How To Operate During A Market Downturn & Recession, A Guide For Founders

Summary

• We’re in a recession, and the fiscal mechanisms that are in place to stave off this recession and curb inflation will probably take 1-2 years to reach their full impact capacity; fundraising will probably not be easy for at least that amount of time.
• Capital is more expensive now; fundraising for founders is going to be 5-10x harder than it was over the past 2 years when cheap access to capital reigned supreme.
• Founders need to reduce their burn rates to lengthen their runway – that is the first step they need to take because it is almost entirely within their control and can be done quickly in most cases, even though it can be very painful, especially if it involves layoffs.
• Founders also need to work on improving key metrics to get as close to cash flow positive as possible – we’re not talking about profitable “on the books”, but real cash flow coming in.
• The main source of burn is employment, we can see this in the huge waves of layoffs because companies over-hired on cheap capital.
• Outsourcing can be used as a strategic hiring decision, where companies can scale up and down without having to lay off people.
• The reduction in burn can help the core team they have already keep their jobs stable and focus on creating value, rather than fearing when they might be laid off too.

The past few months have been very turbulent. Macroeconomic trends are putting founders between a rock and a hard place; venture capital firms are sending their portfolio companies’ founders warning emails about what’s yet to come (Y Combinator), they’re sending them 52-slide presentation deck (Sequoia), and they’re publicly publishing their video conferences (Craft Ventures) trying to coach them how to go through the next year or two.

This year alone, more than 350 companies have laid off over 50,000 people, and that is a non-exhaustive list. We've seen some catastrophic failures as well with companies like Fast, which burned $100M in funding in under a year going bankrupt and laying off 100% of their staff (luckily they were able to help most of their engineering staff members get hired at Affirm).

From Y Combinator to Sequoia (reminding us of their doom & gloom presentation from 2008), to Craft Ventures, Andreessen Horowitz, and many more – the default alive versus default dead conversation started by Paul Graham in 2015 has come back into play, and big time.

Bonus material: check out the default alive vs. default dead calculator by Trevor Blackwell here.

First things first. Why do startups fail? And why does it feel like they’re failing more often now?

If we just look at the current environment and the 50,000+ layoffs that have happened in tech in 2022 so far, we can end up missing the elephant in the room - most startups fail, regardless of the macroeconomic & funding environment. Regardless of how well you’re funded, if you’re not building a product that people want, you will likely fail in the long run, regardless of how much cash you have in the bank.

This is likely what happened in the past two years:

• Companies got bloated valuations on cheap cash, tried to scale as if that cheap cash was going to be around forever, and started operating on negative unit economics (losing money on every transaction) versus trying to build for profitability.
• Investors fed that frenzy in hopes of big returns for their LPs. They also had very cheap capital over the past 2 years and were investing in business models that were yet to be tested, and that was born as a result of COVID hitting and the whole world turning upside down for 1.5-2 years.
• Governments worldwide (with the US taking the lead) kept on printing enough money that created a huge excess of artificial capital (initially meant for quantitative easing purposes), and public companies were trading way above where they should have been trading because of this extra liquidity in the economy.
• We’ll leave the topic of cryptocurrencies, NFTs, and DeFi for another article, as that’s an in-depth topic to cover.

However, going back to basics, there are many reasons why startups fail even without considering externalities:

• Founders give up for many reasons
• Lack of motivation or belief in the vision
• No clear roles & responsibilities
• Co-founder conflict
• Lack of trust
• No funding
• Running out of funding
• Hiring too fast
• Over-engineering non-core functionalities
• Building too many new features without validating the initial ones first
• No (or pseudo) product market fit
• Not collecting user feedback
• Listening to investors instead of users
• Relying only on metrics instead of verbal qualitative feedback from initial users

We’ve compiled a list of videos, presentations, podcasts, and more to help you do a deep dive:

The Startup Founder's Guide For Navigating Economic Downturns - YouTube

‍Disclaimer: Although many of our links point to Y Combinator’s or the All In Podcast’s content, we are not affiliated with either of them. However, they have some of the most extensive content we could find out there. Always make sure to take everything you read or watch with a grain of salt; whatever each person or company says is meant as a guideline, not as an instruction.

So, how did we get here?

As a disclaimer, we want to say that we’re not 100% sure these are all the reasons that are causing this downturn and how we got here. In fact, every decent VC firm, angel investor, analyst, and news publication will tell you that there is no one single reason why we’re here.

What we’re offering in this post is a summary of the publications and research we’ve read. What we’ve come across is that the answer can be broken down into 3 parts:

• Macroeconomic trends, most notably the stimulus funding and low interest rates
• War in Ukraine
• The changing world order
• Oil cost doubled
• All types of assets have inflated for many reasons
• VCs pushing companies to burn money too quickly and scale inefficiently
• Founders thinking that their success is defined by their company’s headcount
• Why VCs Push Companies to Burn Too Fast: Board Management, Cash Burn, Finance | Y Combinator

What does this mean for startups specifically?

• VCs follow the public market to some extent, especially for later-stage funds. Since public companies have lower valuations, this is impacting valuation models that VCs use when making investment decisions.
• This has a trickle-down effect to earlier stage startups that is currently developing. Earlier stage startups are also less affected since they have a longer time horizon to bring a return on the investment made, while later-stage startups are expected to have an exit much sooner.
• Now, there are fiscal policies to help address these points, but they need time to show the effect, probably a few quarters. It is uncertain, however, whether this will take 6 quarters like in 2008 or 3 years like in 2000 – make sure to create several contingency plans.

Here’s a snippet of what Keith Rabois at Founders Fund had to say in a quote from Pulley’s article, an equity management platform where he just led the $30M Series B:

"I’ve been warning of a market crash since October 2021. The situation we’re in now is very similar to the dotcom burst of 2000. For the past few years, we deluded ourselves into thinking things could only go up and to the right. […] With publicly traded tech stocks down 50-90%, it’s become impossible for private companies to escape their public market comps (e.g., any crypto company inevitably is compared to Coinbase, which is down 85% from its highs)." - Keith Rabois, Founders Fund

When should you start your next fundraise?

It depends on many factors, the main factor to keep in mind is how much runway you have left at your current burn rate.

Calculating your runway

Calculating runway is quite simple. You divide the cash in your bank accounts as founders by your net burn rate. Net burn rate is calculated by subtracting your costs from your revenues.

The main issue is for you not to overstate revenues or understate costs. Be realistic and use historical values, resist the urge to use projections from your CRM.

Runway = Money In The Bank / Net Burn Rate = Money In The Bank / (Revenues - Costs)

If you don't have real money coming in, then don't count it here as Revenue. Even if you consider something to be an "investment not a cost", that doesn't matter, it's still a cost that's reducing the amount of money in your account.

For example:

• You have $2,250,000 USD in your bank account.
• You had $250,000 USD transferred from your customers in the past month. This counts as your revenue.
• Your total expenses amounted to $500,000 USD in the past month.
• That means your Net Burn is $250,000 - $500,000 => A monthly net burn rate of $250,000.
• That puts your runway at $1,000,000 USD / $250,000 USD/Month => 9 Months before your bank account is empty if all else remains equal.

If you have 24+ months of Runway

If you have this much runway left, that's great, and you should be able to weather the storm as long as you stay disciplined. Make sure to only expand and scale up your team when you hit product-market fit.

If you're pre-market-fit, then keep tight control over your spending, especially when it comes to payroll, as this is probably your main cost center.

If you have 12-24 months of Runway

Start acting and don't delay. Set up internal and external talks to see where your organization can be more efficient and how you can ensure that your company is still alive in the next year or two, even if you have to make some adjustments now.

If you have less than 12 months of Runway

Act now, make the tough decisions you need to make, and if the decision involves layoffs, make one round of layoffs and explain this clearly to the team and ensure they transition well. Do not go for salami slicing and avoid the death spiral. Make one cut, get lean, decrease your burn to the level where you're able to get to 12 months of runway, then go from there.

What can you do to reduce burn?

Burn is made up of 2 factors: Costs and Revenues.

What you can do to decrease your burn rate by decreasing costs

• Whatever new features & products you’re developing, create an MVP first.
  It is almost never the case that you need to create a full-fledged product right off the bat. Developing MVPs of new products or even small features is a great approach to take which ensures you keep overheads low, and testing out new revenue-generation avenues for your business.

• Move to a remote-first working model.
  Office costs are a huge additional burden on your balance sheet. Many employees now look for remote-first opportunities to make sure they get the best of both worlds. You will also be able to attract all kinds of talent, not just those concentrated in tech hubs and major cities.

• Hire an outsourcing company.
  Did you know that hiring an outsourcing company can reduce your operational expenses by over 50%? There are many things to keep in mind, and you need to make sure to choose the right partner, but the benefits are significant. Keep reading to find out more about whether outsourcing development is the right fit for you.
  
  You often don’t need to hire developers to work full-time on a permanent basis, but for specific shorter periods to release a new product or feature. You also can help your in-house team focus down on your core product and users, while your technology partner handles experimenting with new product and feature releases that you can double down on in-house after you’ve proven that there’s product-market fit for those products & features.

• Put a hold on big expenses.
  Unless you’re in the biotech, manufacturing, or another capital-intensive space - any big expenses you have can probably wait. Get your company’s business fundamentals in line first, secure your team, generate revenue, and then think about capital-intensive activities.
  ‍
• Cut the fat.
  Do you really need all those expenses? Does the team need a full off-site to a 5-star hotel in Hawaii? Or can you make sure that the team gets a nice get together somewhere local and make sure they have a job left in 3 months? If anyone from your team feels like they need a 5-star vacation to be tempted to stay in your company, the startup scene probably isn’t for them.

What you can do to decrease your burn rate by increasing your revenues

• Start charging for your product!
  This sounds so simple, but so many founders have the belief that if they just get enough people to sign up for the free forever plan and then charge based on a freemium model, they’ll make it. Unfortunately, sometimes we get external forces pressuring us to change our models, and this is the case now. If your product isn’t generating revenue, it’s time fo you to start charging for it.

• Experiment with new pricing models if you’re already charging for your product.
  There’s no guarantee that your current pricing is the “right” pricing for your customers. If you’re afraid that your current customers might be upset about increased prices, you can keep their current pricing tier stable for the next 3, 6, or even 12 months before they get moved to the new pricing model. By that time, you should hopefully have developed more features to put their objections at ease.

Additional Reading:

• Sequoia:
  Adapting to Endure | Sequoia Capital US/Europe
  Forecasting & Scenario Planning | Sequoia Capital US/Europe
  Leading in Uncertain Times | Sequoia Capital US/Europe
• Craft Ventures: Operating during a downturn - YouTube