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August 1, 2022

Seeing Through the Clouds: How Startups Can Navigate a Market Downturn

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During a long period of economic growth, huge influxes of capital, and a vibrant IPO market in the 2010s, entrepreneurs became accustomed to a stable and generally favorable environment. That has all changed now, starting with the pandemic, and extending into geopolitical upheaval, falling equity markets, supply chain disruptions, and spiraling inflation.

Today’s volatile economic and financial environment carries many implications for startup companies. The first is the likelihood of slower revenue growth or even a decline in revenue. We expect a change in the demand environment, even for products and services that may be considered mission critical. That is because the customers who buy from startups will themselves be expanding at a slower pace, or even contracting. If a recession does occur in 2022 or 2023, companies of any size and in any market are likely to experience the consequences.

Particularly vulnerable will be startups attempting to create a new product category requiring customers to change business practices or carve out new budgets. Companies with business models that rely on recurring revenue streams, such as SaaS, may retain customers but sell fewer seats.

Startups also may confront a changing hiring environment. Every company is different and will have its own experience with talent acquisition, but some prospective employees may perceive more risk in joining a startup during an economic downturn. A startup that cultivates a strong culture built on a compelling mission and focuses on building value will continue to attract and retain talent.

Could it be time to start a company?

Despite the cloudy outlook, there is a potential positive: now actually could be a good time to start a company. Venture capitalists and other equity investors are putting less money to work, meaning a smaller number of companies will get funding in a particular market space. And less competition increases chances for success.

We like to invest in next-generation players where there’s an incumbent vulnerable to disruption. That’s because a first-generation company has already gone to the trouble and expense of creating a market or product category that customers understand and for which they have allocated budget. But many customers could be unhappy or only partially satisfied with these market trailblazers given they’re the only provider. A disruptive startup may have the opportunity to target an underserved niche, hit a different price point, or find the soft underbelly of the incumbent. It’s a lot easier to be the replacement vendor for an existing budget than to create a new category, carve out a new budget, and instill new behavior.

Perceptions of valuation can change

Perhaps the biggest impact we see from today’s volatile environment is on perceptions of valuation. The experience of startups over the past two decades is now history, and expectations must be adjusted.

Some startups still believe that their last-round valuation was a floor and expect a multiple of that in the next round. But sometimes a flat or down round just may be the reality, and in those cases we will be OK with it. Rather than prescribing a valuation, we believe in letting the market decide.

Setting valuations for private companies is always more of an art than a science. In contrast, public companies are marked to market, so they have a more realistic view of their value.

We’re recommending that young companies extend the runway to allow more time before seeking the next round of funding or planning an exit. (My colleague Scott Beechuk and I shared our views on “Increasing Runway Without Sacrificing Growth” at the SaaStr Annual 2022 conference.)

How to respond to the current market conditions

What should founders and would-be entrepreneurs do in this environment? Here are several suggestions:

  1. Sharpen your competitive differentiation and value proposition. It’s more important than ever for customers, prospects, and investors to clearly understand why you are uniquely qualified to take their money. If you can’t crisply articulate a compelling reason to buy, seek advice on honing your strategy or message.
  2. Revisit your near-term operational plans. Most companies succeed or fail based on go-to-market execution. The best product doesn’t always win, but the best go-to-market strategy and execution usually does.
  3. Set realistic goals for funding. Collaborate with your current and potential investors, as well as trusted advisors, to objectively evaluate the best approach, as to both amount and timing. Don’t prejudge valuations.
  4. Approach potential capital investors strategically. Understand their areas of focus and tailor your messages accordingly. Use personal contacts as much as possible to identify the people you want to reach and to understand their interests.
  5. Engage with your investor partners. The best investors are long-term business partners who can provide you with much more than capital. You should use them to make valuable introductions, offer advice based on operational experience, help bring you into deals, and provide an experienced and independent perspective on funding strategies.
  6. Do scenario planning. Work with your leadership team and trusted advisors to envision possible downsides and alternative responses. Identify signals in the market that would suggest the need to change strategy or tactics.
  7. Manage finances carefully. Identify spending variables and hold back on them until you see how your business is doing and what’s happening in your marketplace.

Don’t give up

Turbulent or even recessionary environments are a time to be cautious and thoughtful, but they are not an excuse to give up. Startups that apply discipline to their spending, focus on their competitive differentiation, and rely on their investor partners will have a higher probability of weathering the storm and emerging stronger on the other side.

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