Do NOT Invest In These Companies

By Matthew Milner, on Wednesday, February 18, 2015

Today, I’ll tell you the amazing story of a once-mighty company.

Formerly valued at $1 billion, it’s now being sold off for pennies on the dollar.

Then I’m going to show you something even more important:

How to ensure that you never invest in a business like that.

From Fabulous… 

In 2011, a company called Fab launched an e-commerce site.

The founders collected unique clothes and furniture from small, independent designers, and posted the items on Fab.com.

When a customer bought something, the designer would handle the shipping, and Fab would get a cut of the revenues. This gave broad exposure to niche designers, and allowed Fab to charge premium prices.

Fab’s customers loved the products – for example, a chandelier made of martini glasses – and the company quickly grew.

By 2012, it had reached $120 million in revenues.

To fuel its growth and help it take on Amazon, venture capitalists poured $340 million into the company.

Within just two years, it was valued at $1 billion.

To Not So Fabulous

What customers loved most about Fab was its original products.

Indeed, Fab’s team was skilled at finding designers who made beautiful things.

But these designers were focused on design

They weren’t focused on fulfilling orders for Fab.

This bottleneck resulted in slow shipping for customers – and slow growth for Fab.

To boost growth, Fab decided to feature many more products on its site… and to manage the shipping and logistics internally.

So they went out and bought a ton of inventory, then they erected a massive warehouse and fulfillment center in Edison, NJ.

The “Kiss of Death”

With this new strategy, Fab quickly went from having 1,000 items on its site, to 11,000 items. But not all of the products were from niche designers:

In order to expand its catalog and justify the cost of a fulfillment center, Fab began carrying more mainstream products.

Over time, Fab’s products lost their originality.

Now Fab looked a lot like Amazon – but with higher prices.

During the holiday season in 2012, workers in Fab's warehouse noticed a problem:

Stacks of inventory were piling up.

As one former employee said, “That was the kiss of death."

Over the next two years, things went from bad to worse.

Running out of money, Fab finally waved the white flag:

This month, it will sell off the remains of its business.

The selling price for this former $1 billion start-up?

As little as $15 million.

That’s 1.5 cents on the dollar.

The #1 Reason Start-ups Fail

There are many reasons why start-ups fail:

They build lousy products. They can’t attract customers. Their business doesn’t solve a real problem.

But the #1 reason they actually go out of business is simpler than that:

They go out of business because they run out of money.

If a business has money in the bank, it can live to fight another day –

That means another day to fix its product, attract customers and understand its customers’ problem.

For people like you who invest in start-ups – or in any company, for that matter – the implications are clear:

Don’t invest in businesses that have a high probability of running out of cash.

But this raises a critical question:

How do you know if a company is likely to run out of cash?

Introduction to The Risk of Ruin

Imagine trying to run a marathon with a TV tied to your ankle.

That’s what it’s like to run a start-up that has high operating costs.

If a company requires millions of dollars for things like inventory (e.g., Fab) or hardware (e.g., BlackBerry), it’ll be more prone to run out of capital – and more prone to fail.

Start-ups with high operating costs have what we call a high “Risk of Ruin.”

As a rule of thumb, you should avoid investing in these types of start-ups.

Instead, you should invest in businesses that are capital efficient –

Businesses like Google, Uber, or Airbnb, where software is its primary product.

CrowdabilityIQ

High operating costs are a telltale sign that a start-up has a high Risk of Ruin.

But there are many other signs, too – from unpredictable revenues, to a team that doesn’t possess the right skills.

It can be a challenge to assess all the different signs, so Crowdability is building a set of online tools to do it for you, automatically.

We call it CrowdabilityIQ.

If you’re one of our Early-Stage Playbook students, you’ll receive an email from us shortly about receiving a free trial of our new software.

In the meantime...

Happy Investing!

Best Regards,
Matthew Milner
Matthew Milner
Founder
Crowdability.com

Comments

If you enjoyed this article, subscribe to updates:

Sign-up today and you'll receive our daily insights on early-stage investing, as well as our FREE "Equity Crowdfunding Action Kit" – where you'll learn:

  • The Ins & Outs of Equity Crowdfunding
  • A step-by-step path to get started
  • Tips from dozens of Venture Capitalists
subscribe to updates

Thank you for subscribing!

Tags: CrowdabilityIQ

Share This:
comments powered by Disqus