Use a scalpel when cutting startup expenses, not an axe

Experienced sailors know that if they turn the wheel too hard, they will soon need to compensate by turning it in the other direction, or worse, they will capsize the boat.

The same holds true for startup entrepreneurs and venture capitalists attempting to manage through lean times.

Unfortunately, many startups and their boards mismanage periods of low capital availability  —  as the current downturn is projected by many to be  —  by overreacting or underreacting.

In this context, overreacting is when you slash expenses too aggressively, compromising your ability to take advantage of new business opportunities and crippling prospects for future growth. In sailing terms, this is like lowering your sails until the boat is unable to move in the water.

Overreacting may help you survive, but it comes at the cost of diminishing any capacity to get to where you really want to go. Venture capitalist Frank Foster calls this approach the “small furry mammal mode” — designed to survive an ice age.

Underreacting, on the other hand, means waiting too long before making the necessary adjustments. This is akin to cruising along at full speed but recognizing too late that your boat is about to drop over the edge of a waterfall.

In my experience serving on startup boards, each of these mistakes is a function of acting  —  or failing to act  —  based on gut feeling instead of data.

Reacting appropriately is a matter of deliberate, measured cash and resource management. The startup needs to survive and also be put in a position to thrive. If you do not have multiple years of runway, you have to treat your cash like it is oxygen in outer space. But you also need to use some of that oxygen to breathe. Knowing how much cash to use requires a plan.

Scenario analysis can help you develop that plan and make informed decisions in real time as circumstances change. This approach requires generating a handful of realistic scenarios your company might face in the near term.

Map out these scenarios based on facts not conjecture. Arbitrary cuts to your revenue plan may be easier to model, but this is a lazy substitute for navigating the route your startup will likely face. As you build these scenarios, it’s a good idea to slow any discretionary spending to preserve cash your company may need.

In my experience, collecting data to model relevant scenarios involves four steps:

1. Call your customers to understand whether any relationships are truly at risk. Don’t apologize  —  your startup didn’t cause the markets to go downhill, so you should strike the tone that you are all in it together. It’s reasonable to ask how it’s going internally for your customer, and what’s better, the same, or worse in the current environment. If your customer is having a problem, open-ended questions give them an opportunity to speak up. You needn’t provide an engraved invitation for your customer to suggest that you restructure your contract or provide discounted pricing. In other words, don’t “lead with your chin,” but do convey empathy.
2. Do the same with any distribution or channel partners that may sit between your company and end customers. Your distributors may or not technically be your customers, but they may be in the best position to assess end-customer demand. Again, approach these conversations from the perspective that you are in this together. If demand is actually increasing, your channel partners will be disappointed if you’ve cut capacity and reduced supply.
3. Assess your pipeline with a critical eye to build a realistic estimate of what new business may be feasible  —  look at your historical sales cycle and update your projections with more conservative assumptions about how long it will take to sign new business. Ask your prospects direct questions about their decision-making processes, budget authority in the current environment and whether anything you’ve previously discussed has changed. A downturn is not the time to assume prior representations are still relevant. Purchase orders and letters of intent are clearly better than verbal representations, in terms of strength of signal.
4. If your product or service requires physical inputs from suppliers, check with them, too. As we’ve seen from global supply chain shocks during the COVID-19 pandemic, market demand is not enough. Your startup may also need raw materials and components to satisfy end customers. Supply chain availability (and pricing) is an important consideration for scenario planning.

Once you’ve mapped out three to five likely scenarios based on feedback from your current customers, channel partners, prospects and suppliers, design an expense plan for each scenario that gets your company through a minimum of 18-24 months given your present level of capital and your projected revenue.

Then pay close attention to ongoing high-value signals from these constituents to understand which scenario is actually emerging. The dominant scenario might even be a blend of multiple outcomes you’ve modeled. Once you’ve determined the dominant scenario, you can fine-tune your spending to the plan that best matches reality.

To build these expense plans, identify multiple levers for preserving cash. This could include cuts to:

• People, including existing and new roles.
• Marketing.
• G&A.
• Investments in new inventory, if you have physical inputs or outputs.

While you shouldn’t resort to being a Pollyanna or magical thinking, do challenge your team to think about increasing revenue. Don’t assume it can’t be done just because the economy is down. Your business might be positioned for tailwinds instead of headwinds, like video conferencing software, media streamers, video game companies, on-demand food delivery providers and many other businesses experienced during the pandemic.

While it’s prudent to be creative about generating more revenue, don’t assume you can just increase prices. While that is likely to be convenient for you, it might cause your customers to abandon ship. An inflationary environment doesn’t automatically mean that customers will absorb your rising costs too.

Other tactics to extend your runway include selling down inventory to generate cash, and of course, raising more capital if you can.

Managing these scenarios and navigating the downturn is not a “set and forget” activity. You must maintain clear lines of communication to get real-time updates as long as your startup is in jeopardy.

You may also need to create new scenarios as events unfold. The key is to focus on the most likely outcomes and avoid creating too many complex models that you won’t actually use. Don’t waste time on esoteric scenarios that have a low likelihood of coming about. That time will be better spent collecting information from your constituents that helps you understand what’s really happening now and what will reasonably happen next.

In summary:

• Don’t overreact, because you may permanently impair your ability to recover.
• Don’t underreact, because you won’t have time to pivot before you fume.

An economic crunch is also a good opportunity for a gut check: Is the startup solving a real problem? Is the team really committed to the business? Do the majority of people involved, including investors, still believe in the vision and mission? Is the plan achievable in a reasonable period of time that will make all the effort worthwhile?

In some cases, a startup’s survival may not even be desirable. Determining this is an important step when evaluating how to handle an economic contraction.

An economic crisis is not the time to spin the wheel and hope for the best. Ultimately, startup managers must pay attention to high-value signals and take a hands-on approach when deciding whether to slash expenses and by how much.