The failure is that start up founders and investors fail to recognize that revenue is your KPI to optimize for in the long run, with a goal of making a profit in the not so distant future. Business is not a social network, and success isn't measured by how many friends/users/downloads you have. Money is the bottom line.
Of course if you give something away for free or sell it cheap enough at a loss, you'll get a lot of "customers". I could do the same by opening a free taco stand on the street. But it is in no way a sustainable business model.
What if your business model were to get a huge investment from some rich friends, give away free tacos, put all the other taco stands in your town out of business, become a taco stand monopoly, and then charge for tacos at any price you want?
If you put other taco stands out of business, their assets are cheap to buy. Tada! You are now competing with someone whose cost base is lower than yours.
Value creation doesn't come from the absence of other value creators.
I see what you're getting at, and that's the logic some VCs seem to be using. But rarely does it ever work, because you'll need to start charging sooner than later, even at a loss. And once you do, competition will show up.
See Uber vs Lyft.
You'd be better off investing in a real business with a real revenue plan. Still, yes, your model works in an environment where collusion can take place. Which is why collusion and the VC aristocracy is so damaging.
Of course if you give something away for free or sell it cheap enough at a loss, you'll get a lot of "customers". I could do the same by opening a free taco stand on the street. But it is in no way a sustainable business model.