It’s been 20 years since the technology sector faced a recession. The Dot Com Recession of 2001 began with the collapse of the tech bubble in early 2001. It ended shortly after the 911 attacks, making it the shortest recession in recent history. Given that nearly 80% of today’s companies did not exist in 2001, most tech startups have little to no experience in surviving a worldwide recession. As the economy contracts, investment dollars become harder to find. That’s why it’s important for tech companies to understand how to raise capital during a recession.
Is It a Recession?
Recession is an economic term that refers to a decrease in a country’s GDP for two consecutive quarters. In reality, a recession occurs whenever the economy begins to contract. Sales fall, unemployment rises, manufacturing slows, and consumer spending declines. It becomes more difficult for businesses to raise capital and find financing, and venture capitalists become more cautious in their investments.
How a recession impacts an economy depends on its cause. For example, companies can trigger a recession by taking on more debt than is safe. At some point, these organizations cannot pay their bills, and the economy begins to shrink. Businesses that have not overextended themselves have a better chance of weathering the downturn.
A sudden and unexpected crisis such as the coronavirus pandemic can also trigger a recession. Surviving a crisis-based recession is more difficult because there is no time to prepare. A tech startup may be in the midst of a new product launch. A cybersecurity firm may have been contemplating a change in its business model. Suddenly, those plans are on hold as they pivot to address the challenges of a global crisis. And many of these companies are probably wondering how to raise capital during this crisis.
Most tech startups are in uncharted waters. Without experience in raising funds during a recession, many startups may struggle to survive. If startups want a better chance of receiving investment dollars, they need to understand what investors are looking for. Let’s take a look at these companies can raise capital.
Start with the Basics
Investors are always interested in three significant numbers:
- Cash Flow Statement
- Breakeven Analysis
- Profit and Loss
In an economic crisis, these numbers take on even more importance. Companies need cash to survive. They must become profitable to grow. And, they should estimate their breakeven point, so they know how long the money has to last before profitability becomes possible.
Cash Flow Statement
Potential investors use cashflow statements to assess the financial health of a company. They highlight three revenue-generating areas of a company:
- Operating cash flow shows the amount of revenue a company generates by selling its products and services.
- Investment cash flow shows the amount of cash or cash equivalent a company earns through its investments.
- Financing cash flow identifies the amount of money that has come through borrowing or investing.
These three areas are combined to produce a net cash flow. Investors use these numbers to assess a company’s current value and its growth potential. The stronger the cash position, the better the investment. That’s why companies should take steps to improve their liquidity. This will help them raise capital in the long run.
The breakeven analysis is also extremely important to raise capital. Breakeven is the point at which a company is not making nor losing money. It is a financial calculation that:
- Identifies the point of profitability
- Ensures appropriate product or service pricing
A breakeven analysis shows investors how long before a startup becomes profitable. It also highlights any weaknesses in product or service pricing. For example, a cybersecurity company may underestimate its overhead costs, resulting in a selling price that doesn’t cover production costs. That means the company is losing money every time it sells its product. Investors are looking for companies that understand how to price their products to ensure profitability and have the numbers to support that pricing.
Profitability helps a company stand-out. Investors look at profitability as a sign of a healthy business. The more profitable, the better the investment, and the more likely to raise capital. In an economy that is down, profitable companies are more likely to receive investment dollars because they present less of a risk.
Startups should focus on cutting costs. Tech startups such as cybersecurity firms may think they have streamlined their operations by working remotely and downsizing office space. But, they should review their operating costs, eliminate any side projects and reassign personnel, so everyone is focused on the core business. In an economy that is down, it is essential to look at cutting costs wherever possible.
When investment dollars are harder to find, financial numbers are essential. For startups, understanding those numbers becomes even more crucial because investors will not only want to see the numbers, but they will also expect an explanation of how they were produced.
Find a Product-Market Fit
No matter how great the financial numbers, investors will want to know how well your product fills a market need. That requires careful market analysis. For example, a cybersecurity firm has developed a new penetration test tool. Before looking for investors, the company needs to:
- Identify the target market
- Conduct research
- Concentrate on a single vertical
- Measure product-market fit
Finding the right fit takes time. Investors will be looking for companies that have performed their due diligence when it comes to product-market fit.
Identify Target Market
Businesses need to be very specific when they identify their target customers. Take that cybersecurity firm. It needs to answer questions such as:
- What makes their product different from other penetration tools? Maybe it comes with pre-defined test parameters that make it easier for companies to configure and run.
- What market segment will benefit from the tool? Companies with limited IT resources can now run penetration tests.
- What is the competition in this market segment? Investors want to know that a company has spent time understanding the competitive landscape.
The answers to these questions must be based on data. Startups must perform research to support their product-market assumptions.
Research requires talking to customers or potential customers. Is that new pen-test tool something a company would purchase? Does it address any of the pain points that users experience? Do you know what the most common complaints are from your target market?
Businesses can conduct surveys, but talking to customers — even from a distance — produces more valuable feedback. By using end-user feedback, companies can adjust their product to address gaps in existing offerings. Investors are looking for a winning product-market fit.
Concentrate on a Single Vertical
With limited resources, startups need to focus on a single industry. If startups use the shot-gun approach, they may run out of funds before they have a single sale. Cybersecurity is a $150 billion dollar industry with well-established industry leaders. By narrowing their focus, startups have a better chance of success.
Instead of going after the small business market for easy-to-use penetration tools, focus on small legal or medical providers who have compliance requirements for penetration tests. A focused approach, backed by careful research, increases the comfort factor for investors.
Measure Product-Market Fit
Measuring a product-market fit as a startup is different from measuring it at different stages in a product’s lifecycle. In the initial stages, a startup needs to measure the following:
- TAM. The total addressable market means the total number of people or businesses that could benefit from a product. It is an estimate of product potential.
- SAM. The serviceable addressable market means the percentage of TAM that a company can service. For example, the TAM for that penetration tool is 100,000, but the startup is only marketing to organizations in the southeastern United States, which reduces the SAM to 50,000.
- SOM. The serviceable obtainable market is the percentage of SAM that a startup believes it can acquire. For example, a SOM of 50 % in a SAM of 50,000 equals 25,000 customers.
Using these values as a basis, startups can develop a business plan that makes investors confident of their investment, improving their ability to raise capital.
During a recession, raising venture capital becomes more challenging. Startups need to be prepared with the basics of how they plan to cut costs and improve liquidity while improving profitability and moving the breakeven point forward. They also need to show that their product offering has a strong product-market fit by providing realistic measures for potential growth. Investors are always looking for sound, data-driven investments. By following these tips, companies will be prepared to raise capital even in a crisis.
Option3Ventures offers a venture capital fund that targets underserved and underfunded investment opportunities in the cybersecurity space. If you’re looking for an investment or investment dollars, let’s explore your options together.