Survival strategies for startups during the crisis - Unicorn Nest

Survival strategies for startups during the crisis

By Vanda Vovk

18 May, 2020

In light of recent events, many startup owners are thinking about how to survive in times of crisis and how to raise money. We recommend listening to Denis Dovgopoliy, who during his career managed to be both on the side of startups and the side of investors. Also, he witnessed the global financial crisis of 2008-09 in Silicon Valley

How it was in previous crises

Of course, the current crisis is very different from the global financial crisis of 2008–2009, and from the Great Recession of 1999–2000, but it is worth paying attention to many significant trends. In particular, the fact that those investors and entrepreneurs who successfully survived the 1999–2000 recession, when the entire industry collapsed, worked much more efficiently.

As soon as the crisis came in 2008, the sub-primes collapsed and the market experienced a shock, startups who raised money shortly before the crisis were in absolute gain. This is true for the startups that raised money in approximately the second half of 2007, almost the entire spring fundraising cycle of 2008, and even until the end of 2008. Those who raised money in time and made the right decisions in the midst of the crisis found themselves in a win-win situation.

Denis has developed a good crisis metric for himself Silicon Valley – the travel time from Palo Alto to San Francisco. The thing is that people who work full time for a long time, most often live in their own or in houses, which they rented for a long period. Most often they live near the places where they work, so they don’t particularly load traffic. Living in the Valley is very expensive, so most freelancers and those who work for the company under a labor contract, who do not have stability, travel from afar, spending about an hour or more on the road. Therefore, if in 2005–2007 the road from Palo Alto to San Francisco from 7 till 8 a.m. took about an hour and 20–40 minutes, and sometimes even 2 hours, in 2008, when most companies laid off freelancers, this road began to take about 45–50, 55 minutes maximum. When the companies instantly shrank, freelancers and contract workers were left without work, the Valley was almost empty. This “Saturday traffic” can be seen in many cities now.

Most startups who then raised the Late A and B rounds tried to shrink and save on the costs: it was not clear when the next fundraising window would open, and people tried to save as much money on their accounts as possible. A lot of investors left the markets.

There’s an unprecedented crisis raging on the market right now. In addition to the financial crisis, which will cover us in a few more waves, we also have a crisis connected with a drop in demand associated with the virus that is roaming around. In this situation, Denis Dovgopoliy offers to rely on the experience of those who survived the 2008-2009 crisis, and especially those who survived it and the preceding 1999-2000 recession. What happened to them?

Most of those who operated on the market 20 years ago are already retired. There are only a few of them. There’s also those who were not in the status of a partner in the fund, but in the status of an analyst then. Most of the funds that survived the financial crisis of 2008–2009 are still in operation, and they are confidently implementing their anti-crisis strategies now.

Three fund strategies

At that time, about 30 venture funds were closed because their investors stopped financing them. The remaining funds chose one of three strategies:

Some of the funds reduced the number, but increased the sums of checks, their idea was: the crisis will end sooner or later, and the most affluent startups will survive it, and later they will be the first in line to the market. It takes about a year and a half to raise money, master it, and build operations on it. So those startups, that survive the crisis without fail, focusing on the product, and retaining the team, will benefit. Therefore, some investors began to reduce the number of transactions. The average number of funds transactions was 10–12 per year, it decreased to an average of 5–6 transactions per year, but the checks grew significantly. At the same time, however, the company’s rating fell. Not much, but slightly.

The second group of investors stopped financing altogether. They decided to wait until the market settles down and then invest in those companies that would survive the crisis. There was about a half of them in the market. They stopped investing for six months or a year but made exceptional investments into entrepreneurs they know.

The third group of investors accepted that difficult times had come and invested all their available funds in support of their existing companies, so portfolio companies of several funds got access to additional financing to survive these difficult times. As practice has shown, the third strategy turned out to be the most successful for the funds: companies that raised money shortly (not less than a year) before the crisis began and gained access to financing during the crisis, in fact, became the main beneficiaries of this period.

As for the angel market, it practically froze. It froze for a short time, but then recovered quickly. Checks from 200k to millions almost ceased to be issued, but during the first wave of the crisis, when fairly serious players went bankrupt and left the market, freshly-funded startups began to come in their place, and later they’ve become quite successful. Most of the successful startups that were stars from 2011 to 2015 are those startups that were founded during the crisis and attracted funding then.

Startup strategies

What strategy did startups choose? Part of the startups of rounds A and B significantly reduced the number of employees and squeezed their operations. Denis Dovgopoliy notes that this turned out to be a rather losing strategy: few startups survived this.

Another category of startups began to actively invest in customer retention cost, which fell sharply in the midst of the crisis and conduct experiments on products. This did not work out for everyone, only for startups whose product did not collapse with demand at all. Companies that dipped in sales by 20–40%, and even 50%, could practice this. Those whose sales have froze failed.

Almost all startups got the opportunity to save on the people who worked for them. Here they could go two ways. The first was to reduce salaries to market wages, which then fell very much: for some vacancies they decreased by more than half. But more experienced entrepreneurs began to replace the employees who worked for them with people of higher qualification for the same budgets. It turned out to be a more winning strategy.

What and who the investors are interested in

So, what startups the investors find interesting to invest in now? Denis Dovgopoliy says they are interested in startups founded by people whom they have known for a long time. This is due to the fact that most investors are not ready to invest in startups if they have not completed on-site due diligence which usually takes from 1 to several days but leaves the investor with a feeling that the startup is live, that it works. After the investor is convinced that the startup is working, all paper audit work begins.

But now, unfortunately, this opportunity has disappeared. Therefore, candidates No. 1 for investments are those companies that went through this process in their fundraising funnel, and the other ones are those startups that were founded by the entrepreneurs whom investors have known for a long time in the market, who are known and whom, relatively speaking, you can trust. These are the first candidates who are able to raise from late seed to round B in the current situation.

Another important comment from Denis: any startups that are now launching on the market targeting crisis opportunities will not raise money. In 2009, it turned out that startups that targeted crisis issues, i.e. any anti-crisis startups, unfortunately, did not survive. Why? Because the opportunities that the crisis opens close as fast as they have opened. Exceptions here exist only for companies with products that become more in demand in a crisis. This is what we now see on the example of Zoom. Most startups that are now taking up large rounds, for example, Airbnb, are, on the one hand, going through very difficult times, and on the other hand, they are too big to fail, so they are given money on draconian terms in order to survive this really terrible period. This is not a standard investment. This is neither round A, nor B, nor C; it is a much later round that allows a large company to survive very difficult times. This non-equity financing, it’s money that goes up in convertible loans, but on draconian terms.

Startups that have a product that is in demand during the crisis can either greatly save on costs (including all the cost of developing, launching a product on the market, attracting users, etc.), or they can generate an additional flow of customers. There are not many startups of that kind, but in times of crisis, the demand for their products begins to grow. After the crisis, this growth stops, but most often, customers do not leave. The conversion into paying long-term customers there is still large. They are the second candidates for raising money from venture capital funds.

Those startups that do not belong to either the first or second category are analyzed solely for how much they can manage their costs. We are not talking about banal cuts in salaries or firing people – this is what everyone is doing. But those skills and the stress tests that investors do with startups before investing now play a rather large role. When we talk about managing costs, we are not talking about cutting costs, but about the ability to flexibly turn fixed costs into variable costs – those that decrease or increase depending on revenue. This also includes customer acquisition cost, which is calculated per customer, as well as all operating expenses per customer.

Startups that relied for example on their IT infrastructure, lost in the last recession. The purchase of large servers brought them huge losses because they depreciated in the next five years, and couldn’t do anything with that depreciation. Whereas startups that relied even on that time on Amazon’s expensive infrastructure won because during a drop in traffic, they drastically reduced their cost of goods and were able to remain at least operationally breakeven. Therefore, the ability to quickly turn fixed costs into variable costs and vice versa has always been an important metric for a startup and a point for making decisions when investing. And during the crisis, this became the key to survival.

Therefore, the third category of startups that will raise money now are those that can manage their costs quite flexibly and can compress these costs to almost zero without much loss of operating activity. One of the investors Denis spoke to said that his main metric for a startup on the late A round (we are talking about raising 10 million or more to scale) is whether a startup can reduce its expenses in a month to 50 thousand dollars per month provided that it has 20-30 employees. This is a very difficult task in European and American realities. Therefore, flexible contracts with employees and an opportunity to negotiate with them are very much appreciated now in startups that are going to raise the next round.

Other important features

What else investors pay attention to is the average age of startup employees. Investors have accepted the axiom that the younger the person, the easier he or she will survive the COVID-19. They are convinced that about 40–60% of all residents of Europe, North, some Central and South America will be infected. They expect a wave of epidemics, so the younger the average age of a startup, the easier it will survive not just several weeks of lockdown, but employees staying on sick leave. If a startup’s founder is over 45 years old, he’s automatically at risk, this is why Denis thinks that in a few months investors will give preference to teams from the regions that have already overcome the virus, and to the founders who have long-term antibodies to resist this virus.

Investors are also at risk: prior to quarantine, they had a huge number of meetings, and they (at least in Europe) fell under a rather big blow. On the one hand, they see Coronavirus as an economic threat, on the other – as a physical threat to a startup. Therefore, says Denis, if the average age of your employees is about 23–25 years and the older generation is not much older than 30, this allows investors to consider your startup (assuming the number of employees is more than 20), as a startup that can, with all other things being equal, survive the crisis with minimal loss in productivity. And it can even do without critical cases inside.

Nowadays, startups that work in industries that are affected by the crisis will hardly be considered. A good example in this regard is the tourism business. Denis predicts that everything related to tourism will not be invested in the next few years. But there are some exceptions, like when a startup can focus on a post-crisis economy. If you have a prediction of what your industry will look like in the second half of 21, when the main waves of the crisis will clearly pass and the economy will begin to recover a little, if you have fresh ideas for working in markets that will suffer greatly, but they will also recover faster, then investors are ready to listen to this. For example, in tourism: when the crisis passes, people will have deferred demand for tourism projects. But that won’t work for everyone. Young investors now are rather scared, whereas investors who survived the crisis of 2008–2009 or who talked a lot with people who survived that crisis, will feel quite confident and look for startups with a long perspective.

Therefore, startups focused on crisis industries can be funded now not for their current situation, but for the situation when they will get out of the crisis. Denis emphasizes that the theory of competition is very important here, you need to understand how you are going to compete with other companies including large ones that will also survive this crisis and not go bankrupt.

Is it worth raising money during the crisis?

During the crisis the ability to do due diligence is very limited for investors, on the other hand, when they raised money in their funds, they promised limited partners of these funds that they would make a certain amount of investment per year. Despite the crisis, despite the fact that their investors will allow them to freeze activity for some time, the more time will pass from the beginning of the crisis, the more dissatisfaction will be on their part. Therefore, now the funds are looking for where to invest now.

This is wht if you have a confident start-up, which has ever-increasing revenues that have not suffered much due to the crisis, for example, for a month it has not sagged by more than 20%, and the churn rate has not dramatically increased. If you have a team with whom you can agree on compression of the bones, and if your product is well-known in the market and you as an entrepreneur at least somehow shone. Then you have good chances to raise money in a crisis. Denis Dovgopoli advises how to properly weigh the pros and cons, because it is a waste of time and money, and only after that decide whether or not to go there. On average, fundraising of any startup costs an entrepreneur about 600 hours of work when raising a round from $ 1 million to $ 5 million.

This is why if you have a confident startup, which has ever-increasing revenues that have not suffered much due to the crisis, for example, they have not dropped by more than 20% in a month, and the churn rate has not dramatically increased; if you have a team with whom you can agree on cutting the costs; if your product is well-known in the market and you have got at least some exposure as an entrepreneur, then you have good chances to raise money in a crisis.

Denis Dovgopoliy advises to properly weigh the pros and cons, and only after that to decide whether to go for it or not. Raising money usually requires a lot of time and money. On average, fundraising of any startup costs an entrepreneur about 600 hours of work when raising a round from $ 1 million to $ 5 million.

If a startup has a situation that it won’t die without money and can make a breakthrough on its own, if there is a cash pillow or cash flow to exist on that will not drop, Denis advises not to engage in fundraising, but to spend time developing the business or keeping it. On the other hand, if you are not launching an anti-crisis product, but you see that your product is starting to become more popular at this time, this is a good time to raise money. In that case, you can go to investors and try to talk to them.

There were one criterion to understand if an investor is interested in your startup or not, and that was if he was wasting time on you or not. But now this metric has become less reliable due to the lack of time for investors: they are checking statuses and thinking about how to help existing portfolio companies. Therefore, if earlier it was believed that if the investor doesn’t spend time on you, then he is not interested in you, now Denis Dovgopoliy advises: “You always need to ask the investor whether he likes the project, whether he wants to invest in it. Propose to draw a roadmap with milestones that you will follow. And then you need to look not so much whether the investor spends time on you or not, but if he goes through these milestones to the next stages.”

Denis notes that this is not easy: in 2008, several startups died from false hopes, believing that the deal was practically in their pocket because the investor held two conference calls a week with them, but it turned out that there was actually no deal, it was a bad metric of project interest.

Features of fundraising in crisis

Fundraising is the same very resource-intensive enterprise-sale funnel consisting of several stages. It eats up a lot of time and resources in terms of preparing documents, answering questions asked by investors, etc. But conversions in this funnel have already fallen, and in the near future, they will fall even more. Therefore, lead generation becomes very important.

When you work with a fundraising funnel, you need to understand which investors you work with. Denis Dovgopoliy strongly recommends for startups raising the institutional round of late seed, round A, round B to form a funnel of investors, which should consist of no less than five hundred investors to whom you send individual letters and pitch decks. Why 500? Because on average, every 100 outbound investors bring one term sheet. It is difficult to determine if the term shit that has hit your table is good or bad until you compare it to another. When you have five term shits in your hands, on average two of them are not worth reviewing – they are given on conditions on which money cannot be taken and from such investors from whom money cannot be taken. Of the remaining three you can choose one or two, or maybe even initiate a deal.

How will fundraising now differ from fundraising six or even two months ago? First, conversions will be monstrous. You may send dozens, hundreds of letters, and everyone will write to you “Sorry, now is the wrong time for investment.” Secondly, the funnel will become more and more resource-intensive due to the fact that investors will have a lot of time to communicate with you. If earlier they asked very clear and important questions and were ready to move forward after getting the answers, now they will spend a lot of time trying to choose the best out of the 20 startups that they have in the pipeline. And they will be afraid to lose at least one of these startups. Therefore, conversions will fall, and costs inside the funnel will increase. Usually, a startup spends a lot of time and resources on this because they are distracted from the main operational activities. This is very difficult and dangerous in crisis because if you get stuck a little and lose a week, you may lose your product and your market. This is why entrepreneurs must constantly keep their finger on the pulse. Thirdly, the stakes are still high. The success rate of startups that raise money during a crisis is much higher than for any other startup that raised the round at any other time.

Summing up, Denis Dovgopoliy strongly recommends: firstly, if you intend to raise money in the next 12 months, weigh the pros and cons; secondly, draw up a project plan, define what resources you can throw there and calculate if they will be enough; thirdly, try to understand how critical it is for you to raise money now. Yegor Anchishkin once said: “I will never raise venture money (without revenue) because then I’d stop my business and spend money to raise more money that will wash my share.” Often, when entrepreneurs multiply LTV by the number of users who can be attracted, by the resources spent on raising the round, it turns out that the potential revenue is commensurate with the round that they are going to attract.

Therefore, Denis advises, first of all, to tighten our belts and try to survive the next 12 months without any losses. And if you see that the startup will not survive the crisis, close it as soon as possible. This tip always works: it saves time and money. Please note that in the nearest future the competition in the startup market for the attention of investors will increase because many people who were laid off will try to launch their own startups. And these won’t be the most stupid people on the market. Therefore, after six months, the competition for startups in the capital market, especially angel investment market, will increase sharply.

Most startups that survive this crisis will be fine.

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About the Author

Vanda Vovk

Journalist, translator.

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