How to navigate the current economic downturn – a guide for start-up companies
Step 1: Effectively Control Costs
With the Ukraine war ongoing, spiraling inflation and increasing interest rates the current economic environment looks increasingly worrisome. Numerous indicators show we are heading into a strong downturn, which could turn into a global recession. Start-up companies suffer significantly from this, as they typically rely on external funding to grow and thrive. This article shows you how your start-up survives the economic downturn. Step 1: extend your runway through advanced cost controlling.
Only recently, Y Combinator, one of Silicon Valley’s most prominent startup accelerators, has advised its portfolio companies to “plan for the worst” to survive the current economic downturn. Their message was clear: cut costs and extend your runway. Lots of leading VCs such as Sequoia support this point of view and actively advise their portfolio companies to thoroughly prepare for the upcoming economic downfall. However, this is not only true in the US. Geopolitical events such as the ongoing war in Ukraine, and the ensuing shortage of oil and gas supply from Russia, puts Europe in an even more precarious situation. Neil Shearings, Chief Economist at Capital Economics, has recently warned in the Financial Times that the recession risk is highest in Europe, “where the inflation induced cost of living crisis is coupled with gas shortages.”
How do start-ups weather this storm? With this article we would like to share a summary of the most urgent steps Founders and Finance leaders in start-ups should be taking right now to master the crisis.
Analyzing your financial health
As a venture backed start-up, you are likely not profitable yet. You are most likely aware of your monthly cash burn. To grow and survive, you have two options:
- Reach the “default alive” state
- Raise additional funds
To determine which path is more plausible you need to thoroughly analyze your financial health. Reaching default alive requires you to become profitable within the timeframe given by your current runway. For example, if you have €2 million of funding remaining, and your cashburn is €200,000 a month, you would have 10 months left to make your company profitable. In order to turn your currently unprofitable start-up into a profitable one, naturally, you have to increase your revenues or cut costs. Reaching default alive is a plausible option if you:
- Already have significant, growing revenues
- You still have significant costs saving potential which does not not inhibit sustainable growth
This is typically not an option for early stage start-ups, which may be pre-revenue, still be looking for product-market fit or are in an early growth phase, and therefore have high development or operational costs. Such companies would need to raise additional capital. In the current economic environment, however, this is easier said than done. Investors now no longer care about growth at all costs. Instead, they want to see that you are putting their capital to efficient use. A standard metric for measuring capital efficiency is the burn multiple. Popularized by well-known SaaS investor David Sacks, the burn multiple is a measure of how much cash you have burned to achieve your revenue growth (measured by net new ARR). Naturally, the lower the burn multiple, the better, as that would suggest you had to burn through less cash to grow our business. A negative burn multiple would suggest profitable growth. Typically measured over a quarter, a burn multiple below 1 is seen as amazing for a start-up company, with a burn multiple above 3 being bad. For an early stage company it is more acceptable to have a higher burn multiple. The following benchmarks can be used for orientation for “good” burn multiples:
- Seed Stage – company just started selling: 3
- Series A – focus on growth: 2
- Series B and beyond: <2 – with sales teams being built out and operating efficiently at scale, the expectation is that burn multiples approach 0 over time (i.e. the company shows a clear path towards profitability).
So what does this mean for you if you want to raise funds? As a Founder or Finance leader, you need to make sure that you are putting your cash to effective use. In short, you have to cut out all unnecessary, non-mission critical and non-growth driving costs as much as possible. Where do you get started?
Cut any unnecessary, non-mission critical expenditures
Typically the easiest point to start are software expenditures. As a start-up, you quickly end up paying for a whole host of SaaS services, many of which you don’t need. More often than not, there is a lot of overlap between solutions you are paying for making at least one of them redundant. It goes without saying that any other non-essential software should be terminated immediately. Naturally, certain services are core to your business operations (for example, your CRM tool or certain DevOps services). However, even for such core systems you should carefully go through the user lists and – if the billing is on a per users basis – remove accounts who do not use the tool regularly. Having said that, certain SaaS tools allow for significant automation and time savings. It goes without saying that such crucial tools should be kept if they justify their associated costs.
Next in line, and all the more difficult, are personnel expenditures. Most start-up companies tend to be asset light and personnel costs are by far the biggest cost block. As a first step, you should carefully re-evaluate your hiring plan. Put a temporary hiring freeze in place before you have not evaluated each position that you are currently looking to hire and whether it is absolutely needed. Certain responsibilities can often be shouldered by existing team members. This not only reduces your future personnel costs, but also avoids the costs associated with the recruiting and onboarding process, in particular if you are using external recruiting services. As a more drastic measure, you must re-evaluate your current team. Are there certain positions which are non-mission critical and do not justify the associated salaries? Such questions are difficult, particularly in a start-up context, but they must be asked if the survival and growth of the entire company is on the line.
Any other non-personnel expenditures, such as travel, hardware equipment and office related costs should naturally also be considered and strictly evaluated.
Putting this into practice
For most companies, getting a transparent overview over their costs is easier said than done. In highly dynamic environments, startups, especially early-stage and high-growth companies, struggle to maintain a clear overview of their expenditures. Constantly changing employee numbers, product development costs, marketing costs and fluctuating equipment costs are among the many things that Founders and Finance leaders need to understand. However, with most start-up companies in Germany, accounting is outsourced to their tax advisors who use accounting tools such as Datev. The tax advisor does the monthly closing of the books, and then usually sends over a pdf export from the accounting tool via email. The start-up then takes this data and maps it into their excel based financial model. This process in and of itself is manual and cumbersome and lots of invaluable information is lost, as typically you only received an aggregated version in the form of your financial statements. It is not possible to drill down into the individual booking level in order to actually understand what transactions were made that led to certain cost items. Hence, understanding what you spend your money on typically requires you to go through unstructured accounting data, line by line. This takes time – time which Start-up Founders and Finance leaders do not have.
Moreover, without much historical data and volatile monthly fluctuations in your costs and revenues, forecasting your cashburn becomes highly speculative. Having real-time financial data and in-house financial experts are therefore crucial to effectively controlling costs. However, most early stage firms do not have the resources to hire experts for this and Founders do not have the time to constantly update their financial models themselves.
As a result, a start-up’s internal finances are messy. Without putting a lot of time and effort in, you have little insight into what you spend your money on, how your cashburn will develop and when you should start your fundraising process. Even though Founders are usually aware of this challenge, and they oftentimes even set up a budget and attempt to forecast costs, they miss targets continuously as they do not have a transparent overview over their data as well as an effective monthly financial controlling process, where they can review their actual expenditures compared to their targeted costs and drill down into each cost position to find out what they spend their money on and why they did not achieve their targets. As a result, your cash burn remains too high, resulting in a tough fundraising process once it comes.
Pectus Finance enables Founders to effectively control costs and overall performance
At Pectus, we believe this problem can be solved. Pectus Finance is a tool which will help you clearly understand where and how you spend your money. With a direct API connection to Datev, the most common German accounting system, we guarantee direct access and insights into your financial data. Rather than having to rely on your tax advisor’s evaluations, Pectus offers a simple, easy to use controlling page, with which you can see your financial data in real time. Simply evaluate your actuals versus your budgeted performance and drill down to the individual booking level to fully understand your costs and revenues as well as any performance deviations. Moreover, Pectus enables you to create custom reports and calculate any performance KPIs to further manage your business performance. Seamlessly integrate all your data and take control of your Finances.