Why the 0.0001 Percent Succeed

If you want insight into how to manage risk on a corporate balance sheet, you could do worse than hiring a Wharton finance graduate. Wharton also produces its share of entrepreneurs—Elon Musk, W’97, C’97, comes to mind—who know how to tap huge startup opportunity while shedding risk. But Stanford—another stop on Musk’s educational journey—offers useful insights on managing startup risk. And such risk is not scarce. After all, as venture capitalist Mike Maples Jr. explained to me—one in 10,000 funded startups hits it big. Not surprisingly, the media lavishes attention on this tiny fraction while ignoring the 99.9999 percent of them that don’t make the grade—though plenty can be learned from the failures. Only one in 10,000 funded startups hits it big. To get a quick course on how to avoid startup failure, I interviewed Mike Cagney, a graduate of Stanford Business School and hedge fund manager. He’s also CEO of SoFi, which he helped to found in 2011 because he wanted to bring “local” back to financial services. SoFi offers student loan refinancing to highly qualified graduates, with savings of $9,400, on average, over the lifetime of their loans. Through May 2014, SoFi has issued more than $500 million in loans to more than 5,000 members, Cagney said. “In the past year, the number of schools represented by SoFi borrowers has grown nearly 800 percent to more than 550 universities, and the number of borrowers refinancing their federal and private student loans has quadrupled,” he said. Here’s what Cagney has to say about how to manage three startup risks that help distinguish the few successes from the many failures. 1. Limits to founders’ capabilities

Elon Musk

Elon Musk is one Wharton entrepreneur who knows how to tap huge startup opportunity while shedding risk.

Founders of many failed startups can’t handle the challenges that come with rapid growth, while founders who run winning startups adapt nicely to them. “If you grow a business fast, there is a danger of outstripping the founding team’s capabilities,” said Cagney. “When you start a company, you might expect to spend two years to prove the concept, then you raise capital and operate the business. But as the business grows, many of the co-founders could lack the expertise needed to manage it.” This can be managed. Coach the founder, but if he or she can’t manage fast growth, cut him or her loose and hire someone who can. “Fortunately, three of our co-founders are still here, and we are on great terms with the fourth one,” Cagney said about SoFi 2. Inability to keep rivals from copying successful products  Failed startups come up with great new products, but rivals copy their best features. Winners, however, build in product defensibility. You should build defenses. “If you enjoy fast growth and charge a high price, you may attract competitors who cut [the] price to take away your customers,” said Cagney. SoFi’s defense is to get the best borrowers before the big banks do and keep them in its fold through community. 3. Bad equity allocation Another reason startups fail is that they allocate all of their equity to their co-founders at the beginning. They give out too much equity to someone who leaves the business and has not earned his share. As a result, startups often lack equity to give to key hires and investors later in the startup’s growth. This risk can also be managed. “You should allocate, say, 10 percent among each of three co-founders initially and leave the other 70 percent unallocated,” Cagney said. “If you have a big pool, you can give it out based on value creation.”

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