After the longest bull market on record – almost 14 years – the NASDAQ reversed course at the beginning of 2022 and continued to slide for months, losing about 33% of its peak value. The M&A market fared somewhat better: Global M&A was down 27% in the first half of 2022 compared to 2021 but was still better than the 2015-19 cycle. Private tech company valuations declined a little in the first half of 2022 then declined a lot in Q3.
In the process, financing for tech companies froze quickly. In the salad days of 2021, tech entrepreneurs could demand financiers present their financing offers within a week, but in 2022, they stopped returning their calls.
What happened? Nothing unusual. The youngest cohort of tech entrepreneurs may have never seen frozen financing markets. But the Gen-X crowd lived through the real estate driven meltdown in 2008, and the Boomers painfully remember the dot-com crash of 2000. They will tell you that we are entering a typical financial freeze.
The Conversation Changes.
Venture capitalists have abundant “dry powder”, or funds not invested. Although they may be required to deploy their capital within certain deadlines, during financial freezes they become very cautious. Here is what happens:
- FOMO evaporates and is replaced by a deliberative, deeper due diligence.
- The financing cycle stretches out. If the company is burning cash, time is not on their side.
- Valuations decrease. Tech companies may not get the valuations they got last time, or expect to get this time, even if they have met their deliverables.
- Companies may not get financed at all.
This last observation needs context. When financial markets freeze, venture capital investors may start to triage: they continue to invest in the top 15% of their portfolio, but the other 85% may not receive further investment, even at a low price. It is the same story with new investments: the best deals will continue to get done, but the overall number will be much lower in frozen markets. All of a sudden, for most tech companies, the financial markets are closed.
Tech entrepreneurs can quickly and unexpectedly find themselves in this frightening scenario. So what should you do?
You are on your own. First, you have to accept the new reality. Assume that financing will not be available, even at a low-ball price. You have to make do with the money you have.
How Long Do I Have? Next, calculate your runway, or the number of months you have before the money runs out. Here is the formula:
- C = cash on hand in the bank
- AR = the value of the receivables you are sure to receive within the next 90 days
- AP = amounts you have to pay to suppliers
- GM = a conservative estimate of gross margin you expect to receive on the sale of your products and services each month
- Exp = the monthly costs of running the business
Then:
- Runway = (C + AR – AP) / (Exp – GM)
For example, if you have $10,000 in the bank, owe $15,000 and expect $20,000 to come in soon, and if you are earning $12,000 in gross margin on sales per month, and it costs $15,000 per month to run the business, then your runway is (10+20-15) / (15-12) = 5 months.
Your next moves and decisions depend on how long your runway is.
Cash Flow Positive. i.e., an infinite runway. If your company is generating cash, then you can maintain business as usual. No major changes are needed. But keep your eye on important customers and partners. Their performance may impact your business plans so don’t let a negative development catch you by surprise. If a competitor stumbles, you may be able to take advantage by stealing market share or making an acquisition at an attractive price.
Runway Greater than 18 Months. If you were smart and raised money up to 2021, you may be in the enviable position of having enough cash to last for more than 18 months. You don’t need to make major adjustments to your business plan. Be prudent – don’t begin new initiatives that will require months of new funding, such as major new development efforts, or entering new markets.
Runway between 6 and 18 months. Surprisingly, this is the worst position in which to find yourself. Running out of cash is not imminent so the need to make changes now may not be apparent to everyone. You have time to plan. Expect that changes will be required. Planning and execution can swallow up precious time. Communicating the need to act now may take some time.
You need “ruthless prioritization”, focussing on a smaller number of initiatives, and doing them well. Start with the product roadmap. Prioritize the features that customers want to buy now. The shortest path to revenue is always the right one. Delay or eliminate the projects that may complete a new release in favour of incremental changes that customers want. Customers will wait for a new release. Accelerating revenue is the priority.
Next, look at sales and marketing. The emphasis must be on sales, sales and more sales. Move marketing people into sales. Sacrifice product management and brand building, for example, to focus on closing new customers more quickly. Focus on finding new customers within the same market segment because you will likely close them faster than attacking a new segment which takes longer.
This is also a time to make the personnel changes that you have been putting off. A smaller, stronger team will accomplish more than a larger team with poor performers.
Ruthless prioritization. Less is better. Focus on the near term.
Runway less than 6 months. In this scenario, you are in a desperate situation. Survival is the only objective. While frightening, the situation is in some ways liberating, since the options are few and the tasks are clear. There is not a lot of uncertainty about what to do.
First take the actions suggested above in the 6 – 18 month scenario. Then there is more: micro-manage the cash: ask your accounting team to develop a weekly cash flow projection with the payroll, each receivable and payable posted, plus a forecast of the cash position at the end of the week. Manage this daily. Pay only the payables that are absolutely required to continue operations. Tell your other suppliers the truth, and work out a payment plan if you can. Most suppliers will, surprisingly, be amenable. The truth is always easier to manage than the fog of no information.
Slash the payroll. Keep only the people that are required to ship product or sell to customers. You may have to start with a blank page and add back employees one at a time solely if they build or ship product. Add a bare minimum of admin people. You may be able to add only a few developers in customer service. Err on the side of cutting too deeply. Saving a dollar too much is better than running out of money a week too early.
Reduce compensation for everyone else. Start at 25%.
Be aware that many of your people cannot perform in this environment. When they have been growing and building for their entire career, a sudden shift to penny-pinching survival mode may not be possible. Those people may have to go too.
Fully Remote Option. You can really cut costs by sending everyone home to work online, and sub-letting the office space. Your expense load will shrink and your team will become more efficient. There is a brilliant example in eXp Realty, a real estate brokerage firm that survived the 2008 financial meltdown by going totally virtual and now generates about $5 billion in revenue and employs 85,000 agents worldwide.
If you do all of these things, you may extend the runway for a few more months during which you might land enough incremental business to reach breakeven.
Sell the Company. Even if your company is not making money, it may have developed something of value. Successful development of one of four pillars of successful early exits:
- Intellectual Property;
- core competencies in a narrow but attractive niche;
- early validation by industry leaders; and,
- market traction in a narrow but attractive niche.
may be enough to attract the interest of a strategic acquirer. They may be looking for a product, technology or market segment that is easier to acquire by buying a company already there. Acquirers are more active during contractions as financially struggling companies with something to offer might be available at lower prices.
If you go this route, be aware that a fully-marketed exit transaction takes 6 – 18 months to complete. If you decide to sell the company, engage an M&A advisor as quickly as possible.
Start Now. As of now, tech entrepreneurs should assume that the financial markets are closed, and they will have to survive and thrive without any external financing. This may require some abrupt changes of strategy and plans, and making hard decisions about who and what to keep or let go.
Don’t make the mistake of waiting too long to act. The best time to extend the runway is yesterday.