October 20th, 2008

The other reason startups need to tighten their belt

in: Exit strategy, Funding, Startups

By now, you’ve probably heard about the grim tidings from VC meetings this month. If you haven’t, well, let’s just say your investors would like a word.

In the wake of economic collapse, founders and CEOs are being told to reel in spending and prepare for the worst. There are two obvious reasons to do this: Less funding and lower revenues. But it’s the third, less talked-about reason that should really make you worry.

Update: Stacey at GigaOm has a great piece on this, looking at some hard numbers.

The obvious reasons

First, it’s harder to get capital to fund your business. Interest is the cost of money—and with less money floating around, the cost just went up. That means your business is now competing with other possible investments. Unless your startup has a tremendously promising proposition, it’s unlikely to get more money; and if it does, it will come with onerous, highly dilutive terms.

Second, revenues are at risk. Many startups bank on ad revenue, and that’s in decline. Paid search is the only form of advertising that seems to work, and Google’s sharing less of that with its partners. If you’re smart enough to have a real business (after all, sales is the missing piece of most tech startups’ business plans) then you face customers who will be pinching their own pennies.

That means the money you have now, plus the revenues you can bring in, is what you’re going to have to live on for the foreseeable future. And since neither of these is easy to grow, it’s time to cut costs.

The third reason

But the really scary part of all this is the third reason: A delayed exit. When I started working in tech startups, I thought all that mattered was cost, investment, and revenue. But I quickly realized that investors care just as much about exit strategy.

The ideal exit, of course, is an IPO—a long shot at best, fraught with risk but full of rewards for the right company. For the time being, let’s just say: Don’t go there. The markets are too volatile, and investment has fled to more predictable instruments like precious metals, bonds, and treasury bills.

On the other hand, you could always build a profitable company. This is a common “exit” for small business owners, who are happy to pay themselves a handsome dividend from their earnings rather than try to get a one-time payoff. It may work if you have a majority share of your startup and your investors can’t force your hand. But for institutional investors like VCs, this won’t work: They want to show a return on an investment so they can close out the fund that backed the company in the first place.

Which means you’re probably planning on exit by acquisition.

Why big fish eat small fish

When a big company buys a small company, it does so to acquire its products, its technology, its customers, and its employees.

When deciding to acquire a startup, the buyer asks itself four basic questions.

  • The build or buy question: What’s the cost to us of building what this startup makes?
  • The accretive revenues question: How long will it take, and during that time, how much will they earn?
  • The IP and risk question: Will we get sued for copying them?
  • The synergy question: How much additional money can we make by cross-selling their stuff with our existing products or services?

If those four questions get good answers—meaning that the accretive earnings plus synergy plus IP risk are greater than the cost of building it themselves—then you’ll get acquired.

The trouble is, the current economy changes those four answers.

Why big fish aren’t hungry right now

It’s easier to hire people in a down economy: Workers want stability, and startups can’t afford to entice star workers with high salaries or the promise of lucrative exits. So the cost of the big company building it themselves drops.

The pressure’s off: The startup won’t be making as much money. It’s not able to fund fast development. It can’t afford marketing. And lack of demand means it won’t attract rainmakers in the salesforce. So accretive revenue is lower.

Risks are smaller: The startup is unlikely to mount a legal defense, because it can’t hire lawyers; and even if it did, it would distract itself from the core task of building a business. So the risk of IP litigation goes down.

Synergies are less obvious: With customers pinching pennies, they’re unlikely to buy the additional bells and whistles that you, as a big company’s partner, have to offer. Which means it’s harder to prove synergistic revenue to a potential suitor.

The result is delayed acquisitions, or none at all, during which your resources dwindle until the big company can acquire you for a pittance.

Okay, now I’m depressed

In this situation, you need to behave like you’re building an annuity-style business that would pay dividends, and reinvest those dividends in additional growth. Don’t grow in anticipation of sales—grow because of sales. Meanwhile, partner with your potential acquirers so they get a taste of that synergy when—and if—the market recovers.

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