Default Alive or Default Dead?

October 2015

When I talk to a startup that's been operating for more than 8 or 9 months, the first thing I want to know is almost always the same. Assuming their expenses remain constant and their revenue growth is what it has been over the last several months, do they make it to profitability on the money they have left? Or to put it more dramatically, by default do they live or die?

The startling thing is how often the founders themselves don't know. Half the founders I talk to don't know whether they're default alive or default dead.

If you're among that number, Trevor Blackwell has made a handy calculator you can use to find out.

The reason I want to know first whether a startup is default alive or default dead is that the rest of the conversation depends on the answer. If the company is default alive, we can talk about ambitious new things they could do. If it's default dead, we probably need to talk about how to save it. We know the current trajectory ends badly. How can they get off that trajectory?

Why do so few founders know whether they're default alive or default dead? Mainly, I think, because they're not used to asking that. It's not a question that makes sense to ask early on, any more than it makes sense to ask a 3 year old how he plans to support himself. But as the company grows older, the question switches from meaningless to critical. That kind of switch often takes people by surprise.

I propose the following solution: instead of starting to ask too late whether you're default alive or default dead, start asking too early. It's hard to say precisely when the question switches polarity. But it's probably not that dangerous to start worrying too early that you're default dead, whereas it's very dangerous to start worrying too late.

The reason is a phenomenon I wrote about earlier: the fatal pinch. The fatal pinch is default dead + slow growth + not enough time to fix it. And the way founders end up in it is by not realizing that's where they're headed.

There is another reason founders don't ask themselves whether they're default alive or default dead: they assume it will be easy to raise more money. But that assumption is often false, and worse still, the more you depend on it, the falser it becomes.

Maybe it will help to separate facts from hopes. Instead of thinking of the future with vague optimism, explicitly separate the components. Say "We're default dead, but we're counting on investors to save us." Maybe as you say that, it will set off the same alarms in your head that it does in mine. And if you set off the alarms sufficiently early, you may be able to avoid the fatal pinch.

It would be safe to be default dead if you could count on investors saving you. As a rule their interest is a function of growth. If you have steep revenue growth, say over 5x a year, you can start to count on investors being interested even if you're not profitable. [1] But investors are so fickle that you can never do more than start to count on them. Sometimes something about your business will spook investors even if your growth is great. So no matter how good your growth is, you can never safely treat fundraising as more than a plan A. You should always have a plan B as well: you should know (as in write down) precisely what you'll need to do to survive if you can't raise more money, and precisely when you'll have to switch to plan B if plan A isn't working.

In any case, growing fast versus operating cheaply is far from the sharp dichotomy many founders assume it to be. In practice there is surprisingly little connection between how much a startup spends and how fast it grows. When a startup grows fast, it's usually because the product hits a nerve, in the sense of hitting some big need straight on. When a startup spends a lot, it's usually because the product is expensive to develop or sell, or simply because they're wasteful.

If you're paying attention, you'll be asking at this point not just how to avoid the fatal pinch, but how to avoid being default dead. That one is easy: don't hire too fast. Hiring too fast is by far the biggest killer of startups that raise money. [2]

Founders tell themselves they need to hire in order to grow. But most err on the side of overestimating this need rather than underestimating it. Why? Partly because there's so much work to do. Naive founders think that if they can just hire enough people, it will all get done. Partly because successful startups have lots of employees, so it seems like that's what one does in order to be successful. In fact the large staffs of successful startups are probably more the effect of growth than the cause. And partly because when founders have slow growth they don't want to face what is usually the real reason: the product is not appealing enough.

Plus founders who've just raised money are often encouraged to overhire by the VCs who funded them. Kill-or-cure strategies are optimal for VCs because they're protected by the portfolio effect. VCs want to blow you up, in one sense of the phrase or the other. But as a founder your incentives are different. You want above all to survive. [3]

Here's a common way startups die. They make something moderately appealing and have decent initial growth. They raise their first round fairly easily, because the founders seem smart and the idea sounds plausible. But because the product is only moderately appealing, growth is ok but not great. The founders convince themselves that hiring a bunch of people is the way to boost growth. Their investors agree. But (because the product is only moderately appealing) the growth never comes. Now they're rapidly running out of runway. They hope further investment will save them. But because they have high expenses and slow growth, they're now unappealing to investors. They're unable to raise more, and the company dies.

What the company should have done is address the fundamental problem: that the product is only moderately appealing. Hiring people is rarely the way to fix that. More often than not it makes it harder. At this early stage, the product needs to evolve more than to be "built out," and that's usually easier with fewer people. [4]

Asking whether you're default alive or default dead may save you from this. Maybe the alarm bells it sets off will counteract the forces that push you to overhire. Instead you'll be compelled to seek growth in other ways. For example, by doing things that don't scale, or by redesigning the product in the way only founders can. And for many if not most startups, these paths to growth will be the ones that actually work.

Airbnb waited 4 months after raising money at the end of Y Combinator before they hired their first employee. In the meantime the founders were terribly overworked. But they were overworked evolving Airbnb into the astonishingly successful organism it is now.

Notes

[1] Steep usage growth will also interest investors. Revenue will ultimately be a constant multiple of usage, so x% usage growth predicts x% revenue growth. But in practice investors discount merely predicted revenue, so if you're measuring usage you need a higher growth rate to impress investors.

[2] Startups that don't raise money are saved from hiring too fast because they can't afford to. But that doesn't mean you should avoid raising money in order to avoid this problem, any more than that total abstinence is the only way to avoid becoming an alcoholic.

[3] I would not be surprised if VCs' tendency to push founders to overhire is not even in their own interest. They don't know how many of the companies that get killed by overspending might have done well if they'd survived. My guess is a significant number.

[4] After reading a draft, Sam Altman wrote: