According to recent estimates, around 90% of start-ups fail. With the global start-up economy valued at $3 trillion, much is at stake.
Our research has focused on a crucial initial phase of new ventures, known as “the death valley curve,” when substantial work on a new enterprise has begun but no sufficient revenue has been generated. During this period, companies deplete their initial capital in their quest to establish the business.
How do successful companies navigate this tricky period? The steps entrepreneurs should take depend on the strategic situation in which they find themselves. We have identified four phases of the death valley curve and created a matrix on which entrepreneurs can place their business to identify the key challenges going forward.
Our matrix is based on two key challenges that all new ventures face: 1) Do they have the right business model? and 2) Do they have growth ambitions?
To determine whether they have the right business model, you should use the two business-model entrepreneurs tests suggested by Joan Magretta: the narrative test and the numbers test. An enterprise passes the narrative test when there is logic and alignment in the business model — in other words, when the story of the business model makes sense. The numerical test focuses on the financial performance of the business model and whether that business model can produce a profit. When turnover exceeds costs, the numerical test is passed.
So-called “growth ambitions” describe a new enterprise’s projected growth targets in terms of customers and financial performance. It is often these growth ambitions that attract investors to fund the costs in the beginning of the journey. Hence, they comprise an important dimension in the decision-making of new enterprises.
The Four Phases of New Enterprises
When we plot business model success and growth ambitions on a matrix, we can identify four phases of new enterprises: shape-ups, stand-ups, start-ups, and scale-ups. Each comes with strategic challenges.
These new enterprises have already reached their growth objectives but have failed to maintain a well-functioning business model. The reasons might include a logic that doesn’t make sense any longer as the market has changed (eg, Tamagotchi), outdated technology (eg, investing in personal digital assistants before smartphones emerged), value propositions that are challenged by competitors (eg, Uber challenging the taxi industry), or significant changes in customers’ demands (eg, trends toward non-smoking, veganism, or do-it-yourself). In the latter case, the problem is not that a offers something better, but that customers are disappearing from the existing market altogether.
All these situations have one thing in common: The business model has become irrelevant after significant growth, and the business is now in a declining market. Therefore, these new enterprises need to shape up to survive. Thus, shape-ups face the significant challenge of (re)inventing their business models, whether through innovation, business development, strategic re-positioning, or divestment. At the same time, these companies must restore investor trust as they are managing through a disappointment. Simply put, these enterprises need to reinvent their business models and themselves as entrepreneurs.
After firms have reached their envisioned size, entrepreneurs’ attention should shift toward stabilizing the business model and securing returns on investment. Stand-ups have momentarily left the valley of death, but that doesn’t mean that their troubles are over. They must do everything they can remain relevant among consumers, outperform competitors, and fight any complacency that might creep in. Put differently, all their effort must be applied thoughtfully to continue to stand up.
The challenges in this phase are to protect the business model and related investments. These aims can be achieved by forcing competitors out of the market, optimizing processes and earnings, or gradually developing the business model. Simply put, these enterprises need to protect their business models — both today and in the future.
These new ventures have an ambitious growth target, but have yet to find a well-functioning business model. Their defining elements are their search for a business model and their constant experimentation, often in the form of trial and error.
Start-ups may, for instance, shift focus from one customer segment to another, develop new products and services, or change their payment options from fixed to subscription to on-demand, and back again. They often also try different means of sales and marketing to find customers. Moreover, they develop new capabilities to support all of these mentioned changes.
In short, in a start-up, nothing is fixed and everything is in flux in the quest to find a profitable — and sustainable — business model.
Of course, the search for an excellent business model is not free of charge. However, as everything is small in scale, total investments are typically low. The strategies applied typically include “fail-fast,” “trial-and-error,” “co-creation,” and “crowd-funding” — some of the most popular start-up principles. Simply put, the strategic challenge for start-ups is to find the right business model.
After a start-up has created a suitable business model, it may choose to scale up in volume, usually following one of two paths. First, scale can come from onboarding an increasing number of customers. In this case, the business model already encompasses the necessary capabilities and value propositions — the focus is on obtaining as many customers as quickly as possible. This is typical for digital, platform-based business models. Second, scale can come from replication of the original business model, as seen in franchise systems. Think of a restaurant chain: Apart from back-office functions (such as supply chain, human resources, and IT), identical copies of the business model are established. Scale in customers therefore necessitates scale in resources and capabilities.
For scale-ups, the challenges entail quickly onboarding customers and finding the resources needed to enlarge the business model’s volume so that capabilities grow in line with the number of customers. Simply put, scale-ups need to fund expansion and limit innovation in their quest to live up to the projected growth expectations.
Companies can fall in each of the four phases, but do not have to go through all phases. Consider Amazon, which went rather abruptly from start-up to scale-up. Jeff Bezos found a business model adequate for the advent of the internet, founded a company with a vision of becoming “the earth’s biggest bookstore” from the beginning, and focused relentlessly on long-term growth at the expense of short-term profits.
Yet, sometimes companies do actually go through all phases at different points of time. Consider the trajectory of Facebook. Initially, they were a start-up that had to find a business model. Then Facebook evolved into a scale-up, seeking to obtain growth by scaling their model. When they went public, they essentially turned into a stand-up trying to secure their model. But with the longstanding criticism of their business model and data usage, they may now have fall into the shape-up phase, where they need to reinvent their existing business model and essentially be entrepreneurial again.
Lessons for Entrepreneurs
Our work suggests that there are three key lessons for entrepreneurs:
- Know which phase you’re in. First, entrepreneurs need to diagnose which phase they’re in. If you don’t know where you are, you don’t know how to get moving.
- Make the decisions required by your phase. All phases come with their own challenges, and should focus on the important ones entrepreneurs related to their current phase. For example, radical innovation and business development are necessary for start-ups and shape-ups — and problematic for scale-ups and stand-ups. Delivering returns on investments are important for stand-ups, but not yet an issue for start-ups and scale-ups, as they focus on selling their dreams and projections to investors.
- Secure an alignment between stakeholders. It’s critical that all stakeholders share the same understanding of the phase and related challenges of the new enterprise. If the founder has the understanding that the business is in a stand-up phase, while investors believe it’s in a scale-up phase, that will lead to severe conflict that will damage the opportunities of survival of the new venture.
The bottom line is that it’s important to honestly assess the organization’s situation and to craft a corresponding strategy. A failure to understand the situation may result in a significant loss of investor trust and investments. The road out of the valley of death is paved with situational awareness and transparent communication — one phase at a time.