#124 - Winter Is Coming

How To Survive A Downturn

May 22, 2022

Hi👋 - Things are getting chillier on Wall Street and in Silicon Valley. With the Nasdaq in a bear market and growth slowing, an increasing number of tech companies including Facebook, Netflix, and Salesforce are pulling back on hiring. Cycles are nothing new. Today, some advice on how to survive a downturn. Thanks for reading.

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Cycles Happen

Hiring is now a privilege in tech1. Citing shifting investor sentiment, on May 9th Uber CEO Dara Khosrowshahi sent an all-company email saying that Uber needs to slow hiring, reign in marketing, and start generating free cash flow. Uber isn’t alone. In April, Robinhood laid off 9% of its workforce. Netflix is cutting too. So is Carvana. Facebook, Salesforce, and Wayfair are slowing hiring and it's rumored that Amazon’s retail division will follow suit. Google searches for Layoffs.fyi, a site aggregating startup layoffs, are skyrocketing.

Source: Google Trends. Layoffs FYI search term.

First quarter earnings reflected slowing growth and heightened uncertainty (war, inflation, interest rates). Recent stock market volatility is churning investor’s stomachs. After a decade-long bull run, things are slowing down in tech.

The transmission mechanism of slower growth moves from public markets to private markets. Late stage privates are already digesting this new environment. In March, grocery delivery firm Instacart slashed its internal valuation from $39 billion to $24 billion. It’s rumored that buy-now-pay-later company Klarna is raising a down round. Barring sudden macro improvements, this pain is likely to filter down to smaller startups.

Cycles are normal. Economies expand and contract. There are bull markets and bear markets. Inflation vacillates from hot to cold. Mr. Market is manic depressive. Yet we’re hardwired to extrapolate. Pain occurs when these two facts collide. The risk of long runs is forgetting about cyclicality. Since history repeats, it's helpful to see how investors and operators dealt with past downturns.

Bubble. com (Howard Marks, 2000)

Valuations untethered from fundamentals. Unprofitable companies raising boatloads of money. Investors giddy about new technologies. A surge in retail investing. Sounds a lot like 2021 or 1999, but it’s actually describing the South Sea Bubble of 1720.

Howard Marks, cofounder of Oaktree Capital Management, has a deep appreciation of history and market cycles. While technologies and companies change, human nature doesn’t. Consequently, speculative manias share behavioral characteristics regardless of whether the asset involved is tulip bulbs or tech stocks. Marks wrote Bubble.com in January 2000, but it sounds current. History rhymes. Ignore it at your own peril.

Bubbles are often spurred by the idea that a new technology is going to change the world. The most dangerous words in finance are, “this time is different.” Earth shattering new technologies can still be a lousy investment. According to Warren Buffett2:

The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.

A century ago, radio was the sexy new technology. Wireless communication enabled new forms of home entertainment, advertising, and broadcasting live events. The Radio Corporation of America (RCA) was the hot tech stock of the 1920s. RCA’s stock went from $8 in 1927 to $114 in the middle of 1929. Over the next three years, it fell below $3 amid the Great Depression. Twenty-five years later, it still traded under $40. Automobiles and airlines are other examples of world changing technologies that haven’t produced stellar returns. A stock can be 90% off its highs and still not be cheap. Marks’ sobering case study is a reminder that valuation matters and that the BTFD strategy doesn’t always work.

Vintage Advertising: RCA's 1920s Radios | The Saturday Evening Post — The Saturday Evening Post, Vintage Advertising: RCA’s 1920 Radios, June 4, 2017.

While greed and FOMO are powerful magnets, Marks (like Buffett and many other investing greats) believes the darkest times produce the highest investment returns3:

In my experience, the big, low-risk profits have usually come from investments made at those times when recent results have been poor, capital is scarce, investors are reticent and everyone says “no way!” Today, great results in venture capital are in the headlines, money is everywhere, investors are emboldened and the mantra is “of course!”

RIP Good Times (Sequoia, 2008)

Amid the Financial Crisis of 2008, Sequoia shared a deck grimly titled RIP Good Times with its portfolio companies. It provided tips for founders on surviving an economic downturn. The medicine is tough, but simple: cut expenses, scrutinize growth assumptions, and move quickly. Spend every dollar as if it's your last. Above all, become cash flow positive.

Source: Sequoia, R.I.P. Good Times, 2008.

The name of the game is survival. Most companies react too slowly in cutting expenses. Budget cycles are typically annual and refreshed quarterly or semi-annually, creating operating interia. During a crisis, Sequoia recommends throwing budgets out the window. Founders should scrutinize hiring plans and salaries, tighten up marketing ROI thresholds, reassess the probability of closing deals in the sales pipeline, and take other actions to preserve capital.

About a decade later, Sequoia followed up on RIP Good Times with a note to founders and CEOs about ensuring business health during the Coronavirus pandemic. The themes are similar, with Sequoia pushing founders to question their assumptions. Do they have as much cash runway as you think? Where is there fat to trim? Could they survive for 12-24 months without fundraising?

Similar to 2008, it suggests calibrating expenses to more conservative assumptions. Reigning in customer customer acquisition spend (LTV can decline during downturns). Scrutinize the revenue forecast and sales pipeline. Reconsider capital spending. Avoid false optimism. Lastly, do this quickly4:

Having weathered every business downturn for nearly fifty years, we’ve learned an important lesson — nobody ever regrets making fast and decisive adjustments to changing circumstances. In downturns, revenue and cash levels always fall faster than expenses. In some ways, business mirrors biology. As Darwin surmised, those who survive “are not the strongest or the most intelligent, but the most adaptable to change.”

Default Alive or Default Dead? (Paul Graham, 2015)

Paul Graham was an entrepreneur during the first dot-com bubble and later founded Y Combinator (YC), an accelerator for seed startups. His essay Default Alive or Default Dead? should be required reading for all founders and CEOs.

A business that is default alive can achieve profitability with its current expense base and growth trajectory. It’s self-sustaining. A business that is default dead can’t.

Graham was shocked that most founders he knows don’t know whether they were default dead or default alive. Asking this question too soon is like asking a toddler what they plan to study in college, but Graham's bias is asking sooner rather than later5:

It's probably not that dangerous to start worrying too early that you're default dead, whereas it's very dangerous to start worrying too late.

The answer to this question dictates everything that comes after. A business that is default alive can plan on doing ambitious new things. A business that is default dead needs to focus exclusively on changing its trajectory.

Default dead startups are reliant on investors to continue operating. Graham notes that as a rule of thumb, investor interest is a function of growth. However, investors are fickle. They get cold feet when shit hits the fan. Environments where investors are most likely to be skittish (recessions, shocks, crises) are the same environments where growth is likely to be challenging and startups need financing. Banking on being able to raise another round is a potentially fatal mistake.

Another is aggressive hiring. Here Graham’s advice is simple: to avoid being default dead, don’t hire too fast6:

Growing fast versus operating cheaply is far from the sharp dichotomy many founders assume it to be. In practice there is surprisingly little connection between how much a startup spends and how fast it grows. When a startup grows fast, it's usually because the product hits a nerve, in the sense of hitting some big need straight on. When a startup spends a lot, it's usually because the product is expensive to develop or sell, or simply because they're wasteful…What the company should have done is address the fundamental problem: that the product is only moderately appealing. Hiring people is rarely the way to fix that.

Fast, rest in peace, is a recent case study. It ended 2021 with 400 employees (including many pricey engineers) against $600,000 of revenue. As funding cools, expect more stories like this.

Premature scaling is a related problem: pushing growth before the unit economics work. In other words, selling dollar bills for eighty cents. Graham admonishes founders to live within their means and focus on product/market fit.

“Oh, Shit!” Moments (Jeff Jordan, 2016)

Jeff Jordan is a partner at Andreessen Horowitz and on the board of Airbnb, Instacart, and Pinterest. Before venture investing, he was the General Manager of eBay North America during the dot-com bubble and CEO of OpenTable during the Financial Crisis. He’s seen some shit.

Like market cycles, slowing growth is normal. Jordan saw slowdowns at OpenTable, eBay, and most of the companies he’s advised. Sometimes they’re gradual, but in most cases they’re sudden: the business is growing one day and not growing the next. Hence Jordan’s “oh, shit!” moniker.

When things slow down, Jordan advocates for the freak-out approach7:

The best CEOs take immediate ownership over the situation and leap into action. They don’t make excuses, and they don’t accept excuses. They assume that growth is under the control of the company — even if it isn’t — and they work like crazy to get it back.

Growth doesn’t magically resume. It's hard work to figure out what went wrong: sounding alarms, setting up war rooms, getting all hands on deck, and copious amounts of caffeine and takeout pizza. This effort should be wide ranging, involving everyone with the expertise and skills needed to diagnose the underlying issue. More people makes dividing and conquering easier. The search needs to be systematic, unpeeling the onion one layer at a time8:

Start at the highest levels to find evidence about what changed, and then use those clues to work your way down into the details. When did the issue emerge? Did it emerge suddenly or more gradually? Was it experienced in all geographies? Was it experienced across all platforms (website, native apps)? Was it experienced in both organic and partner traffic, was it experienced consistently across partners? Was it a top-of-the-funnel issue, or an issue with conversion in the funnel? What did competitors do, and when did they do it? Is your customer-support organization hearing anything out of the ordinary from customers?

VCs have a habit of becoming Stoics during hard times, and Jordan is no exception, urging operators to focus on what they can control and to assume that the situation is self-inflicted until there’s definitive proof otherwise.

Plan For The Worst (Y Combinator, 2022)

Earlier this week, YC sent an email titled “Economic Downturn” to portfolio founders. The note advises startups to plan for the worst by cutting expenses and extending runways.

YC expects the fundraising environment to cool for the next six to twelve months9:

For those of you who have started your company within the last 5 years, question what you believe to be the normal fundraising environment. Your fundraising experience was most likely not normal and future fundraises will be much more difficult.

During this time, VCs will slow capital deployment, deal competition will decrease, valuations and round sizes will be lower, and fewer terms sheets will be signed. Startups reliant on investors funding losses (default dead companies) are in a tenuous position. Echoing Graham, the key for founders is doing whatever they need to to stay alive. The upshot is that companies make up the most ground when they can play offense when their competitors are forced to play defense10:

Remember that many of your competitors will not plan well, maintain high burn, and only figure out they are screwed when they try to raise their next round. You can often pick up significant market share in an economic downturn by just staying alive.

Eat Your Broccoli

This advice is simple, but not easy. Cycles are natural, don’t over-extrapolate. Be diligent on expenses and live within your means. Make sure your business is on a trajectory to be profitable (default alive) so you’re not at the mercy of investors (default dead). Have a bias towards action. React quickly when growth slows or the outlook gets murky. Focus on what you can control. Ultimately, focus on staying alive. Airbnb, Square, and Stripe were all founded during the Financial Crisis. The goal is to keep playing.