For the past year and a half I’ve been driving past a new BMW dealership as it is being built. The project started just before the beginning of the sub-prime saga when the economy was still good, credit was easy, and people were lining up to buy new cars. Now the new building is almost ready, the economy is in a bad shape, and dealerships are struggling to stay afloat.
A number of prominent VCs published letters they sent to their companies on how to survive the downturn. The standard advice includes not hiring, shutting down or cutting R&D, and making everyone, including receptionists, sell. This approach, which boils down to getting as much cash in and as little out, sounds logical, especially for a startup strapped for cash. But what if a company has cash reserves sufficient to last several years even if the sales dried up completely? Is there a better strategy than hibernating until the economic sprint comes back?
A company that operates in the survival mode during downturns ramps up new product development during boom times. In a good economy financing is easy and, as a result, many new companies are being started. There is an increasing demand for engineers and there is a lot of noise from all the new products being introduced into the market.
During a downturn, such a company concentrates on sales which are harder and harder to get (unless the company is selling something that is in demand during a recession). Sales people, at least the good ones, would be let go as the last resort. Since the majority of companies tend to operate in the survival mode, there is not much opportunity to improve the quality of the sales team, at least not until later when companies start running out of cash. This company got an uphill battle in both good and bad economic conditions.
Let’s now examine how the contrarian approach works, assuming the company has enough cash to survive several years with significantly reduced sales. Such a company would ramp up new product development during the downturn and slash down the sales effort, perhaps even purging the sales team. At this time it should be easier and cheaper to pick up quality engineers since there are more of them on the market and there is less competition from other companies. It is also easier to introduce new products and appear as a market leader during a recession.
Towards the end of the downturn the company can try to improve the quality of its sales team by hiring people from failed companies. As boom times come back, the contrarian approach yields new products ready for the market and the sales team ready for the renewed interest. At this point the company becomes cautious of any aggressive expansions as costs increase. Instead, it concentrates on accumulating enough cash to repeat the cycle when the economy turns bad again.
During boom times companies rush to get to market as quickly as possible in order not to miss opportunities. A downturn, therefore, could be a perfect time to develop and introduce radical and unproven new technology that can take years to get right.
The contrarian approach is logical for a bootstrapped or established business that got a chance to accumulate substantial cash reserves during a boom. It is the way investing, especially the VC type, works that forces companies into the survival mode. Raising venture capital in a good economy is a lot easier than during a downturn. It is also easier to get investment for an idea that is in a “hot” market such as e-commerce during the dot-com boom and social networks more recently. VCs also expect their companies to expand rapidly. This makes a VC-funded company burn cash by rapidly growing in a crowded and noisy field with expensive and scarce engineers.
There are other advantages of expanding during a recession. Office space becomes cheaper as the demand slows. It is easier to negotiate better deals with suppliers and partners as they become dependent on the revenue your business brings. Tax incentives for R&D, starting new businesses, and hiring people are often introduced during recessions to revive the economy. It is also well known that teams become more focused and work harder in the face of a powerful enemy. Recession can be such an enemy. Boom times have the excitement of the overall activity in the field as well as easy sales. But excitement is fleeting while the resolve to outlast a recession stays.
The contrarian approach is not without risks, the biggest of which is running out of cash before the downturn ends. The other problem is finding early customers to use your product and provide feedback. However, one can offer the initial version for free or at a significant discount which may work rather well during a recession when customers presumably need your product but simply cannot afford to pay the full price at the moment.
The survival approach is not without risks either. The biggest of which is expanding into a recession, as the BMW dealership example above illustrates. As with the contrarian approach, there is also the possibility of failing to preserve enough cash and generate enough sales to weather a recession.