I remember the day in 2008 when my bank called me and asked for a meeting. I was running a startup that was gaining incredible traction—until 2008, that is. My startup was focused on the construction industry. The bank gave me notice on our line of credit; we had 30 days to pay back the money that had been covering the majority of our expenses.
In 30 days, we also had no way to cover payroll. And guess what? No one was lending. The venture capital community was being highly selective, angel investors were toast, and corporates were worried about bigger things than innovation. We ended up selling our business to a much larger company. They got a great deal. We were lucky because we had customers and revenue that made the sale possible; many other startups did not fare so well.
The economic downturn taught me a lot about keeping a seed-stage startup afloat in tough times.
As a seed-stage startup, It’s important to understand what happens to capital sources during economic downturns. So let’s walk through what the capital sources were telling me.
The venture capitalists had dry powder. They had either money in the bank or committed capital. However, they were in no hurry to invest. Their limited partners were not pressuring them to deploy capital. They could afford to wait and see how companies were progressing in order to get the best buying opportunities. As long as the VC firm didn’t have a high percentage of corporate LPs, that is. Venture capitalists request capital from their limited partners as needed, and during economic downturns I’ve seen corporate LPs miss their capital calls. This means that they didn’t meet their commitment and therefore forfeited the funds they’d committed to date. It’s bittersweet for the VC, because they get free money but they also have less dry powder.
Angel investors deploy their extra capital into startups. They were, of course, in panic mode. They watched all their other assets drop in value. Keep in mind: most angel investors are rich, but they aren’t billionaires. The majority are rich enough but only have extra capital to deploy when times are good.
Not that startups are able to take advantage of debt during the seed stage, but nonetheless, banks were not returning phone calls. They make a flight to the most conservative clients during tough times.
When times are good, corporates have innovation departments. They make strategic investments and can be a great partner to a seed-stage startup. During tough times, the strategics are focused on EBITDA (earnings before interest, taxes, depreciation, and amortization) and not revenue. Wall Street will give them a pass on growth objectives and they will take that pass whether they actually need it or not, and freeze most investment/acquisition activity. Likely, the innovation and CVC teams are cut. I saw large companies pull back just because of the optics to their investors. And as mentioned before, I also saw large corporations miss their capital calls to venture funds.
So, if you can’t get capital from any of the usual sources, what’s a seed-stage startup to do? Short answer: get cash from the customers.
An economic downturn can actually be a good thing for a startup solving real and important problems. Almost every great technology company has flourished during a downturn. Here’s why: for a startup, most of the friction of product adoption comes from customers being set in their ways. Whatever problem your product solves, the customer has likely already been solving it. In an inefficient manner, most likely—but still solving it. Changing behavior is always a big challenge.
During tough times, your customer is laying people off and the pendulum swings. Instead of having room for inefficiencies, they are now under-resourced. The friction of adoption is now lowered. Also, your customer understands that they may have to pay upfront because you as a vendor know that they are probably cash-strapped. Oh, and that competitor that didn’t have a “path to profitability” plan but had the massive trade show booth at the last conference—they are now out of business. You have less competition. This is exactly what happened to me. We survived a year longer than I thought we would because our contract values with two large companies doubled and they paid upfront. I still do a lot of business with one of them.
Now that we know where we can get some cash, where can we save some cash?
Call all your vendors and re-negotiate. There are some areas like rent that are very driven by the cycles of an economy. A landlord would rather have some rent than no rent at all, so they might cut you a deal if they believe you’re at risk of not being able to pay. Talk to your consultants and have a real conversation about your cash flow challenges and how they can help. Honestly, this is where working with large firms is beneficial. They can make concessions. A freelancer can’t really do much for you.
I am not a believer in pay cuts. If you need to get your payroll in line with the new norm, you cut staff. However, during a downturn, it is fair to re-negotiate incentive plans. The supply of labor will increase and drive down the costs of labor. These are very difficult conversations to have with employees. For an employee, their options become limited and the right incentives to make it up when the market turns around may be better than them getting another job elsewhere. It’s tough times all around, so an employee may be better off sticking with what they know. As an entrepreneur, hopefully you have been transparent with your team about cash flow. If you haven’t, then now is the time to start.
If you can start to grow again, the talent you can acquire will be amazing. On a part-time basis, I hired some very skilled people who were out of work. That left them time to look for a new job and generated some income for them while they looked. And, as things rebounded on my end, I had the option of hiring them full time.
This knowledge of capital sources and startup survival during an economic downturn can also be useful to an investor.
I have been investing in startups since my first exit in 1998. In tough times, you really see the grit in an entrepreneur. You notice the people who can truly operate a business in a financially responsible way. It’s also the time when your entrepreneurs need you most; they need your operational experience more than ever.
And the investment opportunities are great. During good times, a down round is a signal that the entrepreneur might not be an efficient consumer of capital. During tough times, a down round is driven by the scarcity of capital in the market. Valuations get a little softer, and the deal flow increases.
As the market stabilizes and the corporates begin to look for growth, they will struggle to do so organically. Since they cut back during tough times, their product pipeline is thin, and revenues have been flat. They will start to acquire revenue and products to execute on their growth. Also, things never turn around efficiently. There will be some “head fakes” that the economy is getting better. Those are great selling opportunities.
And voila, they start buying your startup investments.