Recession is coming. For at least some parts of the economy, in one form or another.
The FED has not raised rates this precipitously since the 1980s, and even then, the pace was slower than it is now. With that in mind, if the rate increase continues, there will be a lot more discussion about a FED-induced recession in the coming months.
What does this mean for business owners? Well, this is the year where people who have real business models separate from those who don’t. This is the year where people who know how to execute will separate themselves from the ones that don’t. For every S&P 500 company that resets their forward-looking guidance for 2023, there’s another company that’s already winning with the right business model.
In 2023, it’s crucial to take stock of how the last year went and where this year is headed for businesses. When it comes to recessions, the playing field has changed and there are going to be differences this time around.
The end of vanity metrics
Or at least for now—and the same goes for the days of every person in the world being a potential customer. Last year, the equity capital market (i.e. the stock market) started differentiating companies that actually make money from those that aspire to make money.
Companies went from trading as a multiple of revenue to a multiple of earnings. Two decades ago, during the dot-com bubble, we saw the same pattern––it was all about growth and grabbing market share. You would hear a lot about “growth at all costs” or “valuing a company based on how fast they were growing revenue”. There was little to no regard for profitability or cash flow, and no attention was being paid to the cost of acquiring a customer.
All of a sudden investors realized that, in many instances, the cost of acquiring a customer (CAC) was more than the lifetime value of a customer (LTV). A company might have been growing quickly, but all they were doing was adding customers who were never going to pay for the expense of the growth being added. Not surprisingly, over 90% of the companies founded during the dot-com bubble went out of business.
If your strategy is still “grow to the moon”, and you don’t know the LTV or CAC of your customers, then you will likely struggle to raise funding going forward.
Cash is (still) king
Now is a great time to optimize and make sure you’ve got enough runway in your cash flow. You need enough to withstand the next 2 years without having to raise outside financing.
Ironically, you may then find yourself figuring out how to change your business model in order to do so, which will lead you to one of two things.
Either your business model doesn’t work because your customer acquisition cost is unsustainable, or it does work if you can rejigger how you acquire customers. That’s how you could actually end up managing your cash flow to a zero burn or even profitability.
This is precisely how Amazon survived the dot-com bubble. They had a negative cash conversion cycle, allowing them to make money before they even paid for their products. This helped them gain significant influence in negotiating the best terms possible with their suppliers and continue to grow exponentially.
Forget about funding (for the most part)
While capital is still being raised, that capital is for companies that are (for the most part) cash-flow positive, or those that are about to be.
A company with a clear line of sight to being cash-flow positive or generating a reasonable amount of earnings, even if it’s an EBITDA-based metric, may be able to raise capital in this environment. Showing that you are capable of generating EBITDA is going to be more than welcome, but keep in mind that EBITDA is just what it sounds like––a pro forma number. You likely have to pay taxes, have debt with interest, and some depreciation on your assets. In essence, EBITDA is just a proxy for future profitability.
Run your business like you won’t be able to raise more capital any time soon, instead of presuming that investors will throw money at you like they did 2 years ago. Simply hoping you’ll get someone to give you money is not a good strategy. Even if you could raise more capital, you would spend so much time chasing investors that you would have no time left to run your business. Who wants to invest in that company?
For those who have already raised a good amount of venture funding, be thankful and figure out how to run your business based on that.
New recession, new opportunity
In theory, recessions should lead to less innovation, but the opposite is often true. We commonly see great innovation when companies are in trouble or are forced to think outside of the box.
This recession can actually give your business the chance to reset and get back on track in a way that’s more engaging and cost-effective. You just have to get in the right mindset and innovate.
Take a look at Apple in 2008-2009, at the height of the financial crisis. The company had released lackluster products for years, like the Cube and Pippin game console—both of which failed miserably. But then came the iPod and iPhone, which were both released those same years, and went on to become some of the most successful products in history.
Today, more people transact over the internet for goods and services compared to 20 years ago. Businesses have much larger addressable markets and can connect with people in different locations (rather than just their local city or state). As a consequence, many more digital businesses are going to survive this time around.
Those of you that started digitizing during COVID need to ensure you’ve finished that transition, especially with recession looming.
Intelligent cuts make the difference
When a recession does arrive, which expenses are first to go? Marketing.
The Pavlovian response to cut expenses at a time when you should actually be doubling down gives an incredible opportunity to knock out the competition. If you can afford to maintain your marketing budget when others cut back, it’s a great opportunity to poach customers from others.
What is another common cut during a recession? Employees. Make sure you have the right people around your table as we head into an unpredictable time, even if layoffs aren’t pleasant.
The reality is that, no matter the size of the company, you may need to make some changes. If your business has grown quickly, like many of our portfolio companies in the last few years, then you’ll likely need to take a step back and look at how well you hired. Statistically, it’s impossible that every hire you’ve made was the right fit. It’s also possible the hire just hasn’t evolved with the role and may be better in another role or organization. This doesn’t mean they aren’t good employees, but they may not be the best fit in the role anymore.
Big companies never let a crisis go to waste. Whenever the economy goes into recession, they cull their staff. For example, the CEO of Goldman Sachs, David Solomon, was discussing his intention to lay off part of his workforce on CNBC. Morgan Stanley’s CEO, James Gorman, did the same thing.
As controversial as trimming fat may be, reallocating your strategic resources at every opportunity is always the right thing to do. Strategic cuts will help you weather the storm.
Final thoughts
This economic cycle is playing out in a similar fashion as 2 decades ago, but with a few very important differences. Firms are more digital, and the internet has become more ubiquitous with both businesses and consumers. Most big venture firms are also more disciplined today than they were before. Having said that, we are entering this tech-bubble collapse with inflation and FED intervention that did not exist last time around.
As for founders, if you understand your customer, if you have good digital tools and good financial acumen, you stand a good chance of doing well. Conversely, if these skills are lacking, improving them may increase your chances of success.
While there may not be as many companies going out of business this cycle, investors must pause and make sure they understand the economics of the business they’ve invested in, and founders must realize funding may not happen and they need to innovate and adapt accordingly to survive.