By Sharon Fisher | June 28, 2022
What goes up must come down. Fortunately, in economics, what goes down can come up again, but only if your startup is still there when it does.
That’s the message local and national venture capitalists and other sources of funding are giving to startups who might be about to experience their first financial crisis.
The good news is that with problems come opportunity.
“Economic downturns often become huge opportunities for the founders who quickly change their mindset, plan ahead, and make sure their company survives,” wrote YCombinator, a startup incubator, recently in a note to its companies.
How did we get here?
You may recall that after COVID, there was a sudden, sharp economic disruption and governments poured billions of dollars into helping companies weather it. That was the right thing to do at the time, but all that economic stimulation resulted in inflation. The way to deal with inflation is to cut back on spending – but that can cause a recession. Basically, the Federal Reserve Bank, which controls interest rates, has to thread the needle between keeping rates low enough to encourage growth but high enough to keep inflation under control. Sometimes that’s a bumpy process.
“Over the past two years, monetary policy loosened to avert an economic disaster in the midst of the pandemic,” wrote venture capital fund Sequoia, in a presentation to its companies. “Negative real interest rates led to effortless fundraising for growth companies and record valuation levels. Given the circumstances, that was perfectly rational.”
Consequently, a number of funds are warning startups that the party is over, at least for now.
“Venture capital, in general, has a structural flaw in that it’s extremely vulnerable to the ‘boom and bust’ nature of the public markets,” said Matt Price, chief operating officer of Killer Creamery and venture partner with Connetic Ventures, in an email message. “When the markets go bust, all that capital that startups were feasting on goes scarce almost overnight as risk aversion in investors soars.”
This is not necessarily a bad thing, Price continued, but individually it can be hard to take. “I think it’s a healthy repricing of what companies are actually worth,” he said. “In many cases, this repricing could be hard to stomach by founders who have known nothing else besides the boom times.”
“For those of you who have started your company within the last five years, question what you believe to be the normal fundraising environment,” the YC letter agreed. “Your fundraising experience was most likely not normal and future fundraises will be much more difficult.”
How startups can survive
This isn’t all bad news, particularly for startups that can be flexible, efficient, and, above all, profitable.
“For years, top line growth (price to revenue) has been rewarded,” Price said. “Today, profitability and distributable free cash flow are the new standards and there’s not many growth stage startups that can make the switch to profitability quick enough to continue to get evolutionary funding the way they were last year.”
“The era of being rewarded for hypergrowth at any costs is quickly coming to an end,” Sequoia agreed. “With the macro uncertainly around inflation, interest rates, and war, investors are looking for companies that can produce near-term certainty. Capital is becoming more expensive while the macro is becoming less certain, leading to investors de-prioritizing and paying up less for growth.”
“I think it’s a healthy repricing of what companies are actually worth. In many cases, this repricing could be hard to stomach by founders who have known nothing else besides the boom times.”
— MATT PRICE, COO OF KILLER CREAMERY & VENTURE PARTNER AT CONNETIC VENTURES
This is less of an issue for pre-seed and seed-stage companies than for companies in Series A and beyond, Price said. “On the very earliest of stages (pre seed and seed), I don’t know if it will affect those startups much,” he said. “Those ventures are just too early to be compared to similar public companies. For companies in the A, B, C+ growth stages, there most likely will be a noticeable repricing in those valuations. The metrics investors used to evaluate those companies change drastically — and overnight.”
For that reason, Price thinks Idaho startups will probably weather the storm pretty well. “I don’t think too many local startups will really feel the pain,” he said. “There might be exceptions made in some of the more mature companies, but I actually think Idaho startups will be fine. Most have never known much outside of bootstrapping, so usually those companies have better unit economics, reliable customer base, and anti-fragile posture anyway. There may never be a better time to launch that startup or expand the business in areas that might not have been considered over the last four or five years!”
“This is not a time to panic,” Sequoia agreed. “This is a time to pause and reassess.”
Here’s a checklist
So what should you do? Here’s some advice:
- Deal with it. Things are going to suck for a while. “Every crash starts with founders not confronting reality,” Sequoia wrote.
- Look for ways to cut expenses and extend the life of the funding you have. “Companies who move the quickest have the most runway and are most likely to avoid the death spiral,” caused by a series of small cuts that affect a company’s ability to perform, Sequoia wrote. “Do the cut exercise (projects, R&D, marketing, other expenses). It doesn’t mean you have to pull the trigger, but that you are ready to do it in the next 30 days if needed. When you have just six months of cash left, focus becomes incredible. Get that focus now regardless of how much you have in the bank. It is easier to preserve cash when you have more than six months left.”
- Look for ways to diversify to get more revenue, particularly from customers you already have such as by providing new features or options.
- Don’t count on being able to raise more money for 24 months, advises YC. In particular, companies that have already raised Series A funding shouldn’t expect to raise more until they have hit market fit, YC added. That said, if you doubt your ability to survive the downturn and you have either new or existing investors willing to give you money now, you might want to grab it, YC advised.
- Look at the bright side: Recruiting is about to get easier, Sequoia wrote, noting that the big four Facebook, Amazon, Netflix, and Google have already instituted hiring freezes. Moreover, employees who were only in it for the money may leave, and the ones who stay are the ones who believe in your company’s mission, Sequoia said. And you can use that. “Time to get your team’s commitment for the path forward or…politely ask them to lighten the lifeboat,” Sequoia added.
- Another bright side: Some of your competitors could fail. “Less investments mean crowded, noisy categories will quiet down some as companies shut down or get bought,” Price said. “Most of the most iconic companies of the next 20 years will probably get built right now!”
Ultimately, the word of the day is survival. “Remember that many of your competitors will not plan well, maintain high burn, and only figure out they are screwed when they try to raise their next round,” YC wrote. “You can often pick up significant market share in an economic downturn by just staying alive.”
“Once your head is back in the game and you know how you can survive this, it’s an amazing time to go identify the areas of the market that will be ripe for some offense,” Price agreed. “Those who can’t get themselves to accept these new challenges will have a very, very hard time.”
Fisher is a digital nomad who writes about entrepreneurship.