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Diversification in Failure

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A framework for failing well

Nobody wants to fail. Whether baking a caking or building the next unicorn (not unicorpse!), success is always the objective. But the question of what to do when all hope of success is lost is much trickier.

Fail with grace

When failure comes, we all want to fail gracefully, to at least succeed at failing, with the hope it will better prepare us to succeed next time. However, actually accomplishing this feat requires trade-offs between stakeholders. If there was a way to please everybody, the point of failure probably hasn’t yet been reached. And managing those trade-offs seems to be the real challenge an entrepreneur faces when attempting to fail with grace.

Most good for the most people

While it’s unlikely one framework applies to all situations, I would like to posit one I think might be pretty applicable. First, I should probably define what a successful outcome looks like for a failed company. Here I will think of success in a broadly utilitarian manner: the most good for most people. That is to say the more people feel positive, or at least not overly wronged by the failure, the better the failure, and so the highest likelihood the founders’ reputation will persevere. Second, I should define a limited, not exhaustive, list of stakeholders to consider. Here I’ll be considering (in no particular order) of investors, customers, suppliers, employees and the founders’ themselves (and their families).

Diverse diversification

That said, the framework I’ve been considering over the past few weeks is to look at your various stakeholders’ diversification, both in the strict asset portfolio sense, and more broadly. Under this framework it’s quick to see how certain groups will shake out. Investors are likely to be the most diversified, with your start-up only comprising a small percentage of a larger portfolio where high failure rates are assumed and modeled out. On the other side, employees are likely to be highly concentrated, with the salary and stock options a much more significant component of wealth and security (and unlike founders may not see the end coming).

This model allows a reasonable amount of flexibility for other stakeholders. While you may expect a start-up not to be a major customer of another company (or vice versa) there are situations where your failure risks that of another company. First time founders are probably less diversified and able to bear the financial burden of failure than entrepreneurs with previous success.

While no one wants to fail, given that most start-ups do, it’s paramount to prepare for the worst. Hopefully this framework gives at least some food for thought!

2 thoughts on “Diversification in Failure

  1. Thanks for this post, Ben!

    I love this utilitarian framework you offer us. The best part is that if you buy into the general thesis, this will also guide your actions in the reverse case — where your investors are friends and family with a ‘portfolio of 1’ whom you bummed for seed money and your employees have easily transferrable skills and the type of risk tolerance that led them to work at a startup in the first place.

    Where I struggle is in the repeat case. As much as I wish it were otherwise, it seems that founders who treat their employees particularly well, but perhaps don’t consider their (well-diversified) investors as the top priority when closing up shop, are less likely to get repeat investors. What do you think about that case?

    1. Yeah, I actually did think about the situation you described, and I personally think this still applies. I think that, based on what we’ve seen, a professional VC should respect the way you’ve shut the company down (as long as treating employees well doesn’t mean draining cash balances for free bonuses) and be willing to invest in you again. Like we’ve seen in class, VCs aren’t interested in making back 50% of their investment. Theoretically that 50% pay back will be a marginal fraction of the big wins they’re getting from successful investments.

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