High inflation, rapidly rising interest rates, and a looming recession all paint a challenging climate for the startup and scaleup community.
VCs have already become much more cautious before parting with cash and their message to founders is clear: extend your runway, get your house in order, and do it quickly.
That sounds like sensible advice.
But, *how* exactly can startups and scaleups extend their runway in a manner that will keep them on the high-growth VC pathway? And, not fade away into obscurity as a 'regular' or - dare I say it - 'lifestyle' business.
To find out the answer to this question, we spoke to VCs and founders thinking about this very problem right now.
Unfortunately, none were willing to go on record due to the sensitive nature of the topic. So, I've provided their quotes anonymously. It turns out cost-cutting conversation isn't very bullish from an optics standpoint!
Investors told us that now was the time for businesses to start cutting costs, reigning in their spending and offloading cumbersome assets. Founders can no longer afford to ignore the bottom line in favour of gaining market share. Their goal should be to be “default alive” or at least to be “default investable” (more on this later!)
This is no mere blip either. Bill Gurley made his views on this clear in May. “The cost of capital has changed materially, and if you think things are like they were,” he wrote on Twitter “then you are headed off a cliff like Thelma and Louise.”
All of this messaging has not fallen on deaf ears. Startups have already started cutting their recruitment budgets. Some are preparing redundancies and marketing budgets have shrunk considerably as belt-tightening gets underway… and this is only the start.
It sounds bleak but, as Y Combinator's email to its founders pointed out, there is a silver lining to the current economic climate:
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. You can often pick up significant market share in an economic downturn by just staying alive.
Y Combinator
The message has taken hold. The leadership team at a fashion startup told us:
We have definitely been looking at runway extension (in light of) the expected economic downturn and a much more challenging fundraising environment.
It was triggered in particular by the Y Combinator email that went out to all their portfolio companies. All the founder networks have been sharing that around and are saying: cut harder, cut deeper and cut sooner than you think you need to.
Fashion Startup
The letter in question sent ripples through the startup community. YC, whose early investments include Dropbox, Coinbase, Airbnb and Reddit, told founders that their best bet was to cut costs and extend their runway within the next 30 days.
No one can predict how bad the economy will get, but things don’t look good. Regardless of your ability to fundraise, it’s your responsibility to ensure your company will survive if you cannot raise money for the next 24 months.
Understand that the poor public market performance of tech companies significantly impacts VC investing. VCs will have a much harder time raising money and their LPs will expect more investment discipline.
Y Combinator
VC firms have been echoing those views. Sequoia soon after held a Zoom conference with its founders and told them to urgently start thinking about trimming costs and pulling in spending.
How quickly are businesses responding to the warning signals?
The fashion startup weighed in again:
In terms of cutting costs, every member of the leadership team has been asked to look at all the cost lines in the business and think, do we definitely need that and is it directly driving either cost savings or revenue generation? If it's not, cut it.
Any discretionary spend on longer term projects has been cut… I've slashed my performance marketing budget, I have terminated the contract with an agency that we had a fixed monthly spend with, and I'm not going to do that on a like on demand basis. We're thinking about discounting more heavily, and kind of doing everything we can to get that stock sold to free up some cash, which we can then reinvest in growth.
Fashion Startup
Businesses also told us that redundancies were in the pipeline. One startup said that it was preparing lists of team members and was discussing “whether we feel that they are definitely going to be part of the journey for the years ahead.” …Ouch!
Staffing costs are a major route to finding cost savings - when it comes to Seed to Series B tech startups, usually about 80 per cent to 90 per cent of costs are people, so headcount cuts tend to be what really moves the needle.
Yet, this may not always be the best option, especially when these people are genuinely adding value and growth to your business. Cutting jobs may be tempting now that everyone is looking at their burn, but investors offered a note of caution when it comes to redundancies. One VC, whose focus is B2B series A-C said:
Of course, you can cut employees, particularly those who are not mission critical to survival.
Obviously, that comes with its cultural complexities and morale issues. It's obviously very tough to do, so any companies that are considering doing that need to get the communication absolutely spot on, and maybe try and signal it upfront.
Then once it's done, really nip it in the bud and make sure that the people who are there left are really on board for a battle and, potentially, a period of hardship.
In a startup, where it's quite a nice environment, it's obviously very difficult when people have been working closely together. If there's a lot of resentment after that it really can rock the company.
VC
There are no easy options but this VC suggested that businesses consider ways of easing the blow when it comes to cutting wage bills. There are alternatives to job cuts that can help keep wage costs down while keeping company morale afloat.
One thing you can do, which may seem like a more equitable option, is to offer some of the employees salary cuts in exchange for additional equity in the company.
That obviously has benefits and it doesn't make people feel as though they're getting squeezed too much per se. Although at the moment, obviously, with the cost of living going up and energy bills going up that is, of course, going to be a difficult thing to do.
VC
Staffing costs aside, there are other budgets that can be trimmed to help streamline the business. VCs suggested a more thrifty approach and belt-tightening on discretionary spending items like paid marketing, travel costs, and employee perks. Businesses could also delay non-essential upgrades to software or infrastructure.
There are other tweaks that can be made. Looking at cash payment terms and fine-tuning them to your favour can also help to bolster a company’s cash position. One VC told us:
Go to your suppliers or service providers, and either try negotiating lower prices or fiddling with the cash profile of your payment terms.
So in the same way as getting paid up front on the cash inside, you could flip it with the cash outside. So basically trying to go from things you might pay 12 months upfront for and instead paying monthly just to bolster your cash buffer in the short term.
VC
Being told to cut costs and expenditure is one thing but how deeply should startups cut and when should they stop?
The burn multiple is key here. Investors said too many startups were reporting growth without contextualizing it against investment. This is unlikely to be tenable going forward.
So, what kind of multiples should companies be aiming for? We were told incredible growth with a burn multiple of 3x will not cut it - unless of course investors deem that the company is still young enough to warrant this. If the multiple is 1.5x to 2x then you are doing good, 1x to 1.5x is great and anything under 1x is amazing.
A high burn multiple may not be a major cause for concern for an early-stage company but businesses that are unable to bring their burn multiples down over time need to think long and hard about how product-market fit they really are. If you have a high burn, what are your KPI’s telling you? If they are not telling you anything, you may need new ones.
It’s not all bad news in the bear market. While investors unanimously told us that now is the time for discipline, the "flight to quality" could present a great opportunity for businesses with strong fundamentals. As one startup founder of a recruitment platform bluntly put it:
Honestly, I think all of this is quite good for innovation. An abundance of capital leads to s*** companies, and I think it'll be a good thing if startups are forced to work out how to make a product good enough that people actually want to buy it to an extent that a viable business can be created off the back of it.
Founder
This founder has just closed a fundraising round and was optimistic about the company’s prospects. He said that the market disruption had not changed anything.
We have several other vcs who keep messaging us saying they will take up the round if it falls through.
We managed to lock in a pretty meaty valuation, which they haven't tried to renegotiate and i do not think they will at this stage. I think if you're profitable and clearly have a product people want, investment is still pretty easy to come by - all that capital has to go somewhere.”
Founder
So maybe now is the time for some tough love. Founders are being forced to put their business under the microscope and consider how investable they really are.
This could play to the advantage of those who have their fundamentals in place, giving them the breathing space to grow without constantly looking over their shoulder at the new set of VC-funded competitors that keep cropping up. They can take the time to actually build their business and their product offering. They also do not have the constant worry that a better-funded rival may poach their employees.
Not all early-stage startups are in such a privileged position and there is, of course, a balance to be struck. Startups do not want to be trimming costs when that results in them choking off growth.
David Sacks, co-founder and partner at Craft, made his thoughts on this clear recently. Instead of being too preoccupied about whether they can “default alive,” founders need to look whether they are “default investable.”
"Default alive” is almost an impossible standard for early-stage startups since it means being cash flow positive.
On the other hand, “default investable” means that your metrics are good enough to raise another round in the current environment.
You’ve got to be realistic about whether you are investable.
It takes mostly “great” metrics, maybe one or two “good” ones, and no disqualifiers (“danger zone”). If you’re not currently investable, you’ve got to give yourself adequate time to fix your metrics.
Tinkering, experimenting, finding PMF — all of that takes time. Fixing problems in the business is typically more successful with a lean team anyway.
David Sacks
Sacks said that instead of being overly prescriptive in their thinking, startups should aim to be in one of the following positions:
- Cash flow positive - always good, obviously!
- Cash flow negative - VCs are truly willing to finance that growth (be realistic about it)
- Low burn, long runway - fixing metrics to become 1 or 2
Everything else is "a no man’s land."
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