Will Your Startup Survive the Next Major Crisis?

To assess the risk of zero, use these four crucial questions.
tony
Tony Yiu
Expert Columnist
June 20, 2020
Updated: August 11, 2020
tony
Tony Yiu
Expert Columnist
June 20, 2020
Updated: August 11, 2020

The risk of zero is the very real risk that a startup goes bankrupt and its equity value goes to zero. Assessing the risk of zero is massively critical whether you are considering investing in a startup or working for one (or already currently work at one).

Unfortunately, unlike public companies, startups are closely guarded with their financials. Without direct access to insiders, we can’t know essential metrics like transaction-by-transaction profitability, cash burn rate, and customer churn. But these are exactly the things we need to know in order to assess their competitive power and financial health — the two main factors that will differentiate winners from losers during difficult economic times.

Minus privileged access, what are we to do? Here are four questions (besides the obvious ones like: “Are you profitable?” and “What’s your cash situation and burn rate?”) that you should insist on getting answered (or answering yourself via due diligence) before signing that term sheet or offer letter. Or alternatively, before starting a company yourself.

 

What Future Growth Rates Are Baked Into the Startup’s Current Valuation?

We’re currently at an economic crossroads — the stock market sits just a few percentage points below its all-time high at the same time as the economy confronts levels of unemployment that have not been seen since the Great Depression. It’s more important than ever to make sure that the equity you are receiving is valued fairly. The value of these options is premised on future growth. At a minimum, the founder and his executive team should understand and be realistic about what needs to be achieved to justify the current valuation. Bear in mind that meeting these expectations just means that the stock keeps its current value; the discounted expectations must be exceeded for the stock to appreciate.

Recessions have a way of revealing delusional growth assumptions for what they are — unrealistic and unobtainable. In these cases, even if the startup is not a true zero (it stays in business), its valuation may take a haircut of 50 percent or more, making equity options effectively worth zero.

Recession investing requires a different mindset than boom-time investing. You need to be more like Warren Buffett and temper your optimism with a conservative assessment of the startup’s probable growth outcome and achievable market share. If this outcome and the valuation it implies is still acceptable to you, then go for it; but now is the time to stay away from investments and companies that require rose-colored glasses.

 

If the Company Were to Lose Its Three Largest Customers, What Would Happen to It?

It’s not just the company itself that you need to worry about but its customers and supply chain as well. If your customers can’t make money, neither will your company. For example, Boeing has owned a profitable oligopoly position on the airline manufacturing industry for decades. But it’s currently hemorrhaging cash because its customers, the airlines, are themselves facing an existential crisis.

Your due diligence process, even as a prospective employee, should include questions like: How concentrated is the customer base? If the top customers account for a significant percentage of business, how healthy are they?

 

Is the Startup’s Product Both (a) Relatively Essential and (b) a Small Percentage of Each of Their Customer’s Expenses?

If the answer to this question is yes, then it’s highly likely that the company can ride out most crises reasonably unscathed. During tough times, most companies look to trim all but the most essential expenses. This means that nice-to-have things like Hint water and grass-fed beef jerky must go, but essential things like Excel, Tableau, and AWS still get paid for. The best products are those that perform a key function, are integrated (meaning that the customer has built it into their workflow or product design), and comprise a small portion of the user’s total expenses. All of these in combination mean that the customer has zero incentive to substitute out your product.

 

In a Liquidity Crisis Where Normal Business Operations Freeze Up, Are There Large and Hidden Fixed Costs That Will Directly or Indirectly Jeopardize the Firm?

These types of hidden threats are everywhere and usually neglected until it’s too late. Here are a few examples:

  • Airbnb is getting hit doubly hard by the current crisis. Not only does it have to grapple with the immediate impact of plunging sales as coronavirus fears cause people to postpone their vacations, but it also needs to confront the fact that many of its superhosts borrowed heavily to fund their rental properties and will probably default and lose them to foreclosure. These superhosts account for a large portion of Airbnb’s revenues. If Airbnb makes it through the current crisis intact, it will likely come out the other side with a significantly reduced supply of rentals, stunting its growth for a while.
  • Opendoor is basically a retailer of homes — it buys a house, refurbishes it, and flips it for a higher price. But like all retailers, it is at risk of not being able to turn over its inventory. But unlike the typical retailer, its inventory consists of houses worth tens of thousands (if not hundreds of thousands) of dollars each. And these houses were probably paid for by debt. So if the real estate market were to freeze up (for any reason), it would be devastating for Opendoor. It would get hit simultaneously by a triple whammy of revenue loss (from reduced transaction volume), inventory write-downs (from declining home prices), and an inability to rollover maturing debt. All the while, it would need to continue to service its interest expenses.

Operating and financial leverage (where a significant portion of a company’s costs are of the fixed variety) allow companies to print money during economic booms. But in a crisis or a recession, they are a leading cause of corporate demise.

 

Conclusion

Economic crises, as anxiety inducing as they are, are also a breeding ground for massive opportunities. Companies that survive will enjoy less competition and a long runway (as the economy recovers and everyone starts spending again). Your job as an investor, prospective employee, or founder is to identify companies, startup or not, that are in a position to not only survive but thrive during difficult times. Answering the above questions will help you do so.

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