Recession, an opportunity for new startups

What is causing the downturn?

Economic recessions, or downturns, are caused by a combination of usually more than a few factors. Their characteristics vary based on the country and time of their occurrence, but some warning signs and indicators remain the same beyond those barriers. 

It’s safe to say that, in general, loss of confidence in investment and the economy drives economies into the ground. When consumers panic and stop buying, businesses run fewer ads, and sales slow down. Then, manufacturers lay off employees because of the lower demand; unemployment rises while the economy goes deeper and deeper into trouble. In a perfect world, this is where the federal government and banks would step in to restore confidence in buyers and, in such, reverse the economy’s decline.

Another cause of economic crises is high-interest rates; very often, governments raise interest rates in the slim hopes of protecting the dollar. In reality, this usually worsens the resulting crash, and often the stock market crashes. This, too, can send the economy into a bear market, when loss of investment starves businesses of their capital. (thebalance) Other angles to investigate are deregulation, falling housing prices and sales, poor management, and war.

However, even though countless causes play a part, the economic downturn seen in the U.S. and the world is an interesting mixture of factors; they seem to have merged at the same time.

Put simply, three elements causing the current downturn include:

• Post pandemic spending has increased. Consumers were unable to go on vacations and use their money as they normally would for two years, so now they’re ready to spend their savings. 
• The economy’s supply link in the chain has been slow in terms of keeping up with the new demand. Across the U.S. and the world, we have seen some supply chain fiascos. This rising demand has caused various disruptions because supply or transport companies can’t keep up.
• Finally, the war between Russia and Ukraine is not large enough to directly affect the U.S. economy, but it has caused major ripples in the world. Additionally, the U.S. has seen a direct reduction in the availability of two critical commodities: oil and wheat. This supply gap has pushed prices up, and it’s already making huge impact on consumers and their lives. (brightmoney) 

Who is being affected?

As individuals, and consumers, we are the first target affected by the economic downturn. Every week, people must buy and cook food to keep their bodies going and fill their engines to keep their cars running. People consume every time they buy new clothes, listen to a certain podcast, get on social media, or decide where to get coffee. As a consumer living in the world, you are sure to have noticed the economic downturn happening all around. 

Periods of crises like these affect individuals, who are the fuel that keeps everything in this impressive machine running. This worsens the state of things, because when customers panic and decide they can’t keep spending their money as freely, then businesses see huge losses in sales. Companies of all sizes are affected by recessions, and certain industries are likely to lose more revenue and investment than others. 

For starters, the retail industry is always the hardest hit when people stop having extra cash. People start losing their jobs in a recession because consumers stop making so many unnecessary, senseless purchases. Over 11% of the U.S. workforce works in retail, so many people lose their jobs.

Also, bars and restaurants often lose business or even go out of business in these downturns. More workers lose their jobs, and wages aren’t enough to live off of. This happened to quite an extent in 2020 when COVID-19 shut everything down. Many smaller, family-owned pizza joints, coffee houses, and bars simply weren’t viable enough to survive until post-pandemic culture. 

Another example of industries that the recent economic downturn has affected is the hotel and leisure industries. Service occupations such as waiters and bartenders often lose their jobs when a recession hits, but then usually find new ones eventually. Restrictions are being lifted, and some people are feeling the freedom of travel once again, but when the pandemic came, hotel and leisure sales shot down immediately.

This just goes to show that these aforementioned industries are volatile and perceptive to changes in the broader economy. Not to mention that: “Automotive, oil and gas, sports, real estate, and many others see heavy declines during times like these,” according to Kenzie Academy.

The labor market also becomes saturated with people looking for jobs. Cash positions, wage workers, and wage jobs all have their shot at popularity in times like these.

Interestingly, people working in the technology industry can be fairly rest-assured that their companies won’t be the hardest hit by this current economic downturn. COVID-19 made it glaringly obvious that in this day and age, working a tech-sector job gives you more job security than many other industries.

Secondly, working a remote job is attractive in many ways; it reduces commuter pollution, there are fewer workplace dramas and distractions, and many people are more productive outside of an office setting. One silver lining of the pandemic is that many jobs that weren’t ever considered to be remote are now. Still, the economic downturn is very present in numerous other facets of the world. People from all sectors of society are feeling a crisis in their day-to-day lives.

How is it affecting startups?

As Yought says, “The tech world, especially startups, have enjoyed a bull run in the last decade with record highs across the board. After all, some of the biggest tech companies in the world have breached the trillion-dollar market capitalization in the last few years (Apple, Microsoft, and Alphabet).”

Many of the world’s top-growing companies were founded in or right after the economic downturn of 2008: Instagram, Uber, Venmo, Slack, Dropbox, Whatsapp, Pinterest, and more. This just proves that it is not impossible for startups to see positive outcomes of an economic decline.

One logical expectation in an economic downturn is that startups, especially new ones, might receive less investment and market opportunities. However, during this recent GFC (global financial crisis), the number of new deals that angels and seed investors made at least stayed constant and actually grew. This could be attributed to the fact that angels and seed investors generally have riskier profiles.

So, they’re willing to take on a case for a higher return. By that logic, if they don’t believe that a downturn would put your startup out of business, there remains no reason not to make an investment. The action also ensures that you get your hand in the game early. During the last GFC, the amount of money that an angel or seed investor offered did decrease, showing a clear risk management precaution. 

In today’s current economic crisis, these past trends mean a few things for startups. First, Venture Capital actually is still invested at high rates in a downturn, perhaps just with smaller sums in the offers. However, venture capital will be harder to access now that there is so much competition, too. As a result, the following might occur for startups: 

• Startups are forced to give out more equity during rounds
• Rounds might become smaller than historical averages
• Valuations for a company might be smaller
• Startups need to prove themselves, even more, to get funding (be profitable from early on).

However, the startups that need to be concerned in moments like these are the ones who need to raise money in order to come out alive and without debt. These startups are not profitable yet, and unless they find some cash quickly, it could mean the end of the company. These startups are what Paul Graham coins “default-dead” startups, according to Yought:

• 2008:
  • Airbnb (private; $38B, 2019)
  • Pinterest (public; $14B, Oct 2019)
  • Cloudera (public; $2.5B, Oct 2019)
  • Beats (acquired by Apple for $3B in May 2014)
  • Yammer (acquired by Microsoft for $1.2B in July 2012)
• 2009:
  • Uber (public; $54.6B, Oct 2019)
  • Square (public; $26.9B, Oct 2019)
  • Slack (public; $12.5B, Oct 2019)
  • Nutanix (public; $4.9B, Oct 2019)

As you can see from the tough market out there, goals such as gaining the necessary traction right away are increasingly important. With smaller rounds and valuations, etc., startups are required to prove themselves more and more, often early on, in order to receive the necessary funding. Therefore, keep the idea of preliminary profit as a cornerstone for startups to reach success in today’s market.

What are the silver linings and realities of the downturn? 

“If your company is lacking basic business fundamentals and burning cash, well, maybe you’re in for a reckoning. But then again, maybe you always were.
But if you have a well-grounded startup built on a good idea with a solid foundation, you can probably ride out whatever storm is coming.”

This quote from Y Combinator is somewhat of a warning; for success in a recession, your product must be a great one, to begin with.

Ask yourself, are you building a product that’s essential to your customer and their life? Or are you creating something less essential? Think painkillers versus vitamins, as Operator Collective founder and CEO Mallun Yen do. You must have a product that consumers will consider essential to their happiness and lifestyle.

“Y Combinator, a Silicon Valley kingmaker, is advising its portfolio founders to “plan for the worst” as startups across the globe scramble to navigate a sharp reversal after a 13-year bull run. If your plan is to raise money in the next 6-12 months, you might be raising at the peak of the downturn. Remember that your chances of success are extremely low even if your company is doing well. We recommend you change your plan,” the firm said in the letter, titled “Economic Downturn.” (Y Combinator) Prepare and expect the worst economy-wise. It was a good, long bull run, but every good thing has to end. Startups should be prepared and know what they’re getting themselves into when looking for funding.

Overall, there are quite a few things to examine before making any plans. First off, nobody can predict how bad the economy will get, but the pronostics are bad. The safest course of action is to plan for the worst. Based on data from the last two economic downturns, the most effective method of preparation is to cut costs and extend your runway within the next 30 days. Your goal should be to get to default alive.

Let’s say you don’t have the runway needed to reach default alive. If your investors (new or existing) are disposed to give you money at this moment, you should strongly consider taking their offer. Regardless of your ability to fundraise, it’s your responsibility to ensure your company will survive without the ability to raise money for the next 24 months.

Another piece of helpful information is that when tech companies have poor public market performance, it significantly impacts venture capitalist investing. They will have a much harder time raising money, and their LPs will expect more discipline.

If you started your company within the last 5 years, ask yourself what the normal fundraising atmosphere is. Your future fundraising experiences will most likely be very much more difficult, due to the changing environment and market trends.

“If you are posting Series A and pre-product market fit, don’t expect another round to happen at all until you have obviously hit product market fit. If you are pre-series A, the Series A Milestones we publish here might even turn out to be a bit too low. If your plan is to raise money in the next 6-12 months, you might be raising at the peak of the downturn.

Remember that your chances of success are extremely low even if your company is doing well. We recommend you change your plan,” advises Y Combinator. That is, your strategy depends on the type of startup you have and the stage it’s at. Remember that as long as the competition does not plan well, maintains high burn, and doesn’t realize they’re in trouble until they try to raise their next round. You can often collect a lot of market share in an economic downturn, simply by surviving.

How can you strategize to weather the downturn?

Keep it simple: Silicon Valley Bank advises that businesses should stay on top of technology trends; stay flexible in today’s fast-paced market. Also, have in mind the long (and fruitful) tail. This relatively new business idea, “the long tail” entered the startup vocabulary after the 2006 publication of a book named the same. The concept was to target many groups of individual customers rather than a few big groups of customers.

Enter the Internet. With the incredible access to information and purchasing power that the web gives us as consumers, things that people didn’t use to buy, or even find, they can now buy online at the click of a button. Therefore, use the long tail strategy and all the available tools to your advantage by advertising to the right people. Lastly, rally your troops but ground them in reality. Don’t lie if the hour is dire.

Moreover, the full impact of COVID-19 will not be known for decades to come, not in the industries of health care, education, etc. Now, we feel as though the worst of the virus is over, it also appears certain that an economic downturn is upon us. Coda advises that startups who find themselves burning through cash should: 1. Do whatever it takes to reach profitability. 2. Do whatever it takes to reach a certain amount of runway. 

First, getting to profitability is the most essential goal for a new startup in the difficult realm of recession. A profitable business stays in business, so reaching that point will be exciting and give you leverage. This way, you will never have to raise funds; you have the opportunity to walk away if you aren’t completely satisfied. However, maintaining profitability comes with the responsibility of hiring new energy and building slowly. 

“If you raised money from venture investors, then you are likely in a big market that can support a massive outcome. While you focus on profitability, it is almost certain that a venture-backed competitor will invest more aggressively. If they are competent, they will generate compounding momentum such as brand recognition and network effects. And if this competitor survives the recession, they will end up significantly further ahead.” (coda)

Another strategy is to reach a certain amount of money. As Coda said, they are planning for a recession of about 2-4 years. Make sure your management team is up for the task. “We have seen the markets recover in response to the stimulus package and the more recent news of the virus slowing down. I would love to believe that this marks the end of any crash, but the path from peak to bottom is often interrupted by false rallies. You could do whatever it takes to get to profitability. Or, you could do whatever it takes to get to a certain amount of runway. In practice, neither strategy is optimal,” they said. Still, it’s better to know the stakes and the tools you have available to help your startup be one of the successful few, despite the economic downturn.

For many startups, Coda thinks that this is the optimal strategy:

• Choose how much runway you want to maintain (e.g. 24, 36, 48 months).
• Every year, adjust your net burn such that your runway is always at this level.
• You can reduce net burn through revenue growth and cost reduction; conversely, you can increase net burn through faster hiring and more marketing.

In case the capital markets don’t recover after the downturn, you will not have to fold or take a down round. If you execute imperfectly, you will not have to fold/take a down round. In the scenario where the capital markets do not recover, you will not have to fold/take a down round. In the scenario where profit keeps increasing, you will be able to reinvest as much of it as possible back into your startup’s team and goals. 

“How much runway should you maintain? But be aware of this critical tradeoff: the shorter the runway, the harder it is to maintain that runway. If you choose 24 months, you have to reduce net burn by 50% every single year in order to maintain 24 months of runway. But if you choose 48 months, you only have to reduce net burn by 25% every single year in order to maintain 48 months of runway,” outlines Coda.

To ensure that you keep up with the fast-moving market and its changes, you might want to adjust net burn more frequently than once a year. Additionally, you can reduce net burn by cost reduction and higher revenue. Increase net burn through faster hiring and more marketing. You can fully control three facets of this equation: costs, hiring, and marketing. But revenue is still hard to control for most companies. Adjust your revenue forecast to use this strategy in the current recession. Most startups we know of are planning for revenue growth to be less than half of the previous estimates. Use the product/market fit score to help.

What are examples of success in a downturn?

Right when the economy started crashing down into recession, in 2008, Sandy Jen and her co-founders were on the prowl for a respectable series C funding round for their startup, Meebo. 

“Meebo was able to secure a $25 million investment, as Jen puts it, “by the skin of our teeth.” It was nothing like earlier raises. “We couldn’t just work on dreams,” she says. Investors demanded that Meebo commit itself to a hasty push toward revenue, a dramatic change after a few years of cushy creative product development. “If we didn’t make a business of what we were doing, we would go away,” Jen says.” (silicon valley bank)

Meebo is a sort of instant messaging and video chat provider. Startups in the technology industry would have been a very smart investment at that time (2008), thanks to the tech boom and a shift to digital, worldwide. Sandy Jen had to be very confident that her product was going to be feasible and attractive in the current market. It was, and it resulted in being a fantastic investment. She and the investors saw the value and decided to commit to making significant cash flow.

Overall, an economic downturn is obviously not a positive thing. However, when dealing with startups, possibilities can arise in recessions. Just as long as the product is a winner, and the founders follow the steps outlined in this article, there is nothing to worry about. Plan ahead hit profitability as soon as possible, and start growing using intelligent strategies. One person’s recession is another’s opportunity!