Startup News & Analysis

What founders can do now to prepare for a possible 2019 recession

Les Szekely /

Les Szekely

Angel investor and venture capital founder Les Szekely. Source: Supplied.

A rising chorus of economists, pundits and fund managers are predicting an economic downturn (or even a serious recession) in 2019. This article explores the practical implications for Aussie startups should this eventuate.

Startups in context

The Australian startup scene is a relatively new phenomenon. It is essentially a post-2008 global financial crisis (GFC) development.

Fuelled by falling tech costs, generation Y and Z cultural attitudes and government support (such as investor tax concessions), it has developed its own ecosystem of financing (such as crowdfunding) and even dedicated real estate infrastructure (such as WeWork).

The danger for this young sector is the expectations of Aussie startup culture have been developed almost entirely in the post-GFC world of easy access to capital and continuous growth. Most startup founders are under 40 and have not experienced a recession in their working lives. Being risk takers by definition and inexperienced in running a business during a downturn, startup founders are particularly exposed to major shocks if 2019 does turn out to be a year of recession.

By contrast, most startup investors (be they angels or VCs) are much older, have working experience of recessions and are schooled in traditional approaches to business valuation. They have lived through times when ‘cash is king’ and the value of non-income-producing assets evaporates.

What happens if the music stops?

The core strategy for Aussie startups is to grow fast and burn fast. Basic business principles such as making a profit (at least in the short-to-medium term) and cashflow management are simply not a part of the lexicon of the startup scene.

This emphasis on ‘grow fast and burn fast’ (which may appear madness from a traditional business valuation standpoint) is rational in a world where valuations are often calculated based on turnover with revenue multiples based on growth rates. After all, this formula always worked … thus far.

But, that which is rational in one environment can be dangerously dysfunctional if things suddenly change.

The very language of doing funding rounds A, B, C, etc. implies the cash will always be there at rising valuations if turnover just continues to grow. But what happens if we do have a recession and the cash for the next funding round is simply not there?

Most founders have not experienced the ‘mood’ that prevails when a recession hits. Risk aversion goes through the roof and there is a flight to income-producing and lower-risk assets. In a recession, many cash-burning startups will simply be unable to raise another round. This future will not be like the post-GFC past. It won’t be about negotiating the valuation, it could be a case of closing the doors!

The risk of insolvency is greater for startups than for almost any other type of business. Not only do they rely on raising equity to keep operating, but often, their assets are valueless to anyone else. This is because the very definition of a ‘startup’ contains the idea founders are innovators doing something which is novel and risky.

In a recessionary environment, traditional businesses (think lawn mowing runs and cafes) can often still be sold to competitors because people will ‘buy themselves a job’. By contrast, the unique nature of a startup means when it runs out of cash it will often be literally valueless in the only sense which has any meaning. Or, in other words, it will not have any buyers.

Will VC funds and angels still invest?

Angel investors are typically older high-wealth individuals. In a recession, such angel investors (as opposed to investment professionals) tend to be particularly infected by the mood of the times. Thus, angel funding might well become extremely scarce in 2019. This augurs ill for new startups looking to raise their first angel, seed and even A rounds from sources such as high-wealth individuals and family offices.

VC funds typically source their funding either from institutions or high-wealth individuals. To the extent that they rely on individuals, it could be very difficult to raise new VC funds in 2019. Institutional investors, albeit less volatile, may also reduce their weighting towards riskier, alternative asset classes. Thus managers that have not raised a fund in the last couple of years may run out of cash to invest.

Fortunately, Aussie VC funds have a raised a lot of capital in recent years, much of which has yet to be deployed. These funds will still be in the market, recession or not. However, given a change of mood and less competition for deals, even startups that have high-growth rates coupled with good metrics will struggle to get the sort of valuations they expect. Valuations can drop sharply in a recession, even if your business metrics improve!

If there is a recession, the best-placed startups will be the larger ones for several reasons. First of all, the supply of larger startups in Australia (those raising over $10 million) is fairly limited, so the funds with the capital to deploy in larger A or B rounds will still have to compete for this limited supply. Secondly, the larger startups are likely to be more mature in that their timeline to profitability is both shorter and less risky than that of early-stage startups. Thus, with an increase in risk aversion, they are likely to attract an increased share of investor interest.

It is also worth sparing a thought for those founders, angels and VCs who may be planning to sell down some equity or do an exit in 2019. If we do tip into a recession, exits will become hard and rare, while sell-downs may become akin to scaling Everest.

The New York Times is already running articles predicting startup valuations will tumble in 2019. This is just the sort of thing which quickly becomes a self-fulfilling prophecy.

What founders and VCs should do now

First of all, if you are about to found your own startup, perhaps you should pause to consider staying longer in your day job. Don’t make the jump until the mood changes or you have your seed capital committed. Recessions end eventually.

If you are a founder of a startup which is already humming, then revisit your business plan, such that survival is not contingent on raising more equity in 2019, and possibly even 2020!

If you are unable or unwilling to switch immediately from a burn-fast-grow-fast strategy to a break-even strategy, then put in place a laser focus on cashflow and a plan to ensure you can turn things around before hitting the wall if fresh equity cannot be found.

Founders have both legal and ethical responsibilities to a variety of stakeholders. For example, it might prove pretty poor form to hire a lot of staff after we enter a recession and still rely on being able to fund a high burn-rate via raising another equity round. It may be more decent to slow hiring, use contractors, or at least be honest with staff about the business strategy.

A changed environment would also present particular challenges for startup directors, whether founders or non-executive. The fact that a business is burning does not in and of itself mean it is trading while insolvent, but boy does it increase the need for caution! Reliance on a strategy which requires raising equity to keep trading is loaded with moral hazard. Even assuming you start equity raising while the business is solvent the equity raising process during a recession is riskier and is likely to drag. Meanwhile the pressure to ‘not pull the plug because we are almost there’ is huge. I can foresee this leading to many conflicts between founders and non-executive directors, such as those appointed by VCs.

It is worth adding as an aside that not only are founders generally not au fait with insolvency law, but startup directors are rarely provided with D&O insurance. I cannot help but wonder what a court would say to a director being pursued for insolvent trading if they ran the defence they had a plan to fund ongoing expenses from an equity raising to which no investor had as yet legally committed.

If we are at the start of a recession, founders and VCs would do well to start adjusting their valuation expectations from now to avoid a major shock later. The basic AVCAL approach to valuations (absent third-party transactions) is to revalue investments using the same methodology as was used when making the investment. This produces the result that if a startup has grown and maintained its other metrics then its valuation will have increased correspondingly. What this fails to take into account is the market reality that upon a change of market sentiment valuations can drop dramatically despite a business having achieved solid growth with improving metrics.

For both founders and VCs, the question of valuation crystallises if and when they cannot raise equity at the expected valuation and have gotten themselves into such a cashflow position that they have to accept a much lower valuation. If the new valuation is less than the carrying value of the investment in the books of a VC fund this may give the manager some pain. However, if as is commonly the case, the VC fund has the benefit of anti-dilution rights the pain may be transferred (often entirely) to others, especially to the founders.

Act now!

The pundits and experts are as yet undecided whether the major correction in stock markets in recent weeks will mark the start of a recession, or not.

The risk for both VCs and founders lies in the homily about how you boil a frog. Despite daily swings and roundabouts, we have already seen a significant rise in risk aversion over several weeks, and a change in sentiment as epitomised by this article itself.

Don’t panic, just yet. But do put in place measures now to ensure your startup can survive in the event that history decides that 2019 will suffer a significant recession.

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Les Szekely

Les is an angel investor, the co-founder and director at VC funds manager EVP.