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In these perilous economic times, the layoff memos often follow a familiar refrain: “We have cut costs by 20 percent. That gives us an additional year’s runway. Or two.” But while yes, companies can cut costs and prolong their survival, when it comes to startups, just because they can doesn’t mean they should.
I’m speaking here of venture-backed startups, which represent a small minority of companies. The sole purpose of most companies is to create a steady income stream for their owners and operators — in other words, survival. Venture-backed startups, on the other hand, are created with the sole purpose of a successful exit.
Why growth is crucial
Whether that exit comes in the form of an acquisition or an IPO, in the meantime, the lifeblood of any startup is growth, be it in terms of customers, usage, revenues or profits. Under most economic conditions, an IPO is impossible without revenue and profit growth, and we are unlikely to see that change any time soon. From an acquisition point of view, stagnant companies are valued at low multiples of revenue, say 1x-2x. And while popular meme suggests that flat is the new growth — given the downturn in the economy, the argument goes, even keeping revenues flat is sufficient — this argument does not apply to startups.
By definition, startups are supposed to be attacking nascent market opportunities and unsaturated markets, and as such should be able to grow even during 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 far better than just growth 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.
It’s no fun to work at a startup that isn’t growing. Stagnation leads to low morale, with people sitting around waiting for the axe to fall. Rather than let the company become a zombie, management would be doing their investors and employees a favor by pulling the plug and returning the remaining capital to investors.
Why VCs often don’t put companies out of their misery
Founders and executives have a lot of emotional capital invested in their companies, so when it comes to making the ultimate decision, their reluctance is understandable. What’s surprising is how often VCs let companies turn into zombies. The reason for this is a subtle misalignment of interests between VCs and their investors. As long as a startup still appears to be, on some level, 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. Every VC portfolio, therefore, 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 to 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 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 in the mirror and ask yourself whether you are cutting away your growth opportunity and just choosing a lingering death over a quick one.