Thinking Through an Economic Contraction

Posted April 1, 2020 by Shasta Ventures

By: Issac Roth
Issac Roth

I still vividly remember the scene in early November 2008: I was raising money for Makara (which became Red Hat OpenShift.) I arrived 10 minutes early at the office of a well known VC on Sand Hill Road where I was scheduled for a first meeting and… I found all six partners plus various other staff waiting for me in the lobby! I was elated — I only had an appointment with one partner.

Then I realized they were all glued to the TV in the lobby watching CNN for that day’s market news. Not a person even noticed as I walked in. The partner with whom I had an appointment was gracious and met with me, but it was clear from the glazed over look of everyone that I wasn’t likely to get them excited about our vision for containerizing web applications.

Today there are even greater distractions and uncertainty. I interviewed my partners at Shasta and added my own experience to compile a kind of “how to” guide for thinking about your business in the face of the changing economy. My goal is not to provide the answers which are surely different in specific to each company but rather a worksheet for which things to think about.

 

Re-plan

It looks like things are going to be different. If your business is likely to grow during this viral season and its aftermath then it will probably be easy to scale up as needed because talent and capital should be available as other companies shrink. Many software businesses are likely to shrink simply because of the economic uncertainty and managers’ tendency to spend less and take a conservative posture in the face of the unknown.

 

Consider three scenarios:

  1. Topline growth is 30% less than you had previously planned for the next three quarters. Churn is flat to 10% rather than the negative churn you probably planned.
  2. Topline growth is 60% less than you had previously planned for the next three quarters, then 30% less for another year. Churn is 20%.
  3. Topline growth is zero. Churn is 50% for 18 months.

 

Try to predict the future

Who are our customers? Are they going to be in business? Are they growing or shrinking? How important is our service to them, truly? Does our service sustain their business or does it make their business more efficient? Do they depend on us or would we be less valuable if labor was less expensive? If they are seeing contracting revenue and must reduce spend, will they lay off staff or will they stop using our software? If we think about our own businesses are we going to lay off staff or reduce the fees we pay to use services? What will our customers do?

Can we actually ask customers these questions?

We might be scared to bring it up, but we might also build a deeper relationship. What if the answer is, “I’d keep your software if it cost half as much.” Would we take that deal to keep the customer? What if the answer is, “I’d keep your software if it can help me replace two more people because I’m being asked to reduce labor expense.”

After asking this series of questions and those related which we can think of to help put ourselves in our customer’s mindset, we then pick the plan which seems most likely. The plan might be wrong but the art of the startup is making difficult decisions with a real lack of information… then carrying them out with conviction.

 

Reconsider product strategy

In a bull market most businesses are striving to gain maximum leverage. Capture the most market, expand the opportunity, out innovate the competition. In a contraction priorities shift. Businesses want to stay alive, they want to hold on to their assets (including their people), their customers value stability over innovation, there is more time and less capital so let’s DIY or do with what we’ve got. Products that directly save money are compelling. Products that create efficiency are good, but ROI feels different when it’s about laying off people vs not hiring new ones.

What can we do in our product to make its value directly about saving money? How can we highlight in our product marketing and business model these cost saving capabilities we offer?

The answer to this may involve a small or very significant product pivot.

This requires the kind of go-away-and-really-think-about-it-with-fresh-eyes thinking that is hard to find when responding to a crisis. It’s important to take that time. This is a great exercise to rope in advisors: “Look at my product and tell me if I’m kidding myself that this can really save people money.” “If I only wanted to save people money, which parts of this product could I eliminate?”

To give a concrete example here, during the 2008 Global Financial Crisis, the value we highlighted and built features around with Makara/OpenShift changed from efficiency of DevOps experience (leverage for hard to recruit talent) to packing more applications on less hardware (direct cost savings) and we focused on enabling development teams to manage their own apps instead of requiring DevOps resources (enabling our customer to shift cost out of their department.) Our competitor Heroku, who had such an efficient runtime model that they could run small applications for free, saw their usage shoot up during this time despite their more restrictive application environment.

Pretty soon everyone is going to be positioning how much money their product can save.

 

Implementing the plan

Most likely our new plan is going to be for lower expected revenue and we likely want to extend runway. That means we’ll need to reduce expenses or raise funds.

This can be lonely and trying work. It’s essential for everyone’s success. I remember the first time I was a CEO enduring meeting after meeting of fundraising rejection and then rolling out a reduced plan… the main thing that got me through was having convinced myself and the team that it was a matter of our business’ survival — either some part of our company was going to live on or all of it was going to be gone in a few quarters.

 

Raising venture capital

Raising money is going to be more difficult in the near term. Screens upon screens will surely be written about this in the coming months. There are many factors but a simple one is supply and demand: there is a fixed supply of venture money but unless every startup instantly rightsizes their operation there will be more startups needing money than there is capital. Another is investor sentiment: VCs tend to follow the public markets and pullback in times of uncertainty. Our partners have witnessed this in 2000 after the dot com crash, in 2001 after 9/11, and in 2008 after the financial crisis plus in several other mini market pullbacks including the mini SaaS correction of February 2016.

In 2009, Series A valuations dropped 13% and the number of rounds was almost a third less.

Chart depicting the effect the 2008 Global Financial Crisis had on VC fundraising for startups

Kauffman Fellows organization released an analysis last week on the specific effect the 2008 Global Financial Crisis had on VC fundraising for startups based on Crunchbase data, from which that chart above comes. Check out their post here for full details. In synopsis:

  1. Less capital raised per round, in some cases 30% less.
  2. More equity sold in each round, increasing from 14% in 2008 to 25% in 2009 and 23% in 2010.
  3. Fewer A/B/C/Growth rounds.

 

Alternate sources of funding may be available

The SBA announced new programs which startups may qualify for.

A customer who is in a strong financial position who loves our service may be willing to invest and participate even more in our success.

However we may be able to raise funds, my advice here is to be flexible, remember that a percent of nothing is still nothing, and underprice.

Today’s inbox is full of businesses offering amazing deals just to move what they have — presumably they are just trying to stay afloat. This general position is widespread and it’s likely that everyone looking to make a new purchase or investment will ignore something that doesn’t seem like a great deal. In this environment I think it’s more responsible to have a few interested buyers at a lower price than one at a higher price. With uncertain market conditions investors may drop out at any time for reasons that don’t have to do with our company.

But there is hope: The nice thing that may happen when using a low price to generate interest can be seen playing out through bull and bear markets in San Francisco real estate: quality offerings even when initially underpriced will be bid up to market (and sometimes beyond).

 

Reducing expenses

The first thing most companies do is try to reduce variable and non-talent expenses. It makes sense because for most of us our key asset is our people. I’m already seeing leases and subscriptions being renegotiated, marketing programs and contractors being reduced, and taking responsibilities in house rather than paying third parties.

Next is people. We can of course and may likely need to reduce the number of overall people we employ. This needs to be aligned with the product and marketing strategy and business model. It may be that a product pivot to the money saving parts of the product means that entire efforts can be abandoned or postponed while new marketing and sales programs should be ramped up.

Instead or in addition we can ask our team if they want to continue the mission but with reduced wages. Many companies will offer an additional equity package as incentive to stay with reduced cash compensation. (Be careful not to directly trade as we might end up pricing our equity and thus running afoul of 409a regulations.) This kind of change in employee compensation should be discussed with the board but many board members will be in favor even if it requires extra ESOP allocation because the alternatives may be even more dilutive.

Does the changing economy create less competition in our market and thus we can pursue our goals more slowly? One company I know realized they were market leaders and competitors would catch up more slowly and receive less investment so they are implementing a four day work week combined with a pay cut until their revenue can afford to pay everyone full time again.

 

Optimistic wrap up

Just calling it what it is: as entrepreneurs we are naturally optimistic or else we wouldn’t even try to start new businesses when our chance of failure is so high. There is reason to be optimistic. Companies that weather this time will come out stronger with more focus and fewer competitors. The competition for talent may become more reasonable. Valuations will likely reduce but so will costs so the overall equation of how much equity do I have to sell to realize my vision could remain constant. VCs will probably stop pushing so hard to grow faster and instead focus on profitability — that’s not a bad thing! Customers and financial markets will reward quality products backed by great teams — that is what we are all striving for anyway. And they may even reward them more highly than before. Great companies will survive and be created so stay optimistic but make the hard choices to save cash now.