After the dotcom bubble burst at the turn of the millennium, many startups disappeared overnight. For this, there are number of reasons:
- For the really early stage companies, seed money dried up.
- Some companies had crazy valuations despite having no turnover, let alone profit.
- “Raise, raise, raise” was considered a viable business plan.
- Companies with extensive debt around the business had that debt called in.
- Staff, even founders, simply had enough of the space. Or their once lucrative packages become worthless.
The financial crash of 2008 created a similar situation, although less so for a startup world that wasn't as noisy as it is now, where technology is the predominant growth industry.
Let’s start with the cash issue. In the early 2000s, venture funding dried up – it may have been gradual between March and September, but eventually there was a proper ‘drop off the cliff’ moment.
There are still plenty of companies with very little cash in reserve that have built a business based on crazy valuations. I remember at one point in the noughties a group of investors I was involved with paid $1 for a company that had been invested in up to $120 million. This may sound small by US standards, but the company had done everything except make a sale and had risked an exit for investors based on market hype. When the market went into recession it was left pretty much worthless very quickly, so timing is everything.
Even listed companies were not exempt from going bust, just look at Commerce One. In the UK there was a company called Infobank, £2 billion market cap on AIM, it was rebranded as Izodia, sales dried up, staff left, and the company disappeared.
Be prepared, even if you feel it's too late
In most cases we do too little too late, even if we see a downturn coming. My job as an advisor is to be the boring or difficult one who sometimes bangs on about a contingency plan if things don’t pan out as expected, whether than be a downturn or weak sales targets. This can often come across as a dissenting voice in the room, especially in an industry as predisposed to sunny optimism as technology, but it is a necessary one.
Operating loss companies are the ones that find life very hard indeed during the downturn, so draw up that plan B today. You need to weather the storm, it's pretty simple.
How are VC’s and investment affected?
The cost of capital increases in a downturn due to higher risks. Venture capital firms typically raise funds once every 1-2 years. When a downturn becomes long, then the high-reward, high-risk VC funds are less attractive to investors. This shrinks the pool of available money, meaning VCs find it a lot harder to get hold of that capital, which means less for them to invest into startups and, what they do have to invest, will be done in a very different, probably more cautious way.
This means startup valuations drop and equity demands go up, which rewards more proven startups with experienced entrepreneurs and teams.
If you do raise, or have just done?
Hold onto that cash. Whatever the plan was, revisit and make sure cash is king to you for a period of time. If you have access to other funds being raised as well, in most cases I would say get hold of it. Don’t assume an offer today is still standing next week or next month.
When 18 months is not all the same
So general history shows that a recession is usually an 18 month period. For some VCs, investors and entrepreneurs, the next one will be their first. The good news is, while it can still be a bit of a roller coaster, it generally reaches a major bad point and then starts to slowly recover back. So when doing your contingency plans, always keep this sort of timeline in mind.
Anti-dilution protections and downrounds
Bear in mind that you may have to use the dreaded “downround” term in a recession.
A lot of entrepreneurs sign anti-dilution clauses, especially with VCs. So if the investment is done at a lower valuation, those who had preferred shares, end up with more interest in the company, to the detriment of founders, other shareholders and employees. I have seen employee stock options become worthless in these cases.
With this in mind, make sure you have a good handle on your cap table and model ahead of time for future rounds where clauses are becoming active.
Then, with employee stock options, once you have done the models above, you may want to take a look at key employees and how best to keep them focused during hard times. Remember: most employees use stock options against a 1-4 year period of salary expectations. Don’t make the mistake I saw during the dotcom boom, where staff jumped ship because no one ever thought about a plan B.
Get close to customers
Yes, product fit is always important, especially when you are a B2C company, so make sure you understand how your consumer values your product.
In the case of B2B, for me, it's about making sure your people really understand your clients. I would go as far as using a Red Amber Green (RAG) status against clients and really sure up those relationships as soon as possible.
Honestly, I can tell most founders to go away and look at costs and say they will find it nice to have non-people costs. They usually go screaming and shouting but you would be amazed how many “nice-to-have” costs companies can lose.
There are opportunities
Office space becomes cheaper in a recession, living in major cities becomes cheaper, staff become cheaper. I always say to companies: your competitors may disappear. In fact, if you're a well-funded, later stage company, you may end up buying them out.
One of the best pieces of advice I can give is communication. Staff get worried in a downturn, but you would be amazed how tolerant they can be.
Founders: don't leave them to make their own assumptions. Communicate with them clearly, honestly and regularly. Don’t hide the fact that their job may go if it gets really hard.
Then you have shareholders. They are not dumb. They have most likely been there, seen it and done it. Lean on them, get them involved if you have to.
I have been through this – it even made me bankrupt at one point – but you can see the experience as a good thing by the end of the downturn period. It clears out a very noisy space and makes people calm down a little. If it's your first time, yes it's scary, but it gets better, and you will be prepared better for next time.