Why Start-Ups Fail and What We Can Learn From Them

Start-ups face a lot of risk. But research suggests that 65% of start-ups fail because of one particular problem: people.

Motley Fool host Ricky Mulvey caught up with Martin Gonzalez, creator of Google’s Effective Founders Project, to discuss what public investors can learn from the people problems that plague start-ups (and any other organization).

They discuss:

• How to spot strong leaders.
• The downside of overconfidence.
• How company culture affects stock returns.

To catch full episodes of all The Motley Fool’s free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on May 12, 2024.

Martin Gonzalez: A lot of companies always struggle between winning the short game and winning the long game. To be clear, you need to win both games to be successful. If you don’t win the short game, you won’t be around to play the long game, and if you overoptimize for the short game, then you make decisions that aren’t good for the long term.

Mary Long: I’m Mary Long, and that’s Martin Gonzalez. He’s the creator of Google’s Effective Founders Project, a lecturer at Stanford, and author of the book The Bonfire Moment. Martin has built a career on studying start-ups and their founders. He researches what makes talented people tick, whether they’re CEOs or middle managers, and he’s got a whole lot of insight into how culture can build up or tear down any organization. On today’s show, Ricky Mulvey talks with Martin about what public investors can learn from a venture capitalist approach, why treating people like volunteers is a recipe for success, and what a computer character can teach us all about arguing well.

Ricky Mulvey: Martin, some of those listening prefer to take a venture capital approach to stock investing. These are folks you know pretty well where they’re essentially going for a slugging percentage versus an on-base percentage. If you’re playing that game, one of the things you write about start-ups in these smaller companies is that these venture capitalists are really picking the jockey, not the horse. They’re looking for leaders, team, culture, fit, that kind of thing, not necessarily the idea or business they’re going for. Can you explain that decision or that bias, if you will?

Martin Gonzalez: It stems from the belief that ideas are cheap and that execution is what matters, and that’s where the people, the cultural dynamic, the quality of the people really come into play. There’s a really classic study that really spurred me onto a lot of this work I do with start-ups that surveyed a bunch of venture capitalists. Think of the last companies in your portfolio that failed, and why did they fail? The study revealed that 65% of start-ups failed because of people issues. It was, by far, the most important thing. It wasn’t so much the idea or the timing, and that study gets replicated again more recently, and you find literally the same. Let me tell you what the stats were in the recent one, it’s 55% were because of the team and only 10% because of the business model, 9% because of timing, and somehow these factors of the business model, the timing, the product, these all tend to be, I guess, more salient factors when we make investment decisions. It’s just not the psychology of the VC.

Ricky Mulvey: It’s also changed over the last four years since the pandemic. The thing I can’t decide is if culture for a company isn’t for investors evaluating it, it becomes more or less important as many of these companies go remote and hybrid, and the employees become more, I would say, mercenaries to the business they’re working for.

Martin Gonzalez: It’s a good one. I think what a lot of companies struggled with when they went fully remote was the way you identify with your company, a lot of it has to do with the building you enter, the swag you wear, the colleagues you meet, and that builds your sense of identity, so I agree that it’s been quite a challenge. I think the one thing though is true, and the pandemic was accompanied by some economic crisis. One of the things that we write in our book, which is data we thought deeply about, is there’s a study that was done by a French economist who looked at, I think, four decades of stock returns and looked at companies that were known to have good culture, so these were companies in “the best companies to work for” list. They looked at what the monthly alpha was on each of these periods of time. They’ll separate that between the overall industry and these best companies to work for. The results were pretty nuanced. They said that the upside is very minor on good years. On good years, it’s very subtle that you’ll see an upside from good culture. The real upside is seen during these global crisis, so they looked at the dot-com crash, they looked at the global financial crisis, and in these two periods, they found 1.5% monthly alpha, which is quite significant. I’m quite convinced that these cultures become really important to take you through those tough times.

Ricky Mulvey: 1.5 per month ends up being quite a bit over a year. Martin, a little earlier you mentioned the overconfidence of some founders and how that might be an issue. As part of your writing, you researched Daniel Ek, who’s the CEO of Spotify. What did you learn from researching and writing about him?

Martin Gonzalez: Daniel Ek was such an interesting case study to study. He went through both these journeys of overconfidence and then found somehow a good equilibrium. When he first started, he tells the story of how he thought that he would just build a really cool product and then all these artists would then throw in their music into Spotify and did not realize that the licensing companies had to come into play, so what to him was like a two-month effort became a two-and-a-half-year effort. I think he learned a lot about overconfidence and hubris, but I think, over time, he builds up this really understated, very humble demeanor that meant he would lean on experts on his team. He would seek feedback. He would be happy to be wrong, and he didn’t need to let people know that he was the smartest person in the room, and chances are that he wasn’t all the time. There were times where he would be, and he just didn’t feel the need to let others know that, so I think, for that reason, he’s a really good role model for a lot of founders as they navigate the ups and downs of confidence.

Ricky Mulvey: I think that played out a little bit in the latest earnings call. Spotify had a significant pop on really good user growth, so revenue growth, and then even in the earnings call, Daniel Ek comes in and says, hey, investors, don’t expect this forever. Essentially inevitably, this can and will slow down. If you have a brash, overconfident CEO, I don’t think you would be hearing them say such things.

Martin Gonzalez: That reminds me of a really fascinating study by a collaborator of mine, Amir Goldberg from Stanford. He studies what he calls performative atypical premium. He looks at these CEOs who come into these revenue calls, who come in a very bombastic way or show off some really larger-than-life personalities. A lot of analysts will look at that and think, wow, this is exciting, it’s rebellious. What happened is that that increases investor expectations. Then when he controls for all these other factors, he finds that these performative CEOs actually create a negative earnings surprise at the end of it, so I think that’s a really good lesson in how investors need to read the behavior of CEOs in these calls, I think in many ways the overconfident CEO is something to really raise a flag. You need to really look at that with a lot of scrutiny and think, OK, well, what are the fundamentals here that are maybe not true based on what’s being said.

Ricky Mulvey: Your book looks at a lot of the traps of young companies. I think there’s one in particular that can affect public companies that we follow, which is the trap of speed. I know you focus on younger start-ups in this, but can you explain a little bit of what the trap of speed is and how we can identify it as investors that like looking for a lot of growth?

Martin Gonzalez: Yeah. In the book we talked about how a lot of companies are always struggle between winning the short game and winning the long game. To be clear, you need to win both games to be successful. If you don’t win the short game, you won’t be around to play the long game. If you overoptimize for the short game, then you make decisions that aren’t good for the long term. I think that the same applies to a lot of investors. I think when you see a lot of and VCs know this intuitively, you can actually make sure that your quarterly returns look abnormally positive and risk longer-term success. That’s something I always look out for when I look at companies, to what extent are they optimizing for Wall Street? To what extent are they optimizing for shareholder perception? I think that tends to be a very difficult path to go down because there’s very little you can do to cover things up in the long term.

Ricky Mulvey: Some of the research in your book I want to talk about is about how companies go public in the compositions of their teams. This came from the research from the Stanford project on emerging companies. It breaks down start-up types into autocratic, I know there’s a fourth one, but commitment and star. The two that really stand out are the commitment type start-ups, this rings alarm bells for me, but it’s the company saying, we’re like a family. We’re looking for those strong cultural fits. Then you have star start-ups, which we’re going to look for outstanding people and give them what they need in order to do their job. What the research found is that the stars start-ups, your talent-based start-ups are much less likely to go public than the commitment ones. But if the star start-ups go public, then the shareholders in those can expect much better returns. What do you think explains that phenomenon?

Martin Gonzalez: The study, which is quite a seminal study and it’s surprising to me that it doesn’t get more press or it didn’t get more press when it first came out. What it basically says is that star kind of blueprint companies who tend to hire for extremely talented people and give them the freedom to operate. They tend to go for bigger goals, like more ambitious, more difficult, impossible goals. As a result, they bear a lot more risk. The risk of them going public is so much higher. But when they do, because you have these powerhouses, this bedrock of really amazing talent, then they’re able to really grow far beyond their peers that might be more of a commitment-type model. Now on the other hand, the commitment-type model you optimize for fit. What’s interesting about that is the commitment model start-ups tended to have lower failure rates. A big part of what the study explains in that is, the lower failure rates are a result of people having somewhat more homogeneous ideas and homogeneous commitment that they can go in a single direction pretty single-mindedly and succeed in that single direction. But the moment they go public or they reach a point of growth where they need to expand into new markets or expand to new business units. That’s when the failing of this homogeneity kicks in where they’re not then able to break out into a whole new product areas, etc. The big caveat of that whole thing, which is something we caution a lot of leaders for is when you see a company trying to pivot quite significantly, and this is interesting about pivoting in general. I think start-ups in general think, it’s always good to pivot quickly and fail fast, etc. Well, other research is pointing to the fact that pivoting actually could be more damaging. In this case, when it comes to culture, when a company goes from commitment to star, for instance, because they somehow realized you need to hire differently, you actually have a bigger downside and the bigger risk of failure when they try to switch blueprints.

Ricky Mulvey: Many of the people listening may not be in a founder or even a leadership role at their company where they’re managing people. Through your work, through The Effective Founders Project, what have you learned about being a good teammate at work, being a good work partner for the people you see every day?

Martin Gonzalez: One of the things we talk about in the book actually is dealing with inner circles and how it’s the natural state of play that inner circles get formed in a company. Inner circles are sometimes formed around people with power, so people like your manager, the leader, but it could also be formed around personal power, people who are outspoken, people who maybe have specific kinds of expertise. The one thing that we’ve learned in terms of how you become a good team member is that great teams are actually teams with a lot of conflict. But the conflict crucially is about ideas and not about personalities. To the extent that you can, as a team member, find that way that you can debate and disagree. You actually help the team make better-quality decisions and execute a lot more effectively. I think it’s very common for people at lower parts of the organization to defer a little bit to the boss or anchor to what the expert in the group says and almost discount their own instinct. I think that discount rate that you apply to your own ideas and instincts oftentimes actually results in a worse-off team. I would say, trust your instincts, put your ideas out there, be more willing to disagree and debate because I think that just makes the work all the better.

Ricky Mulvey: It’s the type 2 disagreement.

Martin Gonzalez: That’s right.

Ricky Mulvey: You’ll explain it better than me.

Martin Gonzalez: I know. This comes from actually one of my favorite characters in computer history. This lab manager, Bob Taylor. Bob Taylor is a manager in Xerox PARC. For those of your listeners that don’t know, Xerox PARC is probably one of the most prolific places for innovation in the late ’70s and early ’80s. From there you got the personal computer that Apple then commercializes. Adobe comes out of there, PicsArt comes out of there. We have got all these technologies emerge from this place. He talks about how his job, his main job as a leader was to make sure that he graduated Class 1 disagreements to Class 2 disagreements. Class 1 disagreements are straw man arguments. They are Ricky, if you told me what your point of view is, I will represent it in the weakest way possible and then debate it, and that’s usually an easier way to do it. A Class 2 disagreement on the other hand is, let me represent to you, Ricky, back to you your point of view in the strongest way possible in a way that you feel satisfied. Then let me offer my opposing point of view. Bob Taylor says that his role is to ensure that every Class 1 disagreement it graduates to a Class 2 disagreement, and by the way, it’s not always his role to resolve any of these disagreements, but to make sure that they are all Class 2 disagreements. I think as a team member in your job, find a way to actually achieve those Class 2 disagreements, those become really useful.

Ricky Mulvey: I think if we didn’t have Class 1 disagreements, we would not have talk radio.

Martin Gonzalez: Fair enough.

Ricky Mulvey: It would be a problem. Let’s extend it. We’ve talked about inviting disagreement and being willing to disagree with others’ ideas as a team member. Maybe one or two traits that, middle managers, people in leadership roles at a company, but maybe they’re not a founder, can take from those highly successful founders that you’ve studied.

Martin Gonzalez: The No. 1 thing that we found at that data actually was this idea of treating people like volunteers. As a researcher, I wasn’t so thrilled to see this because I’m like, we don’t need another message around having a compelling vision and rallying people around it. But somehow this emerged to be the most critical predictor of success. Treating people like volunteers isn’t about, do you have a compelling vision? It’s really about, do you understand how your vision of the future will actually benefit the people who you’re asking help from? Can you actually talk about the benefits of following you on the premise of what your followers care about? For instance, one of the founders that I think has done this well was a founder based in Indonesia. I was then based in Google Singapore. He called me to the food court of the building to chat. He invited me to a chat mostly to talk about some of his cultural challenges. At the end he said, “Look Martin, you can stay on at Google and be a spectator of all this great innovation or you can come join me and be the Laszlo Bock of Asia.” And Laszlo Bock for those who don’t know, he’s basically the guy who builds the people operations team at Google. This founder knew what would potentially tug at my own heartstrings and my motivation. Obviously, I didn’t jump ship and I’m still very much at Google. But that’s what it means to treat people like volunteers, that people have options. Now, if you’re a leader, a manager in your team and you think that the paycheck that’s your team members receive is a good excuse to treat them poorly or treat them disrespectfully, will know that good people have options and that they can walk away. If you start with that premise, then I think you’ll behave and you’ll deal with them very differently.

Mary Long: As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don’t buy or sell stocks based solely on what you hear. I’m Mary Long, thanks for listening. We’ll see you tomorrow.