Ep. 48 Why Startups Fail with Tom Eisenmann Part 2

JUNE 15, 2021

Dr. James Richardson (00:18):

Hey everybody, I have a very special guest with me. He is the Howard Stevenson professor of business administration at Harvard Business School, Tom Eisenmann. He is also the faculty co-chair of the Arthur Rock Center for Entrepreneurship at HBS. He’s been there since 1997.

Dr. James Richardson (00:38):

So this is part two of our interview, and this one’s going to be on more advanced topics related to startup failure.

Dr. James Richardson (00:46):

Tom, talk to us about the speed trap, because you have an interesting way of looking at that, that I think my listeners need to hear.

Prof. Tom Eisenmann (00:52):

The speed trap in a sentence is a startup that grows too fast, but we have to ask why? A big reason why is entrepreneurs love to grow. It’s how a lot of them keep score, and the way it plays out in a lot of businesses, and I think this is true in tech and outside tech, a venture gets some momentum. They find the early adopters who love the product, who spread word about the product through word of mouth and who buy and buy and buy again, and all that is going great. Time to raise money and scale.

Prof. Tom Eisenmann (01:23):

They can, the investors, whether they be venture capital, private equity, whoever angels, come in and they come in at a high price for the equity, with the expectation of continued growth. In a perfect world, hyper-growth. The entrepreneur doesn’t need her arm twisted, because she wants to grow too. That’s how entrepreneurs keep score. So everybody’s in sync, but in the background, other entrepreneurs have noticed this.

Prof. Tom Eisenmann (01:47):

One of our students launched Birchbox, sort of makeup samples in a $10 a month subscription box and within months they were cloned, and then within months after that, anything you could put in a subscription box, craft whiskeys? Got it! Designer socks? Our MBAs, they were cranking out subscription offerings, crafts for children. So the clones come and then sometimes big tech wakes up and they can copy you, and they might be motivated to, and sometimes the big incumbents in your space sort of wake up to some interloper in their space.

Prof. Tom Eisenmann (02:24):

So competition’s coming in, and the other thing that happens is that to get to the next wave of growth, which you need to satisfy the growth expectations, the hyper-growth expectations, they almost by definition aren’t as interested in your product as the first wave were, so you’ve got to discount your price. The first group came all organically, now you have to do paid marketing of some sort or another, advertising, promotion, whatever it is, but more bad things happen.

Prof. Tom Eisenmann (02:55):

If you have any kind of business where you need more humans as the business scales, and this is most business, not all software businesses, sometimes they scale magically, but pretty much everything else if you triple the business, you’re going to need a lot more humans to answer phones, to pack things in a warehouse, whatever it is. Hiring them and training them is no small feat, and this is being done in a new venture that has no systems for managing people, no systems for inventory planning, no systems for much of anything.

Prof. Tom Eisenmann (03:24):

You’re putting in the systems at the same time that you’re scaling the thing up. You’re hiring middle managers for the first time who are going to manage these legions of new employees, and it’s just easy for all that to turn chaotic, particularly since entrepreneurs resist what they feel is bureaucracy. You’re talking about systems and processes, what could be worse for them?

Prof. Tom Eisenmann (03:44):

More bad things happen, which is you start to get some cultural noise in the company culture. There’s an old guard, the people who were present at the creation who love the founder, who believe in the company’s mission, who understand it, who are the jacks of all trades and sort of shifted from one crisis to another as needs required, and now they’ve got all these specialists. The person who is in charge of intellectual property law, the warehouse management expert, and so forth. And the specialists think that the old guard is clueless about their contributions, and the old guard thinks that the new guard is clueless about what the company really stands for and why it’s important.

Dr. James Richardson (04:27):

Right.

Prof. Tom Eisenmann (04:27):

Then you get fiefdoms too. The warehouse has a different subculture than the marketing unit and so forth. There’s finger pointing, and you haven’t sort of figured out how to do cross-functional coordination. So the culture goes wobbly, and meanwhile the economics are getting worse and worse. You still want to grow, because of this push to grow has kept your burn rate high, so you need more capital and to get more capital, you have to grow.

Prof. Tom Eisenmann (04:51):

At some point, finally the investors new and old realize that the growth is unprofitable and they basically say no more. Then you get a down round, which for your listeners who may not know is just as simple as the equity sold is at a lower share price than the last round. And boy, that’s bad news if you’re holding stock options, so you leave the company if you’re an employee and the thing can unravel really fast once nobody will put more money in. So that’s the speed trap because you speed past the policemen with the radar detector heading at 80 miles an hour straight for a wall.

Dr. James Richardson (05:30):

My listeners I would think hear this and think of some companies that are announcing SPAC’S or IPO’s during the pandemic. Those were almost assuredly folks, those were massively negative EBITDA, wannabe unicorns. And that’s what Tom’s talking about. Wannabe unicorns that are growing really, really fast. You and I “wink wink” know they’re making no money. And the only way you save yourself is getting right into the LPs Wall Street pockets. There’s more and more of that. But I think what I find interesting about the speed trap that’s different in CPG is that, and it was really fascinating reading your book, is that institutional investors don’t go anywhere near CPG companies that are selling less than 10 to $20 million in trailing annual sales. And 90% of the companies are below that.

Dr. James Richardson (06:19):

And they’re going to flame out for other reasons long before VMG Partners calls them. My listeners don’t realize that the advantage of not having those people interested, is huge. And your book really made me almost ecstatic. I’m like, this is actually a massive advantage, because it forces you to have not only a decent gross margin business, but to be able to build it on the backs of basically heavy users and stack the markets up very intelligently. Add the accounts in a way that you can service them, pace the distribution, and every single tortoise that I’ve seen that’s scaled that slowly, quote, unquote ha-ha. They’re the ones who win every single time in my industry, every single time. People have written off Spindrift multiple times because they’re like, “What? Wait, didn’t VMG, didn’t they put equity in like five years ago. Where is the business?” Lance Collins can scale things in two years. What’s there? What’s happening? You know, and they just don’t understand the model.

Prof. Tom Eisenmann (07:17):

I teach an MBA elective called Entrepreneurial Failure and the students do a paper at the end. They get to choose the topic. One of the things I let them do is a, pre-mortem not a post-mortem, pick a company that exists, go into an imagined future, where it has failed and write from the perspective of somebody who can explain why this failure happened. I had never heard of switchel until a week ago, when one of these papers was about one of those companies and entrepreneurs are actually slowly making it work pretty well, but she is just absolutely exhausted. Exhausted. It’s been such hard work,

Dr. James Richardson (07:57):

But I say that the fact that institutional capital doesn’t have any, can’t give you the time of day on that journey to what is an enormous achievement, which is 10 million in annual recurring revenue is a massive achievement for an entrepreneur in my industry. Unbelievably unlikely. That should give you the ability to say, “I don’t care about my competition”. You might care if someone did get a big seed round, but even then, if someone’s equally inexperienced and they get a million dollars and they’re equally inexperienced to you, wouldn’t you agree, Tom, that, why are they more likely to succeed? Just because of that money? I don’t see any evidence. The cheque by itself is not like the-

Prof. Tom Eisenmann (08:33):

It’s easy to spend if you ask me.

Dr. James Richardson (08:35):

Yeah.

Prof. Tom Eisenmann (08:36):

I was just curious. The winners you’ve pointed this, the tortoises have just done it from internal cashflow or do they use angels, because it’s so capital intensive to launch these businesses?

Dr. James Richardson (08:46):

It’s mostly angel and seed money. I have had clients who are from, basically 1% trust fund families, so they can start with family cheques of a couple million. But even that, a couple of million sounds like a dream check to most listeners here. They would die for that to start off with. But as you just mentioned, and I will tell people who are listening, you will not flame out in phase one up to half a million, absolutely. It’ll definitely carry you through Phase 1, you’ll just jump to seven figures, hallelujah. The faster you jump man, without doing the things that Tom and I are talking about: introspection, studying your business and learning from it and tweaking it, it doesn’t actually increase your odds, I have to say.

New Speaker (09:30):

You talk a lot about problems staffing up, and I appreciated that discussion. It clarified a bunch of things for me that have been very messy. This Help Wanted theme was really powerful to me. Can you talk about the problems you’ve seen bringing in public firm alumni and talent directly? Like passing go and going straight from Kraft Foods to You?

Prof. Tom Eisenmann (09:56):

This can happen at any stage in a startup, but it’s particularly big risk at the later stages. So after you’ve scaled, to some extent, I’ll illustrate with a case that we use in the book to talk about this Help Wanted pattern it’s Dot and Bo. And it’s online retailing of home furnishings. So couches and lamps and chairs and things like that. And there’ve been some pretty spectacular disasters in that space. Wayfair is a public company worth billions that has never made a nickel of profit.

Dr. James Richardson (10:27):

I still don’t understand.

Prof. Tom Eisenmann (10:31):

Exactly. Don’t try. But fab.com is, was also in, they blew through 300 million and One Kings Lane was sold to bed bath and beyond for having been raised, hundreds of millions of dollars was sold for 30 million or less. So this company actually found a good demand generation formula where they could sustain customer growth. And I won’t get into the specifics.

Prof. Tom Eisenmann (10:53):

The founder and CEO was a TV guy and he’d learned TV storytelling. And he started, he turned the room into an episode and the furnishings were characters. And people related to that in weird ways, they basically, they wanted to keep all the characters together. You’re going to buy the chair and the lamp. And so they had big average order volume and good repurchase rates and so forth and really strange because this is the problem that the competitors all had was, they were paying a fortune for people who would order once and disappear forever. But this guy, it turns out it’s really hard to ship a couch from a warehouse in California to Kansas City, because it’s got to arrive on Tuesday morning when you took off from work, it’s not like your Amazon books. If they come two days early, you’re delighted. It can’t come early. It can’t come late and then you don’t want it to come damaged.

Prof. Tom Eisenmann (11:44):

And this is turns out to be remarkably hard to do, remarkably hard. Cause the thing also was made in Asia and you basically had to figure out is actually in the warehouse in California before you commit to fill the order. And this excellent demand generator could not get the operations under control. They bought the wrong ERP system. So they had no idea what was in inventory. They had no tracking of customer orders and ability to communicate with customers. And so his first solution was, well, let’s get a seasoned chief operating officer type. And he hired a generalist general manager who didn’t know is actually the person who did the wrong ERP system and couldn’t get the operations. So the backlogs are growing. Customer service queries are going unanswered. Round two is a dude from… Corporate guy from Netflix, Netflix now being a big corporation who in theory know something about shipping things.

Prof. Tom Eisenmann (12:38):

He shipped hundreds of millions of little red envelopes, but shipping a little red envelope is different than shipping a couch. So he gets some stuff under control, cause he’s an experienced operations guy, but manages to piss off the founders because he’s obviously doing corporate stuff, he’s sort of massaging the numbers. The things he’s supposed to be working on look great, but he’s ignoring all the other things, not thinking like an entrepreneur and owner. And so they fire him, even though he’s made some solid progress. And it took three tries basically before they found somebody who could get the operations under control. And the third guy did, but by then the company had burned through so much cash and the e-commerce markets slammed shut in 2015 and the company died. And so the point is, it’s not just big company employees and I’ll come back to that.

Prof. Tom Eisenmann (13:26):

But it’s often the case that the CEO founder, the entrepreneur will have experience in one function, but have no clue how to even evaluate a candidate. They don’t have a network rich with candidates. It’s not like I can just sort of go through my Rolodex and pick out the 17 people who will be good at this. And then even if you bring them in, I can’t tell a good one from another one. So the world is just scaling startups, rife with these hiring errors in these crucial functions. And boy, you haven’t screwed up for four months. It takes you four, six months to figure out that’s not working. And then another three or four months to fill the job. I mean, that’s a long time in the lifetime of a startup to sort of go nine months with the wrong person in the role or nobody in the role.

Prof. Tom Eisenmann (14:09):

So Help Wanted is: how do you avoid this? And so the big company dysfunction can happen at any point in the startup’s life. But the real problem is big company people are interrupt driven. Like the life of an executive in a big company is just full of dozens and dozens per hour of messages and meetings and so forth. In a startup, especially in early-stage startup, nothing happens unless you make it happen. Like the big company person will come and sit at his desk and like, okay, where’s my assistant? Who’s coming in with a to-do list for today. Like ain’t happening?

Dr. James Richardson (14:45):

I have a metaphor, they’re reactive. They’re not proactive. They’re like the worst management consultant associate ever. And now notice that my…. But notice that McKinsey, they get fired in like four months or less. Even if you got through the hiring process, if you appear on the job at McKinsey or being with that attitude. If you’re not crucified by your own colleagues, the partners will get rid of you. I just had this conversation, I have a theory that management consultants, I have seen management consultants consistently do better founding and operating early-stage companies than employees of General Mills, Coca-Cola, you name it with one exception. The people come from the big companies that they kind of worked at one startup and screwed it up. Sometimes they do figure it out, by number two and three, I’ve seen it.

Prof. Tom Eisenmann (15:42):

It rings very true. I’ll give you the one cautionary note, but it rings true. And it’s basically because I mean, you are under so much pressure. Having spent 13 years as a management consultant at mostly at McKinsey, but also at Booz Allen, that you get very oriented toward deliverables. At McKinsey, we called it end product orientation.

Dr. James Richardson (15:53):

[laughter] That’s very clear!

Prof. Tom Eisenmann (15:53):

And just right from the start of the engagement, you are thinking like: what do we need to deliver to the clients to make a happy client, solve the problem. And if you don’t have end product orientation, you’re right. You’re fired. So when you bring that same orientation, that’s what a startup needs. The complicating factor I would say is a lot of management consultants are how to say this politely, too smart for their own good.

Prof. Tom Eisenmann (16:29):

And they can see patterns and connections where mere mortals won’t see them. And they can actually, because they’re articulate, super smart and articulate. They can sell it to investors, to people that are trying to figure out whether to join as employees and so forth. You can, especially in a frothy capital market, like the bubble we seem to be in, you can get some very over-complicated business models that seem plausible. And people that come out of management consulting are particularly good at conceiving these things and pushing them forward. And sometimes they work. But-

Dr. James Richardson (17:05):

Yeah, I would say that’s a really insightful point, which is that the management consultant and the BigCo bureaucrat, do you have one thing that I tend to do those really bad habit and that’s over-think and I see this all the time. Well, I want to let you go. Thanks so much for your time. This has been great.

Prof. Tom Eisenmann (17:20):

Yeah, that was fun. A lot of fun.

Be safe out there.