A Guide for Finance Leaders Managing Businesses in the Current Economic Environment
Learnings from my Interactions with Entrepreneurs and Investors.
A year ago (mid-2021) investors and founders/CEOs were focused on the first five items on the timeline above.
Today (mid-2022) the three bullet points to the far right of the timeline above are what really matter.
The macro-environment has changed hugely from just 9 months ago, driven primarily by higher inflation and resulting higher interest rates. Publicly traded high-growth companies have been revalued downward. The Wisdom Tree Cloud Computing Index (WCLD) is down ~50% from its peak 9-months ago. The Nasdaq 100 composite is down almost 25% over the same period.
The public market stock price reductions are impacting the valuations of all private high-growth businesses, changing portfolio marks shared by VC/PE firms with their LPs, and impacting the priorities of Board members / existing investors.
Company leaders are reacting to these changes. They are re-orienting strategy to prioritize free cash flow and extend runway months.
Efficiency is much more important than it was 6 months ago. Most investors are willing to trade lower growth rates for higher efficiency.
Most companies burning cash are conducting layoffs of 10-40% of staff. Those not doing active layoffs are allowing natural attrition and planning not to backfill many of those roles.
I offer a series of insights on how start-ups are making adjustments in go-to-market, efficiency metrics, personnel, other operating expenses and capital raising.
I work closely with CEOs, COOs, and Finance Leaders at early-stage companies — bootstrapped, pre-seed, seed, Series A, and the occasional Series B. My goal is to help founders build great businesses - profitable, defensible, and growing.
I am fortunate enough to speak with investors (traditional venture and growth capital investors), so I hear their perspectives as well.
Change is Rippling Through the Start-Up Ecosystem
The topics for discussion in Leadership Team meetings and offsites, Board rooms and investor calls have changed materially in the last few months.
Although the recent stock market top was actually in early November 2021, it took until mid Q1 2022 for the public market changes to fully filter into the private market psyche.
The theme is a reduction in ‘risk appetite’ away. High-growth / high cash-burn stories are out of favor. Much greater emphasis is being placed on efficiency and related financial metrics. As a result, priorities are changing, impacting business strategy.
Changes in Priorities are Impacting Business Strategy
Financial leaders are juggling new challenges that were far less central to their role just 9 months ago.
Financial fundamentals matter much more today than they did in the last two years.
Months of remaining runway (cash in the bank) is the leading metric for most Q2 2022 Board meetings.
While the disruptive vision is still important, efficiency metrics are being discussed regularly (e.g., gross margin, CAC payback, and burn multiples.)
Profitability, in the form of free cash flow, matters even for the biggest public companies. In the public markets there is increased focus on free cash flow per share (i.e., dilution from stock compensation expense is getting increased focus.)
Boards are expecting CEOs and Finance Leaders to cut costs to extend their runway.
Most investors in private companies ‘mark their portfolios to market’ on a quarterly basis. These valuations are the centerpiece of the reporting VC Funds provide to their LPs (‘limited partners’) who are the investors in their funds.
Valuations are based on comparable analysis (public market multiples for similar companies). Given the stock market downturn, these multiples are far lower in Q2 2022 than they were in Q3 2021. (A report in the Term Sheet newsletter says the equity IRR of the Blackstone Growth Fund is down from 90% at Q3 2021 to 43% in Q4 2021 to 17% in Q1 2022. The IRR will fall further in Q2 2022.)
Extending the runway creates more time to ‘grow back into’ or near the valuation placed on the business six to nine months ago.
Innovation remains critical, but CEOs and CFOs are demanding tighter guard rails.
Experiments to: (i) improve product<> market fit, as well as (ii) unlock improvements in scalable, repeatable profitable growth must continue.
The constraints today are stricter, including doing fewer new projects while executing ‘better.’
Better means a couple of different things — (i) having concrete targets against which to measure the results of experiments; (ii) favoring experiments with faster cycle times (so the decision to abandon or refine or double down can be made more quickly); (iii) emphasizing ‘must have’ qualities (e.g. increased revenue or reduced cost) and not just nice to have (e.g. greater time efficiency) in all new vendors, marketing channels, roles etc.
Growth is still imperative for start-ups to secure additional funding in the coming months and years.
Specific Changes Being Made in Most Start-Ups
In the Revenue / Go-To-Market Functions:
Expect and proactively plan for slower sales cycles (even beyond the normal summer holiday slowdown typical of the third quarter.)
To maintain sales momentum, figure out how to lower the risk for the buyer. Some examples include: (i) Pricing changes which lower fixed costs in return for higher variable costs, based on usage; (ii) Guarantees on RoI to the buyer, with a make whole of sorts; (iii) Undertaking proofs of concept (ideally paid) with clearly defined performance above certain baselines leading to a paid purchase.
Work with the finance department to evaluate moving to usage-based pricing if that is possible. The idea is to convert fixed costs to variable costs to create greater alignment between customer and vendor.
Internally focus on CAC Payback months (rather than LTV:CAC) to manage cash burn and increase the efficiency of growth.
Cut lower performing salespeople (AEs, XDRs etc.) while allowing the higher performers to receive more leads increasing their likelihood of beating quota and staying with the business.
A Renewed Focus on Unit Economics.
Savvy CEOs are mandating that the entire GTM team collaborate more closely with the finance organization to update this analysis. Unit economics matter now more than ever.
Not all customers are created equal. Bigger contract value or higher monthly recurring revenue does not necessarily mean those customers are more valuable.
Quality analysis requires businesses to evaluate unit economics at the appropriate segment level. Customers can be segmented by size (if the business model serves different scale customers through a sales-driven strategy) or by acquisition channels (if the business is primarily reliant on a marketing-driven go-to-market motion.)
For those businesses with a meaningful variable cost element related to how software or services are delivered (e.g., Twilio, Datadog etc.), finance leaders should calculate a rough contribution margin per customer. Certainly, some customers will be much less profitable than others. That realization will allow the business to change how it serves certain customers (from both a product and customer success standpoint.)
Pricing should be revisited. Figure out price points below which the business will not accept new customers. Make this threshold and the logic behind it clear to the Sales and Account Management teams. Keep this price discipline in place until you can optimize your cost structure to serve customers at a lower price point.
Headcount Reductions to Extend Runway.
Headcount is the largest cost in most start-ups. Extending the runway involves cutting headcount.
Right now, the justification is easy for cutting ‘less needed’ roles and/or lower performers. Large, well-capitalized companies are making the necessity of high performance by employees clear. Both Tesla and Meta recently shared this perspective with employees.
In addition to cuts, plan on cancelling or delaying new hires (including backfills) for all but the most critical roles.
Act sooner than later. Faster action has multiple benefits. Employees are expecting some changes. Typically, uncertainty is more damaging than bad news. The sooner a company acts, the more generous it can (theoretically) be with severance/COBRA and the more cash it can conserve for the longer term.
Clear, transparent, and honest communication from the Leadership Team is critical to maintain employee engagement and motivation during this resizing period. Be very intentional in the layoff process. Admit where you (as the business leaders) made mistakes and how you plan to avoid repeating these going forward.
Carefully Evaluate Other Non-Payroll Sources to Reduce Cash Burn.
Renegotiate contracts with vendors to reflect fewer heads today and lower expected headcount growth in the future.
Focus on working capital management. Collect faster and extend payable terms as appropriate.
Convert fixed costs into variable costs, if possible, by outsourcing certain necessary but non-core functions (e.g., recruiting.)
Marketing remains critical to future growth. However, not every channel needs to have investment at the scale as was done in the past or even considered in the 2022 budget (made during the good times in Q3/Q4 2021.)
Reset Expectation on Fundraising Cycles. And consider M&A.
Fundraising cycles will continue to lengthen back towards 6-9 months. Build that into your expectations around the timing for the next round.
Be prepared for deeper diligence and higher standards on information provided. Ensure the business is collecting all the necessary information (financial, customer KPIs, product KPIs etc.) going forward.
M&A is now on the table. For the last two years easy financing meant no need to consider M&A unless it was an unbelievably good outcome. Companies should explore stock mergers, especially within their own sector, where synergies would be the highest and the integration potentially easier.
My Conclusion: A Healthy Reset on Expectations
Building a great business that generates a lot of value is hard work.
We have gone through a period when FOMO and greed was so great, that investors / buyers were willing to believe the rosiest potential future outcome. That has changed now. And in many ways that is a good thing as capital will flow to entrepreneurs, ideas and organizations that will make the best use of funds.
In the last few years, there was a palpable sense among investors and entrepreneurs that anything short of a unicorn outcome (or even possibly a decacorn) was a failure.
I want to reassure everyone that building a business that is sold at a $50 million or $250 million valuation is a wonderful outcome. Because of the adverse selection of reporting, we only hear about huge success (the caveat being these are most often ‘paper valuations.’)
Most venture backed businesses don’t exceed $100 million in value. Focus instead on capital efficiency. Your chances of being rewarded for your effort as an entrepreneur and an employee will increase.