How To Startup Part 4: What Happens To Startups During a Downturn

While I was initially going to write Part 4 about MVP (minimum viable product), the topic of how to survive an economic downturn seems more relevant as it appears we may be on the cusp of a recession. A big question many people are asking right now is…

Why Is This Happening?

The main reason this downturn is happening is due to inflation. As interest rates have sat at zero or essentially negative since the beginning of COVID-19, asset and labor prices have gone up and everything costs more. The Fed is now raising these rates to combat inflation. When interest rates rise, it clobbers stock prices - specifically for high-growth companies whose earnings are mostly in the future.

To further understand this, you must understand how investors value companies. Analysts apply a discount rate to the future earnings of a business to value a company. To discount stock values, analysts project what future revenues and future profits will look like for businesses, and then discount the value of those back to what they are worth in the current day. So as interest rates rise, analysts increase the rate at which they discount future earnings. For example, what previously was $100 worth of earnings in five years, may now actually be only $50 worth of earnings in five years. Therefore, the value of the company, or its market capitalization, declines.

How Does This Affect Startups?

When public companies, particularly tech companies, are growing very quickly, their valuation gets slammed when interest rates rise. When valuations go down, it can affect startups, valuations and fundraising in several ways:

1. Businesses are compared to similar public companies. For example, proptech startups will be compared (“comped”) to public real estate and tech companies like Zillow, Redfin, Compass and Offerpad because they are the closest in comparison. If Zillow is now only worth ⅓ of what it used to be worth, then venture capitalists will base their valuations of startups at a significantly lower rate than when the company was valued higher.
2. VCs have less money to invest in private companies. Although many venture funds have “dry powder,” they undoubtedly will have fewer exits and fewer markups in 2022 than in past years. This means they will have less recycled capital available to reinvest, and they will have a harder time raising more money from their Limited Partner investors.
3. Crossover investors have plenty of public options. Much of the froth in the funding environment of the last few years was driven by crossover investors – firms which make both public and private investments. Specifically, many hedge funds and even mutual funds invested in private companies in the Series C, D and E stages. But now, with the stock market down so much, those crossover investors are not doing private investing and they have returned to their focus on public stocks where there are many great investing opportunities given the recent downturn.
4. VCs will support their existing portfolio companies ahead of making new investments. VCs are being asked by their portfolio companies right now to invest in rounds that will help them extend their runway, so VCs have less capital available for new deals.
5. Everyone is in a bad mood. Yes, that’s a thing. Everyone is in a bad mood because they have lost a lot of money in the last few months, and that makes people sour and skeptical.
6. The FOMO is gone. So much of the exuberance in venture capital the last few years was driven by investors’ fear of missing out (FOMO). We now face the opposite situation, where investors feel no compelling reason to stick their neck out and invest aggressively when their competitor firms are mostly in hiding.

What Should Startups Be Doing?

While downturns are not all bad news, you’ll want to do everything in your power to keep the momentum going. Remembering that eventually this too shall pass, here are some tips on how to survive and thrive as a startup:

1. Reduce your burn. Startups in this type of chilly funding environment should aim to have at least 12 months and ideally 24 months of runway. If you want help figuring out how long your runway is, check out this Forbes guide to calculating and managing monthly burn.
2. Use conservative math. Assume revenue is likely lower than what it was in your previous plan. If you are thinking about reducing your burn, you also need to keep in mind that the revenue side of the equation is also likely to come down. In turn, your cost side may need to come down more than what you initially planned for.
3. Reduce non-people expenses first. Expenses such as software, real estate, perks, marketing expense or non-necessities.
4. Reduce headcount once. Drawing out multiple rounds of layoffs is bad for company morale and can leave employees anxious or angry. If you have to make cuts, use this as a time to get rid of low performers if possible. While it’s an unfortunate and difficult thing to do, remember to lay off with compassion.

If you’re less of a reader and more of a video-watcher, Craft Ventures did a great video on how to operate during a downturn that covers these topics and more. NFX also has an extensive guide to thriving in a 2022 downturn and YC advises founders to plan for the worst. Sequoia shared this deck with its founders describing what to do and why we’re here, and Uber CEO Dara Khosrowshahi sent a memo to his team describing how the company is navigating the current market. Many other VC perspectives are available on Twitter.

If there is anything we can learn from the pandemic, it’s that challenges create opportunity and we are more adaptable than we think. Downturns can be scary and stressful, but if you plan well and welcome change, great companies can thrive during these times too.