For Startups, Survival is not a Strategy

Note: As I was working on this post, I ran into Om Malik and showed him a draft. He liked it and asked to post it simultaneously on GigaOM. If you've read it on GigaOM, you can skip reading it here.

In these perilous economic times, the layoff memos often follow a familiar refrain: We have cut costs by 20%. That gives us an additional year's runway. Or two. Yes, startups can cut costs and thereby survive for longer. But just because they can, does not mean they should.

Let me state at the very outset that this article applies only to venture-backed startups, which are a small minority of businesses in the economy. The sole purpose of most businesses is to create a steady income stream for their owners and operators. Venture-backed startups, on the other hand, are created with the sole purpose of leading to a meaningful exit for founders, investors, and employees. Such an exit might be either an IPO or an acquisition.

The raison d' etre for such startups is therefore a successful exit, not mere survival. And the lifeblood of any startup is growth. Growth along some dimension: customers, usage, revenues, or profits. Under most economic conditions, an IPO is impossible without revenue and profit growth  -- and we are unlikely to see a return soon of the times when it was. From an acquisition point of view, stagnant companies are valued at low multiples of revenue -- say 1x to 2x. The comparables are utilities.

A popular meme suggests that "flat is the new up." Given the downturn in the economy, the argument goes, even keeping revenues flat is sufficient. This argument, however, does not apply to startups. By definition, startups are supposed to be attacking nascent market opportunities and unsaturated markets, and so should be able to grow even through a downturn. If a startup cannot find growth in this environment, it's a clear message that the market opportunity might be better served by an established company. Of course, growth in profits or revenues are way better than growth just in usage; but even growth in usage is better than stagnation on all three fronts. There is at least the possibility that a company with strong usage growth might one day be attractive to an acquirer with a good monetization engine.

From a subjective point of view, it's no fun to work at a startup that is not growing along some dimension. Growth is necessary for everyone to enjoy the experience, and feel they are accomplishing something. Stagnation leads to low morale, and people sit around waiting for the axe to fall. It's a slow, agonizing way to die. Rather than let the company become a zombie, management would be doing their investors and employees a favor by advocating in such cases that they pull the plug on the company and return the remaining capital to investors.

Why VCs don’t put the zombies out of their misery

Founders and executives have a lot of emotional capital invested in their companies, and so it is understandable that they shy away from making the ultimate decision. However, the surprising thing is that VCs often allow the zombies to survive for far too long. The reason for this is a subtle misalignment of interests between VCs and their investors. As long as a startup is still alive, VCs can carry the company on their books at the valuation set by the last round of financing. Once they pull the plug, the fund will receive pennies on the dollar, a loss that has to be recorded on the books and doesn't look good when the firm goes to raise their next fund. That’s why every VC portfolio has its fair share of zombies.

Another contributing factor is excessive preference overhangs. Investors receive preferred stock with the right to get back their invested capital ahead of common shareholders in an exit; in some cases they have the right receive a multiple of their invested capital ahead of common shareholders. The total amount that investors need to receive before common shareholders can participate in an exit is called the "preference overhang." 

If a company has raised so much capital that any realistic acquisition will be below the overhang, then common shareholders stand to receive nothing from the sale; and so company management has no incentive to look for such an exit. In such cases, it's important for the VCs and management to agree to restructure the preference overhangs to make such exits attractive to management. Otherwise the company is destined to become a zombie.

Every startup founder and employee has to consider three possible outcomes. Success, failure, and zombiehood. Success is much better than failure, but quick failure beats wasting years of your life on a zombie. If you are a company founder, and you are considering layoffs to extend the runway (perhaps on the advice of your venture investor), you should look at yourself in the mirror and ask whether you are cutting away your growth opportunity and just choosing a lingering death over a quick one.

Comments

[Ranjit Nayak]

Timely and very appropriate post. As difficult it is to stomach, founders, management and employees need to assess their situation and make the right moves.

Ranjit Nayak