for a business is retention. Whether you're measuring users who stay engaged or enterprises who continue to increase the dollars they're spending.

If you retain users you can spend more to acquire them because their LTV will be higher. If you have to spend to acquire a customer and then spend to keep them the ultimate value each customer will drive can only ever be so high. And as your market becomes more competitive and your competitors become more sophisticated that margin per customer will become increasingly thin.

A lot has been said about "growth for the sake of growth." There is an obvious need to build an effective engine rather than chasing unsustainable growth. But ultimately if you can also capture value as you grow that will allow your company to take advantage of a compounding effect. The majority of the benefit from compounding comes at the very end of the compounding period. Think of the example of putting a grain of rice on a chessboard and doubling it for each square.

You might think "yeah, the biggest chunk of value comes in the latter parts of the board.” But in fact 50% of the entire value comes in the very last square. This is why companies that start to see precipitous declines in growth, even before IPO, are concerning. They're not demonstrating the ability to take advantage of the compounding that the very best companies see in the latter years of their existence. In 2021 Amazon generated $470B of revenue. That represents 21% of all the revenue combined that they've generated since 2000.

As I spent time thinking about the most common causes of death for startups I found countless resources. The key takeaway for me? Live with paranoia in the back of your mind. Every founder and investor should be curious when they see a founder, startup, or project fail. They should be eager to ask the question "what went wrong?" No failed experience is wasted if someone learns something from it.