The global economy has endured a number of recessions over the past 100 years. When COVID-19 first began to impact the world, market experts initially predicted an economic climate that would quickly rebound. It’s now readily apparent that COVID-19 is presenting a once-in-a-generation global economic event. Its closest precedent is the Great Depression.
The coronavirus economy hit many new lows since the 1929 Great Depression, including the fastest market selloff.
COVID continues to generate macroeconomic headwinds that are landing startup founders in incredibly challenging positions. According to a March 2020 survey by First Round Capital, 7% of founders reported that they had reduced their workforces. This number grew to 19% by April 2020.
As a startup executive, I empathize with the difficult decisions leaders face, particularly while navigating uncertain economic conditions. Nevertheless, I challenge new founders to put people first and turn to layoffs only as a last resort: How founders treat people today will determine perceptions of the company in the post-pandemic world.
At a past startup, I wrestled with decisions about layoffs, albeit in a different economic and global context. In the interest of saving on costs and streamlining, the leadership team replaced the original engineering team with a smaller team, new tools, and automation. The transition demanded more resources than we expected and the tax on company morale was onerous and long-lived/lingering. A year into the overhaul, savings showed on paper, but we struggled to confront legacy issues—previously handled by the original team—that affected millions of our users.
Layoffs proved shortsighted. Investments in team efficiency (broadening their duties, rotating them to different assignments, etc.) would have yielded higher returns, quantifiably and in terms of team morale. Startups often pursue a mission for years before achieving definitive commercial success, and yet we often make short-term human resource decisions that are ultimately unwise.
This moment, perhaps more than ever before, demands a people first mindset. Job loss amid some of the highest labour force dislocations in modern history, and during shelter-in-place orders, will precipitate long-term unemployment for many, putting entire families and communities at risk.
If you’re a founder trying to keep your startup afloat, the following alternatives might help you both avoid layoffs and strengthen your business for the long term.
When faced with a recession, typical advice calls for extending the startup runway to at least 18–24 months. Marketing expenses, perks, and office spend tend to go first in these calculations, as this nfx survey shows.
For example, say you may need to find $1M to extend your runway to 18 months out. Just in January, $1M in San Francisco was equivalent to five senior software engineers for a year (plus equity).
Rather than laying off those five people, consider these three alternative scenarios:
1. Scenario A — Raise additional capital
Today, mid-April, you can raise $1M on a 50% lower valuation than was possible just 3 months ago according to this NFX survey, resulting in dilution that you can model in LTSE Equity.
- Pros: Keep the staff and hopefully your fundamentals are strong so venture capitalists feel they got an excellent deal and saved the company.
- Cons: You and the staff all face extra dilution. Rather than a price round, maybe you can raise on a convertible instrument with a guaranteed discount percentage when you raise your next priced round.
2. Scenario B — Lower salaries
You can lower collective salaries by $1M and issue more stock options to everyone to cover the difference. Heck, you could go to the board and ask for an increased option pool so that all investors (and not just founders and employees) take a proportionate dilution. If you have contractors, this is a great time to introduce or further increase their equity compensation in order to preserve cash.
A typical recommendation is to reduce exec pay only to show management responsibility with pay cuts across the board discouraged, as that makes employees an easier target for companies with strong balance sheets. Reducing pay across the board and offering compensating equity may both strengthen solidarity and the feeling of ownership.
Understand how option pools dilute you and your investors in a funding round with LTSE Equity.
- Pros: All investors bear the cost and all employees take a collective hit to save jobs.
- Cons: Those salaries will likely need to go up in a year and even more likely those cash flow reductions will impact some employees more adversely. Also, comparing the first two options, one needs to model the effect on cash flow between having $1M extra right now vs saving $1M over the next 12 months.
3. Scenario C — Get a line of credit or debt financing
If you have sizable assets or revenues, a $1M credit line or other debt financing may bridge the gap. In this case, you are likely not modeling equity dilution but need to carefully model future cash flow, including interest owed.
Minority owned businesses that have historically encountered issues securing loans can look into a variety of alternative financing routes. Our partner, The Plug, which covers inclusive innovation ecosystems and shares resources tailored to underestimated founders, recommends looking into Small Business Administration loans and programs which support women and minority businesses as well as local community development financial institutions. These often provide low-interest rate loans with less stringent requirements up to the millions.
Note: Triggering any of the above scenarios is likely going to trigger a need for an updated 409A valuation. It’s quite likely your FMV could be lower than the most recent 409A valuation, which can create an additional incentive for all employees receiving compensating equity grants and any new hires joining over the next year.
A deeper dive into cost reductions
Thanh Nguyen of Connery Consulting, a boutique Human Resources consulting firm, has additional insight on potential avenues for cost reductions. “As we think about alternatives to layoffs in more detail, whether scenario A, B, or C is decided, spending time delving into the make-up of your workforce including duties, responsibilities and business impact will be critical in your ultimate decision making. Your total company workforce should include full-time and part-time employees, individual independent contractors and vendor service providers. If implementing restrictions (hours etc) or pay reductions, be clear on what work will be delayed or stopped and where continuing work will be going. Money saved in one area may simply end up being reallocated to another budget — for example, moving money from Payroll to Professional Services or vice versa. In this unprecedented time as part of invoking a people first philosophy, we’ve been asked by many of our clients and others what cost controls they should be evaluating to help reduce cost in an effort to mitigate the need for layoffs.”
Startup CEOs often assert that people are their most precious resource. Yet a month into the shelter-at-home order, we’re seeing a massive and still-building wave of layoffs. Is this not the pinnacle of short-term over reaction? In just under a month, the startup ecosystem has gone from a highly competitive talent market, ever-higher salaries, and 20%+ placement fees to widespread layoffs and displacement.
So what should you avoid doing?
1. Avoid treating this as a convenient cover to let go of under-performing employees.
Performance issues should always be dealt with individually and expediently, and people should be given a chance to improve through a well-documented performance management process. These processes are hard but valuable learning opportunities for the organization and those involved. Terminating employment for performance reasons without due process, while legally permissible in at-will states, hurts everyone.
2. Avoid reflexively shutting down incubating projects.
Immediately shutting down non-performing projects and cutting associated staff is reactionary. While it can be easily shown on paper that these projects are pure cost in the short-term, some of them might be essential to your long-term prosperity. Instead, take time to re-examine what conditions might have changed. Then if a project still makes sense, see how it can be aligned with the new fiscal constraints.
3. Avoid automatically furloughing people whose jobs are affected by shelter-at-home and social distancing orders.
Instead, find other work they could do. Customer Success staff could join crisis response agencies to offer phone and email support. Salespeople could check in with customers and vendors to find out how they’re doing and if they need help. This will certainly strengthen your business relationships, with an upside of leading to new product insights created by the current conditions.
Though the current situation is uncertain and the “new normal” has yet to be defined, we know that we are stronger as a society when we take care of each other.
As LTSE CEO Eric Ries has said, “The actions you take now will define the rest of your corporate life. If you don’t take care of people, if you haven’t put them first, you think they’re not going to remember when the recovery comes?”
If you have questions about the options outlined above or just need guidance on how your company can navigate the crisis, we are here to help. Email us at email@example.com.