Why did the Tech sector, until recently fighting tooth and nail for every candidate, start firing droves of employees?
As 2022 rolls to an end, a series of natural and man made disasters does not seem to come to an end. But while demand remains robust, especially in the tech sector, some other factors came to play, initiating a chain reaction that forced many managements to lay off a massive number of emloyees.
In this post I will try to show an explanation.
The life of a StartUp
What is a StartUp?
Wikipedia states that "A startup is a company or project undertaken by an entrepreneur to seek, develop, and validate a scalable business model".
Crucially, a StartUp ceased to be one, i.e. matures, when it starts to generate positive free cashflows, and profit' distributable to its share holders.
The stages leading to this end - Finding, developing, validating, and scaling, are usually cash negative operations, with the amount of new cash increasing from step to step.
Developing a solution is usually more expensive than finding the problem, validating - often referred to as "Product-Market-Fit" is even more expensive, and scaling up is the most expensive stage, where the amount needed to expand depends largely on the size of the market you are trying to capture.
The rationale of these growth stages stems from the fact that in many markets, it is only the market leaders that are able to retain high margins, and stay profitable over time, whereas lesser players are forced to compete on price.
Growth, Future Investments, and Profit
Consider the management of a successful StartUp, who is executing on their plan to grow. This StartUp has identified a pain, built a solution, and is in the midst of its scaling up stage:
Sales teams are set up, the marketing department is beefed up to be able to generate awareness in growing numbers over a wider geography. Support and customer success operation is mounted, as no technical product goes without them. Even the R&D team is expanded, since more customers reveal more needs, more business cases are found, and more features need deployment to retain the company's advantage.
All this requires cash, usually outlaid from capital injection, to fuel aggressive growth, reach market domination, and sealing the StartUp status as a profit-raking market leader.
This is the StartUp game plan. Although there are slower, organic, growth paths to follow, they will probably not lead to domination and exceptional returns, keeping investors away.
The management is therefore in constant balancing act between Growth and Profitability, and the level to which it leans towards one of these strategies depends mainly on Investors' appetite for risk, and the resulting available future investments.
Weather Change in Capital Markets
What we are experiencing in the past several months, is a mood change in capital markets, caused by macro-economic developments.
The short explanation consists on two intertwined phenomena:
The base interest rose up briskly: By the end of the year the forecasts are anywhere between 3% to 4% percents. "Base Interest" translates in close proximity to "Risk-Free Interest". All lending, including StartUp investments, base their discount rates on risk free interest. As this goes up, capital gets more expensive.
The existence of higher yielding risk-free securities, on the other hand, sucks cash out of the market, as investors are happy with the lower risk, yet rewarding instruments.
And this is the gist of it.
Management Reaction
Without change in company performance, and forecasted demand*, the potential sources of future capital are drying, making the journey much riskier: As startups are still on their runway, they count on future investment rounds to grow them bigger and bigger, before they turn profit.
Cut these expected future flows of capital, and the whole scale-up-to-become-leader paradigm is shattered, and management will have to pivot to conservative strategies, foregoing explosive growth for now.
How this is done? Management cut expansion budgets, and suddenly, it turns out that a large numbers of personnel is made redundant, reducing the cash outflows.
The effect is clear: The P&L goes up, the burn-rate goes down, and the next funding milestone is pushed to the future, possibly to the next business cycle.
* Macro-economic shocks tend to be avalanching, as firms - once understanding the new state of the market cut not only on employees, but also on contractors and purchases.
Disclaimer:
This post is offered as education material only, and should not be construed as a concrete advice or consulting aimed at any specific situation.
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I can be reached at yoel@theroadtlv.com