Startups: When Cutting Costs Won't Cut It

Entrepreneurs seeking capital in a downturn need a "must-have" business proposition, enough cash to keep operations on track, and a team that can execute

By Rory O'Driscoll

In just about every Silicon Valley boardroom the conversation inevitably turns to cutting costs. Once the pleasantries are exchanged and election handicapping subsides, executives eventually ask a variant of "How bad can it get?" and "How much should we cut?"

Those are the right questions to be asking, given the dour market news and that superb but gloomy and widely publicized analysis by Sequoia Capital, the leading technology venture capital firm. Indeed, the world has endured a financial shock significantly greater in magnitude than the 2000 collapse. And while Silicon Valley is at its edge and not the epicenter, the consequences of this shock to the Valley are real. Investment capital will be scarce and expensive, exits will take longer, and revenue growth will be tough. In this environment, cutting expenses may be necessary to survive.

But don't forget that surviving is not winning—and winning requires more than cutting. In fact, sometimes cutting eliminates the possibility you can win. Winning requires three things: a business proposition that customers embrace even when customer spending is down; enough cash to fund the business appropriately when cash is scarce; and great execution by the team. Let's look at each in turn.

First, will customers come calling when the chips are down? Customers reorder priorities quickly in a recession. U.S. companies that are shutting factories will not have the budget for experimental social media advertising. Every worker not hired is $5,000 worth of IT spending that will not happen. Consumers who are failing to pay their mortgage don't upgrade cell-phone plans. However, customer anxiety and cost-cutting can be your friend. In a downturn, people will think the unthinkable, reexamine existing commitments, and allocate budget to what works now—not what worked in the past.

Must-Haves Prevail

Look at the 2000 crash. Internet direct response and keyword search exploded as marketing executives who had to justify their budgets turned to media that could deliver and prove it. The result: Google (GOOG) is now worth $116 billion. Productivity-enhancing tools like Research In Motion's (RIMM) BlackBerry wormed their way into corporations, despite IT resistance; having your employees available 24/7 is handy if you have just halved your staff. Little wonder that RIM is worth $26 billion. Open-source software, or low-cost software delivered over the Web, as a service, might not be as ready for your business as you'd like, but the IT director who has been told to cut 80% from a software budget might have no choice. Witness Salesforce.com's (CRM) $3.5 billion valuation. On the consumer side, Amazon.com (AMZN)and eBay (EBAY) exploded despite the recession. Must-haves rise to the top.

Nice-to-haves fall to the bottom. Which are you?

Now, let's assume you have the right idea. Then the question becomes, Do you have the cash? If you did not raise money last year when it was easy, then you have to understand the postdownturn fundraising reality. Now even the credulous are suspicious. It's here that the Sequoia Capital presentation is spot on.