What Is The Main Reason Most Startups Fail?

What Is The Main Reason Most Startups Fail? | Risk Free Rate

What Is The Main Reason Most Startups Fail?

There are many reasons why a startup will fail. But at the very top of the list is the main reason why almost all startups fail: money.

What Is The Main Reason Most Startups Fail?Company Has No Money

What Is The Main Reason Most Startups Fail, A startup needs a ton of money just to get off the ground.

Most startups that get this far fail. Not because the idea is bad, but because the company has no money to get through the idea stage.

For a new company, the first year is crucial. If the company misses even 1 major payment on its ~$50 million in debt, the company is in big trouble.

And if the company misses 2 or 3 payments, it is really in trouble. That’s why new companies normally skip year 1 and go straight to year 2.

Not An Ideal Strategy – What Is The Main Reason Most Startups Fail?

I know that this is not an ideal strategy, but it works most of the time.

What Is The Main Reason Most Startups Fail, Why is it that the moment you start missing a payment, the company is in trouble? Because the minute you miss a payment, you have less cash on hand to make the other ~30 payments needed to service the debt. And if the company misses so much debt, it goes out of business.

Skip Year 1

This is why few companies can skip year 1 and go straight to year 2. Most companies are simply not structured right.

Now, for a company with cash, it can fund the idea to skip year 1. How much cash it needs, we don’t know. But we know that the moment a company misses a payment, its equity is reduced.

Equity Is Reduced

The reason that equity is reduced, is because the company may have a lot of goodwill leaving it with less cash on hand to fund the skipped year 1.

In other words, if a company misses the first payment on a $50 million credit line, it must have a lot of goodwill or equity left to fund the skipped year 1. If it does not, it cannot fund that skip year 1. The company is in trouble.

Now for a company with equity, we know that its equity may be reduced by the amount of the missed payment. If it is, and it is willing to pay $50 million for the skipped year 1, the amount of equity is still $15 million.

Now what?

The company can still use that $15 million equity to buy back its $50 million debt or continue financing the company with debt. It has a way to go, but it is not yet at risk. If it is, then equity must be on the line.

What Is The Main Reason Most Startups Fail?

 

Let’s say, the company missed the first payment on its credit line, but it paid a lot more than the market will accept, or the debt market will accept for the skip year 1. Equity does not go down. But the skipped year 1 equity may drop 20% to 30%. So, what? It is not at risk.

Equity Will Be Sold

It is at risk if the skipped year 1 equity drops more than 50% to 60% of the skipped year 1. That means that half of the skipped year 1 equity will be sold. That means a big haircut for a company. A 50% haircut, would mean the skipped year 1 equity drops 75%.

But the skipped year 1 equity does not drop 60% or more of the skipped year 1 equity. In other words, the company is still not at risk.

Risk-Free Rate

In the world of risk, the goal must be for the equity to rise above the risk-free rate. When the equity does not rise above the risk-free rate, the equity is not at risk.

Equity is not at risk when the stock market is trading at a high or a low.

Model Captures Equity Risk

I am using a simple model here. But, it is clear that the model captures equity risk. The model is a risk model. If the company is going to miss payments, then the skipped year 1 equity must be lower than the risk-free rate.

To understand the risk model, you must understand that the skipped year 1 equity is a credit risk. A credit risk happens when you are not at risk.

That means the skipped year 1 equity has a higher value than the risk-free rate. But not all equities have risk-free rates equal. If the equity has a lower value than the risk-free rate, the equity is a risk.

The stock market rises at a risk-free rate. If the equity misses the risk-free rate, then the equity is a risk.

Two Models Look Similar

What Is The Main Reason Most Startups Fail, To understand the equity risk model, you must understand that the equity risk is the sum of the equity risk for each year. The two models look similar. But, the equity risk is bigger for more years.

The formula is not simple. But, it is simple for you to understand. In theory, there is more equity risk in year 2. From the data, the stock market is in the top half of the cycle in 6 out of the last 9 cycles, and in the bottom half of the cycle in 3 cycles.

We can predict the end of the cycle. The gap is big for the last cycle. With this formula, there is more equity risk in year 2.

You must remember, this formula takes into account the risk of missing the risk-free rate. A company may be at risk of falling below the risk-free rate every year.

Impact Of The Fed Funds Rate

This means the company has a smaller value than the risk-free rate for every year. The formula does not account for the impact of the Fed Funds Rate. The formula looks at the equity risk for each year.

The Federal Open Market Committee FOMC

For the last cycle, The Federal Open Market Committee FOMC did not increase the Fed Funds Rate. That means there is less risk for the market in year 2.

The risk-free rate will not be constant. There is no method to predict it. There are many reasons why the risk-free rate may rise.

One is that companies need to pay the creditors every year.

Pay The Creditors

The risk-free rate increases when the companies pay the creditors. When the companies fall below the risk-free rate, the risk-free rate goes down. The value of the risk-free bonds goes up. The risk-free rate is important in the risk of missing the rate. Thanks for reading What Is The Main Reason Most Startups Fail?.

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