S6 E10 Advice from business’s best thought leaders made easy to understand and practical to implement - Jeremy Gray
Season 6 Show 10
Advice from business’s best thought leaders made easy to understand and practical to implement
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Show 10 Season 6
Continuing our case study approach today we are going to look at another business that had phenomenal success. Indeed, it achieved Unicorn status in June 2013, in just over two years from its founding, only to collapse and by mid 2014 it was for all intents and purposes out of business. The company was a victim of the speed trap.
Let’s go back to 2011. Jason Goldberg and his partner Bradford Shellhammer raised $3 Million and decided to pivot their business, with the support of their investors, to a flash sale site called Fab.com. A three-month viral marketing campaign using the offer “Convince 10 friends to join to get $30 credit” resulted in the site attracting 165,000 members before it opened in June.
Fab offered deep discounts on carefully selected products, chosen for their aesthetic appeal and quality. Customers were attracted to unique products that conveyed a quirky attitude such as a chandelier made of martini glasses. Fab had instant success, selling $600,000 of merchandise in the first 12 days. As manufacturers drop-shipped items directly to customers Fad did not need to hold inventory. This simplified the company’s logistics. Last week we looked at Dot & Bo whose multiple supply methods were a major cause of their downfall.
The offers were so attractive that they went viral on social networks that Fab.com did not need to spend money on advertising. The result? The business had positive cash flow. By the end of 2011 the start up had over one million members and had raised another $48 million in venture capital.
To expand further Fab secured another $120 million in funding in 2012. Sales reached $115 million. However, cracks in the business were beginning to appear. Despite the $115 Million in sales the business lost $90 Million. To supercharge growth Fab had to invest in marketing, $40 million worth of marketing. Unfortunately, the customers attracted through the ads were less focused on design than the early customers. These customers were much less likely to buy multiple times or recommend the site to friends. When on-line marketing began to falter, Fab turned to TV and direct marketing which are expensive. Although Professor Eisenmann’s book does not mention it, I suspect that the Life Time Value of the incremental customers was lower than the Customer Acquisition Cost. IE the LTV/CAC was less than one.
Adding to the cash drain Fab was expanding rapidly in Europe. Their business model was quickly cloned by several companies, including Bamarang founded by the highly controversial Samwer brothers. The Samwar brothers were infamous for successfully copying successful US ventures such as Pinterest, Airbnb, eBay and then demanding that the US company acquire the cloned business to avoid trench warfare.
Jason Goldberg said of the Samwar brothers that they had cloned Fab almost literally pixel by pixel. But he figured that since Fab had designers all over the world that it was a credible entrant overseas and Jason was not going to cede Europe to the Samwar brothers. The move abroad was strongly supported by Fab’s board.
To accelerate its move into Europe Fab acquired three overseas flash sale startups, committed $12 million for a ten year warehouse lease and staffed a European HQ in Berlin with 150 employees. By August 2012 Fab had 1.4 million members in Europe which was generating 20% of the company’s sales. Later that year Bamarang was shut down and Fab achieved victory in their fight with Bamarang. But at a huge cost, the European operations were hemorrhaging cash.
April 2013 and Jason Goldberg was worrying that flash sales would lose steam. He would pivot away from that model and become an e-commerce site. Mr. Goldberg believed that daily deals were a good way of drawing people in at the start, but every time you send another daily email you burn them out a little.
At that time only a third of Fab’s sales were coming from daily deals. The balance came for the eleven thousand products listed on the site. Fab redesigned their site to make it easier for their 12 million members to find the items they wanted. As drop-shipping had generated customer complaints about slow delivery times, Fab shifted to holding more inventory in its own warehouses and shipping from there. To complete the transition Fab increased its efforts to design and sell Fab branded items which commanded higher margins. As part of this expansion Fab acquired a German company that design and sold customized wooden furniture for $25 million in stock.
Meanwhile a crowd of new companies were entering the market, competition for products increased costs as the companies outbid each other to gain supply. Then Amazon entered the game, as competition became intense. Goldberg recalls that at the start it took Amazon thirty to forty days to copy Fab’s flash sale products. By 2013 Amazon was able to do this in 24 hours. They called Fab’s designers and said, “hey we would like to feature you” It was hard for Fab to match Amazon’s offer. Amazon was offering the same product, from the same designer at the same or lower price with free and faster shipping.
The new business model was capital intensive, holding inventory means a company runs the risk of buying the wrong stuff. Fab saw that in the 2012 holiday season. They felt they were great at picking winning products but that holiday season they failed to sell a lot of products. They were beginning to lose their edge.
In April 2013 Fab’s board met to consider their options. Plan A was to retrench, focus only on the US market with the aim of generating positive cash flow from the $150 Million in sales. Plan B was to continue pushing for 100 percent year on year growth. The overwhelming majority of the board voted for plan B.
In June 2013 Fab raised $165 million in new capital with a post money valuation of $1 billion. The company had achieved Unicorn status. But Jason Goldberg knew this was not enough. Fab needed $300 million to pursue their plan and to support the investments already committed. Mr. Goldberg says of this time: I fielded phone calls congratulating me on achieving Unicorn status and being sick to my stomach. “Not many people know what it’s like to raise $165 million at a $1 billion valuation, fully aware you are sailing into disaster”
Fab’s cash burn rate hit $14million per month. To regain control Goldberg hit the brakes hard. Fab laid of 80% of its US based staff, terminated most of its top managers, and narrowed its product selection. The European ventures shut down everything except its profitable custom furniture business. This business was spun off as a separate company called Hem which was later sold to a Swiss design company for a reported $20 Million. Fab’s US assets were sold in an all-stock transaction to customer design company for around $30 million.
Rapid Rise and Rapid Fall. By expanding at an unsustainable pace Fab ran into a speed trap from which it could not recover. Here is how the speed trap evolves.
1) The entrepreneur spots an unmet need and develops a solution. In the case of Fab their daily deals met the needs of shoppers who shared their sense of design and were looking for distinctive products.
2) Early growth is strong, driven by word of mouth by early adopters. Growth can be fueled by the network effect, the service becomes more valuable the more people who use it. There was some network effect with Fab as a result of their sign up campaign. Attract 10 members to get a $30 coupon. Remember that helped to secure $600,000 of sales in the first 12 days.
3) The business attracts enthusiastic investors willing to pay a high price to get a stake in a business that seems to have the potential for rapid expansion.
4) Success attracts competitors. In the case of Fab, their business model was cloned by others particularly in markets outside their US base. And then of course Amazon got into the game.
5) The market becomes saturated. The customers that most closely fit the venture's value proposition are signed up. To grow the business must attract the next wave of customers. This costs money in the form of advertising and promotional offers. The Cost to Acquire Customers CAC is increasing while their lifetime value is decreasing. These latest customers are not as aligned with the company's values. They are less loyal and less likely to make repeat purchases.
6) Lack of staff. Rapid growth requires rapid hiring. Finding the right people becomes challenging, and training them is even more challenging. Capable workers are in short supply, mistakes will be made, the company becomes less responsive to customer needs. Corners get cut, this can be insidious, leading to lower standards. To be fair to Fab they seem to have avoided the worst mistakes in this area.
7) The business adds more structure and complexity. As the business grows it needs to add senior managers with relevant experience. Information systems need to be able to keep up with the growth. The temptation to fix problems by bringing activities in house can create difficulties. Fab set up its own warehouses and started manufacturing their own furniture lines. This added a whole new level of complexity to the business
8) Silos begin to form. These can be functional silos, sales versus marketing. Sales complains about the quality of leads that marketing is generating, while marketing complains about poor follow up by sales. The silos can also be based on attitude. The early employees may resent the ”it's just a job” attitude of the later employees. Specialists hired for their skills can get frustrated that early team members do not appreciate their contribution. Goldberg admits that Fab suffered from this problem. He says ”I allowed silos of teams and thinking, and that seeded an awful cancerous distrust.” I think avoiding silo thinking and keeping the company pulling in the same direction is one of the greatest challenges a founder entrepreneur faces. There is intense pressure to hit the numbers and when numbers are missed, as will inevitably happen at times it is easy to point fingers and blame someone else. Of course. this does not help solve the problem. Remember, be hard on the problem, soft on the people.
9) And now we are approaching the end game. The investors get alarmed, and employees begin to leave. As a company burns through its cash, stock prices decline. Employees who had been hoping for a big payday see their stock options become worthless and seek greener pastures. Investors become reluctant to commit more capital. As the risks become greater any investor who is willing to inject more funds will ask for a huge number of new equity shares diluting the equity stakes of the founders and senior managers.
10) By now it is clear that the company cannot sustain its growth and needs to slow down. The question is how hard do you apply the brakes? What degree of retrenchment is required? Can the company be sold to a corporation with deep pockets that sees a strategic fit?
Recall that in June 2013 Fab raised $165 million with $1 billion post money valuation. At that point Goldberg knew he did not have enough money to sustain the company. He had identified that Fab needed $300 million. But it was not until four months later that Goldberg hit the brakes. If he had acted faster could he have saved the company? Maybe, maybe not, but once the writing is on the wall it is time to take action.
All the companies we have looked at in this short series on why startups fail have all had to face the decision on whether to close down or continue to battle on. This is an incredibly hard decision to make, it is full of emotion, the founders identity is closely aligned with the venture he or she founded. In the case of Fab, Goldberg not only had his personal stake in the company, there were hundreds of employees who had made a commitment to Fab who would be personally impacted. So maybe it took the four months from failing to raise enough funds to reach the conclusion that things had to change and change dramatically.
So how should entrepreneurs react when facing the end game for their business.
A difficult decision is how transparent should you be with your employees about the situation you are facing? Rand Fishkin, founder of Moz, a start up that provides search engine optimization software expressed regret about not being open with his staff before a big reduction in headcount. Moz had expanded its product line to provide a full suite of tools for digital marketing. To stem the cash outflow after these products stalled Moz laid off 59 of its 210 employees. Rand Fishkin recalls “There were tears and anger, nasty writeups about the company on blogs, lost friendships, lost trust and lost reputation. Worst of all this news came as complete surprise to most of our team”
Mr. Fishkin says that when Moz decided to expand into multiple products knowing that they might have to lay off a substantial portion of the team they should have said so upfront.
Again there is a balance, most employees of startups know they are risking security of employment for the potential opportunity to be part of something bigger. If you want security of employment, go work for your government. Entrepreneurs have to be positive about their company, and it is not too likely that Mr. Fishkin expected his product line expansion to fail. So I am not sure how he could have communicated upfront. However once he saw the warning signs he could have began communications.
The next question an entrepreneur will face is how deeply to cut. Conventional wisdom is that a CEO should cut deeply enough to avoid the need for a second round of layoffs. A second round will create a deep sense of insecurity in the remaining employees. Employees who the company would have liked to keep will begin to depart as they lose trust in the management or confidence that the venture will survive.
Fab’s Jason Goldberg on the other hand regrets imposing massive layoffs in Europe and reducing the US team from four hundred to eighty five employees. He criticizes himself for being too quick to focus on slashing costs and narrowing scope versus taking a step back and devising a plan that could preserve value for the shareholders.
He puts it this way everyone says ”cut fast and cut deep” But is should be “cut smart, cut with a plan, and cut with help”
Who should you cut? To my mind there is no hard and fast rule for this decision. Certainly what used to be the basic guideline of last in first out is no way to do this. Nor should the cost of an individual be a guiding criterion. Terminate your poorest performing employees and retain your most talented employees. Focus on the person not the role. If you are cutting back your marketing efforts and within your marketing team you have a talented employee who has skills that can be used elsewhere, redeploy them to a role where they can continue to contribute.
You may be able to persuade some employees to take a pay cut, or defer some of their salary until the business is back on track. Thus be able to reduce the number of people who have to go. But be sure you check the law in your jurisdiction. You may be personally liable for unpaid deferred salaries.
If none of the above work, the entrepreneur faces the difficult question – is it time to shut down? Or does your venture have enough potential to warrant more effort?
This might be a very difficult decision to make on your own. Many founders lack a sounding board. You are the confident face of your company, when asked how things are going, you will accentuate the positive and downplay the negative. One consequence of this is that maybe no one else is sufficiently informed to provide the founder good advice on this very difficult decision, Close Down? Or Soldier On.
At this stage you have nothing to lose by opening up to people. Your situation is not unique, 90% of startups fail. Most people are willing to help. If you have investors talk to them, your senior employees, take them into your confidence. Maybe consider consulting with someone totally independent from your company. I can recall a case of a business based in Shanghai that had got into trouble. The owner called in someone to help with no prior knowledge of the company. Pretty quickly between the two of them they were able to chart away out of the problem.
Take a look at history, again without apportioning blame, review how you got to this unfortunate state of affairs. This might enable you to identify what you might call your minimum viable company. Can you put your company on life support that will allow it to survive until times get better?
Consider whether you want to shut down gracefully. A graceful shutdown is one where you pay off your suppliers, meet your customer commitments, pay your employees in full, with maybe a little severance and your investors get some of their money back. To achieve this, you need to have a good understanding of your company’s commitments and your cash burn rate. A graceful shut down will enhance your reputation within the business community especially if you are hoping to launch again in the same market sector.
An advantage of planning the graceful exit is that it does give you a deadline to determine if you can continue. Have you exhausted all options for raising funds, selling your business as a going concern, pivoting to a new model, trimming back to the minimum viable company. Continuing on beyond this point might make you liable for trading while insolvent where, as a director you may become liable for your company’s debts. In Singapore this is called Wrongful Trading.
No one wants to see their company fail. Hopefully by learning lessons from some companies that did not succeed you can avoid this fate for your startup.
Keep in mind that changes made earlier in your startup’s development are more likely to be successful. Pivots are easier while you are smaller. PayPal started as a way to beam funds between Palm Pilots. Seeing that this market was too narrow, they introduced fund transfer by email. Fortuitously for them just as e-bay was taking off. YouTube started as a service to allow on-line daters to upload videos of themselves.
Keep a strong eye on cash. All the businesses we have looked at over the last few programs shut down when they ran out of cash. Too rapid expansion was a problem for most of them. People and systems are where their expansion plans generally fell apart.
Learning from the lessons from others is a great way to understand the pitfalls of entrepreneurship.
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