Five Reasons Why Startups Fail

No one likes to talk about it, but the odds of success for startups are pretty slim. In order to move the needle in your favor, you first need to understand where the potential minefields are. Avoid these five startup killers, or do your best to have controls in place to mitigate them.

1. Poor co-founder fit

This can be hard to accept, but founders are the greatest threats to their startups. Why? Because disagreements between founders can lead to premature departures.

Be smart when it comes to your co-founder search. Look for someone who is committed. Similar to dating, the right match is all about alignment on values, compatible approaches to the relationship’s and business’ ups and downs, and having a back-up plan to rely on in case things don’t work out.

Have a contingency plan for what you will do if a co-founder decides to or is asked to leave. A good way to do this is by putting a Founders’ Agreement in place. Talking through and agreeing on the main points is an important way to raise issues and set common expectations for:

  • Roles and responsibilities
  • Sharing equity
  • Cash contributions
  • Time commitment
  • What to do if one of you leaves
  • Don’t forget to include a vesting plan. Four year vesting with a one year cliff is pretty standard.

2. Not safeguarding your intellectual property

Make sure you know who owns the company IP. This might seem obvious, but plenty of founders have been surprised to learn that what they thought was “their” IP was actually owned by their software developer, an academic institution one of the co-founders graduated from, or the company the founders worked at previously.

To be clear: if you have not legally assigned intellectual property rights to your company, you don’t own the IP even if your co-founder developed it while working on your business. Read the fine print and make sure you have all IP assigned to the business through a Confidential Information and Invention Assignment Agreement.

Let me give you a piece of advice on NDAs: never ask VCs to sign them. Do use NDAs and confidentiality agreements with strategic hires. But just having someone sign an NDA does not mean you can rest easy. NDAs are difficult to enforce in court. So be careful what you disclose.

Patents are the gold standard for Protecting IP. But that protection does not come cheap. Expect to pay $20,000-$30,000 for one. But you can file a provisional application that gets your technology on file for a fraction of the cost. Later, once you have more cash on hand, you can upgrade to a full filing.

3. Failing to comply with accounting and tax requirements

You can seriously damage your chances of getting funded and put yourself at risk for heavy fines and enforcement investigations, if you don’t stay on top of your accounting and tax obligations. Here are some pointers:

  • Open a business banking account and never commingle the funds with those in your personal accounts.
  • Separate business and personal expenses  — This is non-negotiable. For one thing, it is key to keeping good records both for income tax purposes and for tracking your business’ financial history.
  • Keep records of all your receipts and invoices — Expensify is a good, inexpensive system.
  • Understand your tax obligations — Even if you’re not profitable and won’t owe taxes, you still have filing requirements at the federal, state, and sometimes municipal levels. California has a mandatory filing requirement in order for businesses to be “in good standing.” Investors require a certificate showing that your business is “in good standing” as part of their due diligence process.
  • You are responsible for payroll tax and other obligations. Pay attention to how you categorize employees versus independent contractor. The fines for getting this wrong can be substantial. Many states aggressively pursue scofflaws for payment of back payroll taxes and you could also face legal action from an aggrieved former worker.
  • Maintain accurate stock records — The last thing you want is to get into due diligence with a potential investor or acquirer and then have things fall apart because you can’t produce a coherent record of your equity ownership.

4. Making the wrong choice of legal entity

You can always change your business entity down the road, but it will cost you. There are multiple options, each with its pros and cons, but if you expect to raise equity, you will need to be a Delaware C-Corp. In addition, you have to register as a “foreign corporation” in whichever state or states you do business in.

5. Not playing by the rules when issuing securities

Issuing restricted stock is your best option (founder preferred shares are sometimes issued). As the name suggests, restricted stock vests over a multi-year period. You must file an 83B election with the IRS within 30 days after the stock issuance to avoid being hit with a tax liability as your stock vests.

If you issue debt (convertible notes are very common in seed rounds), you’ll need to file securities registrations with the SEC.

You should raise cash only from accredited investors. But if you do call on friends and family, make sure they fully understand the risks of investing in your startup. You should also think through the potential damage to your relationship if you are unable to return the funds.

The world of startups is full of risks and rewards. There are no guarantees whether your new venture will succeed, but hopefully understanding these five startup killers will help you mitigate the risks and improve your odds to be a successful entrepreneur.

Guest blogger David Ehrenberg is the founder and CEO of Early Growth Financial Services, an outsourced financial services firm that provides early-stage companies with accounting, finance, tax, valuation, and corporate governance services and support. He’s a financial expert and startup mentor, whose passion is helping businesses focus on what they do best. Follow David @EarlyGrowthFS. This post is a summary of the “Startup Killers” webinar given by Kevin Smith, CEO of SEEDCHANGE, and Glenn McCrae, Chief Strategy Officer for Early Growth. The two shared insights into some of the biggest threats startups face and how to avoid or mitigate them.