Options for very early stage startups during a downturn

The past few weeks in the startup ecosystem have been challenging. From massive layoffs to hiring freezes at places like Facebook (I mean, Meta) and Uber, to markets being down while inflation and interest rates rising, it feels like we’re at the brink of what could be a long couple of years.

I’ve been tracking what I’ve felt is a way too frothy environment for quite a while. The startup Fast is the easy scapegoat here, having raised hundreds of millions in funding with a how-is-this-even-possible low “six-figure revenue total in 2021” according to Techcrunch. But the funding market didn’t stop there, I’ve had both first hand knowledge as well as anecdotal reports of hundreds of startups raising huge rounds at high valuations despite little to no revenue traction over the past couple of years. This tends to happen in hot markets, and I’m not going to dwell on what we could have or should have predicted two years ago. If you were able to raise money and were able to do so at a crazy high valuation – congrats – consider yourself lucky timeline wise. But to set the tone for this post I’d like to focus on what is likely the new reality.

What the short to mid term market likely looks like

I fully expect the next few months at a minimum to be slightly chaotic. It’s hard to make predictions on the market, and I won’t attempt to do so – but I’ve prepared my team for 18 months of potential bumpiness. Anything less than that will be welcomed, obviously, and anything longer than that and we’ll be prepared. I’ve been through two downturns – both as an employee and founder in the tech space. My first experience was not good – I was laid off at the end of a long round of layoffs in the dot com boom. The second experience was better. I successfully navigated the 2008 downturn while running my own product development company, and then moved to a larger agency where we accelerated growth during the recession, eventually selling the business a few years later. Today’s market feels similar to both previous downturns, but closely aligned to neither of the downturns I’ve experienced.

Today’s market feels similar to both previous downturns, but closely aligned to neither of the downturns I’ve experienced.

Craig Zingerline, Velocity Growth

On one hand, the crazy valuations and easy funding plus the speculation that we’ve seen in the Crypto space plus the shocking lack of diligence done on early through growth stage companies with funding rounds from 2020 through early 2022 feels a lot like 1999 all over again. On the other hand, we don’t have the same macro issues we had in 2008 with the housing market in the USA. But we are facing global issues going on at the macro level (war, inflation, interest rates) that I believe will put us closer to 2008 than we’d like to be. Add the fact that the summer is about to hit when things across most industries slow down and we are likely looking at a summer very unlike 2020 and 2021. As such, we should be as prepared as possible.

Before diving into how I’d approach this episode of the market, I wanted to share a recently leaked email from Y Combinator – arguably the most influential startup accelerator in the world. I’ve pasted a screenshot of it below:

I also came across a really straight forward and pragmatic talk that David Sacks and the Craft Ventures team gave in early May that I thought was fantastic for providing both context about what’s happening as well as ideas on how to manage through this potential downturn. Here’s a tweet referencing his talk:

https://twitter.com/craigzingerline/status/1525644173851901953

Finally, I want to share one more article – this one from Sequoia (you need an Information account to read the whole thing…but I think we get the point…).

It’s daily now that I’m seeing doom and gloom reporting everywhere.

Before we move to options to consider if you’re a founder in this market, I wanted to point out one other thing. So much of the focus of these articles I’m seeing (mostly by VC’s) talks about how you mostly need to look at staying alive as a company while you wait out your next round. But what’s not often said is that there are other consequences at play in a down market.

1. Some of your peer companies could go out of business if they can’t raise and can’t get to profitability. This will have emotional and potentially financial impacts.
2. Some of your clients may go out of business. This could have a material impact on your ability to monetize, and will vary greatly by what industries you serve.
3. If you are providing a nice to have but not must have product or service, expect your users or clients to take a closer look at the value you provide. Find ways to provide more value for the money you charge.
4. Your team may get nervous, but it’s your job to clearly communicate with them to make them aware of how you are thinking about and approaching this market. So many founders put revenue pressure on the team – but revenue is a lagging metric – so figure out ways the team can dig in deeper to provide more value, but look at leading metrics and own the stuff that you know leads to revenue.

Ok – all of that aside, I think now is a great time to build if you can stay solvent. As such, I’ve put together some thoughts on how to navigate this stage that we’re in. Hopefully you find some value in this, or that it at a minimum gives you some new ways to think about where we are at right now.

Options for founders and startups to consider

I’ve attempted to provide some guidance below based on use case. This is not meant to be binary, there is no easy path in any scenario, and some of this may or may not make sense for you and your startup. But I wanted to provide some ideas based on experiences I’ve had during downturns. There likely are more options available than you may think.

This guidance is meant for very early stage startups, but could be applicable to slightly later stage companies as well. My assumption is you have fewer than 20 employees and that you didn’t over-hire to the point where you are already in panic mode. With that aside, let’s dig in.

Startup: Not yet profitable

This is likely the most common scenario for most of us. The vast majority of startups are not yet profitable, and the ones who are likely are barely putting money in the bank. If you are bootstrapped you likely have a slight advantage since you likely have been controlling your burn and only growing the team and increasing expenses when you can afford to do so. If you raised capital, you likely are pulling money out of the bank each month, based on your team size and expenses.

First, the common advice going around is that if you can raise money immediately to increase your runway, do it. But I’m seeing some crazy stuff happening – founders of tiny companies giving away a ton of equity in a down round, VCs pulling out of rounds after saying they’d commit, investors being super opportunistic and not founder friendly, trying to adjust terms on the fly.

My guidance here is that if you have to raise money and you have the ability to do so right now then you should do it – unless you’re going to get crushed on the terms. More on that below. But if you are a tiny startup still, have some revenue, and have some marketable skills – I’d consider what your other pathways might be. Can you drive more revenue and can you get in front of your P&L needs? How long will it take you. Here are some questions I’d think about:

1. Can you pull in a side hustle and reduce your own pay?
2. Can you rally your team around doing billable work in your industry or in a related industry to bring in additional capital short to mid term as a series of one-off projects or engagements?
3. Can you bill out part of your team while the other part focuses on the core business?
4. Can you pivot short term as a team and find a larger company in your industry that is hiring for some of the roles you could fill, and get your skills in front of them?
5. Can you renegotiate your office space terms if you have one / what other big expenses do you have options to remove?

Ask yourself if these are viable options and if they are better or worse than taking terrible terms in a down round. Just like a product or business model may pivot, sometimes we need to make hard choices along the journey, and pivoting to simply provide a means to an end is the best option.

Why bad terms are bad

The thing founders and teams often forget is that while their bias is towards keeping the company afloat, and they have a fiduciary and moral responsibility to do so, when you get taken advantage of in bad markets, the likelihood that you’ll have a successful story in 3-5 years goes down dramatically? How? Look at the terms you’re agreeing to and think about what that means upon exit. And unless you’re building a lifestyle business (nothing wrong with that, by the way) you’re likely playing this startup game to go for an exit.

I’ve had a couple experiences raising capital in down markets and doing bridge “down” rounds. In those scenarios, the “not amazing” investors universally seem to double or triple down on their liquidity preferences when things get really rough. This means that in normal times, the investors get 1x their money back before anyone else does. That’s what you usually sign off on when you raise capital. But in a down market or when you are struggling, you may be presented with “liquidation preferences” from the investors. I’ve seen these as bad as 3 or 4x – meaning if you sell the company these investors get paid back up to 4 times over before you see a dollar. Needless to say, usually early stage angel investors and advisors get crushed in these scenarios along with the founder. These are the investors, by the way, that I’d never work with again. If you’re an investor and you’re doing this to your founders, just know you likely will become known as a bad seed, overly aggressive, opportunist, etc.. It might be great business for you, but it’s not great for anyone else, and the startup world needs more supporters, not detractors.

Now, as a founder this view of a down round may seem extreme. For you this may not be a massive issue since you probably have a major equity stake, but for your team who has much smaller percentages of ownership, it can be the difference between them building liquidity and not on an exit. Think about the tradeoffs you’re likely making your team make as you (probably) pay them under market salaries now, and then eat into their liquidity if you choose to accept bad terms. For your team, you need to think about this set of tradeoffs and understand what you’re getting into.

If you have the ability to pull in revenue by doing things that don’t scale – consider that as a viable option. At two of my startups we’ve done service work to pay the bills while building out the product. There is nothing wrong with diversifying your revenue streams. If you’ve done your job as a leader to be transparent about the pros and cons of your current scenario, it’s likely your team will get behind whatever decisions you make. Lean into this.

If you can’t raise money right now and you can’t monetize services (which I’d be shocked if you can’t…if you were able to build a startup you can probably sell services for a while to pay the bills) then you need to completely own your P&L model to forecast what the next few months looks like, and you need to preserve as much capital as you can.

This may mean that you are faced with either a layoff scenario, a salary and expense reduction scenario, or some combination of the two. This is a terrible place to be, but given over 90% of startups fail, you are not alone. (If you need to chat about this and are under stress, feel free to reach out to me and I’ll make time to chat.) I’ve again been on both sides of this – I’ve had to let people go and I’ve been laid off, and those are two of the worst days you can have as a founder or early stage employee. But as a founder you need to make decisions around what is best for the viability of the company, so be prepared to get to this point if you exhaust your other options.

If you do have to make cuts, please talk to someone who can coach you on the process if you have not done it before. Make sure you have someone you can talk to from a mental health standpoint as well, as this is a very lonely spot to be as a founder. Be fair, be decisive, and do not look at startup failure as a personal failure. Again, 90% of startups fail at some point, and a downturn a very tough thing to survive as a startup.

Nontraditional options for funding your startup

That morbid piece aside, there are a few other ways you can deal with a downturn if you can’t raise capital and you can’t monetize services and you don’t want to downsize the company in an extreme manner.

1. You can cut pay across the board (starting with yourself and your partner(s) and anybody else who can voluntarily go without pay or go on reduced pay. Use your discretion but there is nothing wrong with crafting a side deal with one or more team members who have flexibility where they move to a reduction in pay in exchange for more equity in the company – likely eating from your founder or founding team set of options to be fair to the rest of the team. If you can do deep enough cuts perhaps you’ll survive, and if you can continue to produce more revenue as times goes on, you may find this to be a short to mid term solution.
2. One of your co-founders takes a leave of absence without pay and gets another job, and helps fund the company short to mid term. Again, this is unconventional, but if you have more than one founder, this could be a viable option short to mid term. If you think about the average tenure of most startup employees being somewhere between 1.5 and 3 years, having a co-founder move the startup to side-hustle status and potentially put money into the company to help sustain it while having another job might be a viable option.
3. Review options you have to drive more recurring and more stable revenue. Relentlessly focus on this.

Startup: Profitable

If you are profitable and running a startup, congratulations – you have done what so few are able to do. I believe in this market, profitability is going to no longer be seen by investors as a “lifestyle business” environment and instead will be seen as a new baseline way to run a startup. Frankly, if we can be smart enough to not forget this in an up market as well, the whole startup ecosystem would be better off.

99.9% of startups out there do not need to blitzscale their way to a zero sum scenario where they are the only winners – that’s total BS – there is almost always room for competition, and competition is healthy. But unfortunately, we’ve been trained to equate fundraising total with running a good company, and the two are completely mutually exclusive. You can be a terrible leader and company who raised a ton of capital, and you can be an amazing leader and company who simply can’t raise capital for whatever reason. While I am in no way against raising capital (we’ve done so ourselves at Velocity Growth), I am against too aggressive hiring, too high of a burn, and pushing growth before some sense of product market fit or at least an indication that you can monetize whatever you are selling.

My guidance to founders who are running profitable companies is to keep an even closer eye to your P&L in this market, and try to anticipate where the challenges will be during a downturn. What consequences of a down market may impact you now that didn’t impact you a few months ago? Can you get ahead of this?

Non full time founder working on startup

If you have a full time job: keep it! I can’t tell you how many founders I know regret not saving enough capital to give themselves enough runway to do their startup full time without stressing 24/7 about paying the bills. If you are in a spot to have a job and start your startup on the site, now is a great time.

VCs and investors who tell you that you have to do your startup full time are wrong at least until you decide to raise capital, at which point it’s very hard to raise while holding down another job. But that doesn’t mean that your co-founder can go full time and you keep your job. Or you keep your job and you co-founder becomes CEO to raise money. Talk to other founders that you know and ask them how their personal situation changed for the positive and negative when they decided to jump into startup life full time, and see how that resonates with your goals.

Most of the startups that I have founded have started as a side hustle, and a couple of them have gone on to later get to product market fit and even raise capital. This is a very good option if you have the flexibility to work on the startup while getting paid by an employer.

The good news

There is still a lot to be excited about. Yes, markets are down, but look at the ride the last 2 years has been. It’s not really realistic to have a market that goes up and up and up and never resets. I personally feel like the past 2 years was way too frothy – at least if you were a founder who had connections and could pitch a crazy vision for your startup. Never was it easier to raise money for some in the market.

But a downturn will likely normalize the startup building process. This includes presenting opportunities to startups who have a strong focus on sustainable growth, a good leadership team, and a strong path to revenue growth. For these companies that make it, once the market starts picking back up again – and it always does – they’ll be able to accelerate faster than ever before since what goes down must come up.

Good luck out there.