On May 24th, just five months into 2022, NASDAQ composite index, which is very heavily weighted towards the IT sector, was down almost 30% for the year. A couple days later Sequoia Capital — one of the most successful venture capital firms globally — came out with a 52-page presentation to its portfolio companies. The message is loud and clear — don’t expect quick recovery, forget growing at all costs, there are no quick-fix policy solutions that the governments could apply in order to reverse the negative trend over the short time horizon. High inflation, significant geopolitical instability stemming from Russia’s ruthless invasion of Ukraine, persisting supply chain challenges have brought us to this downturn and will continue to fuel it over the next months and possibly years.
If you are a technology start-up, you must be worrying. Your ability to raise capital going forward will be significantly impacted. Valuations are steeply down. Given the rising interest rates, the cost of capital is going up. Weighted average cost of capital (WACC) is one of the key inputs into the DCF (Discounted Cash Flow) valuation model, which is a popular way for the investors to calculate the present value of the company they consider investing in. The higher the WACC, the less your business is worth to investors, with all else being equal (your expected rate of growth, operating profit, etc). The most annoying part is that as a businessperson you don’t have any influence over the cost of investors’ capital. But the value of your business fluctuates wildly with the swings in the broad interest rates that directly impact the cost of capital.
Here is a simple example to illustrate. Let’s imagine your business today generates an operating annual profit of $1 million. You have $100K in capital expenditures every year, your expected growth rate is 12% a year, and 30 years of cash flow are assumed in the DCF model. The cost of capital for your investors is 15%. With these inputs, the DCF model sets the value for your company at $18.9 million. Should everything stay the same, but the cost of capital goes up from 15% to 20%, the value of your company to investors collapses from $18.9 down to $11.8 million. That's a 38% drop with absolutely no changes to the financial metrics of your business! That is totally unfair, you may say, but that is the reality of the broader economy in which we find ourselves in the middle of 2022.
So what do you do, other than cry yourself to sleep?
Here are some important things we want you to keep in mind in order to survive this downturn and position yourself for success in the future:
Put an extra effort into preserving your most important accounts. Hopefully, your most important accounts are not start-ups, as a lot of those will be going out of business given the macroeconomic conditions. Assuming you have some solid enterprise accounts, make sure you reach out to them. Relay to them with confidence what you’ve done to “weather the storm”, and give them every reason to believe that the SLAs they have with you will not suffer, and that you’ll do everything possible to maintain the quality of services they have been receiving from your company.
Make cash preservation one of your top priorities. Given you may not be able to raise funds anytime soon, it’s important to make sure you are as frugal as you can be with the money you have in the bank. All good start-ups are great at doing more with less. A decade of cheap and easy money made good founders either forget or not realize that in the first place. If your company’s practices do not reward frugality and have loose controls around expenses, now is the time to change this and do so fast. Unfortunately, this may also mean downsizing your team. If you have to do it, decide and move quickly and with great empathy to the people you have to let go. The faster you do so, the lesser the morale impact on those best performers you are keeping.
Remember, you are not the only one hurting. Many of your competitors are hurting too. The good news is that if you survive (and the chances are that a significant number of your competitors won’t), you will be positioned for spectacular growth during the good times, which will inevitably come. This is not the first economic downturn, nor is it the last. After bad times always come good times. That is the nature of economic cycles. It’s just always hard to predict the length of those cycles.
Focus resources on your differentiators. If there’s a cost-effective way to outsource parts of your solution, which do not make you stand out in the marketplace, do so. For example, a lot of solution companies in the IoT space spend tons of time building capabilities around ingesting and deciphering compressed data from the IoT devices. By doing so, they are essentially re-inventing the wheel. Using an aggressively priced third-party offering such as flespi’s telematics hub is a great way to optimize the back-end processing. Your development resources should be focused on the user experience and unique and tangible features that your customers love about your product. Not a single customer you have will ever appreciate how well you parse out that binary payload from a telematics device.
Difficult times lie ahead. But with thoughtful execution, streamlined operation and utmost focus on your customers’ needs and wants, your start-up will get through this and thrive for years to come. Good luck!
