Startups: When Cutting Costs Won't Cut It

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Essentially, Sequoia is saying what's always true but rarely stated about investing: If you run out of money before you have proven that your business model works, then the terms of any new investment round will be unattractive for the entrepreneur at best; in a worst-case scenario, there will be no more money. Proof in a downturn does not mean trial customers. It means real revenue and preferably accelerating growth. If your company has already raised a first round but does not yet have revenue—or worse, has low growth or flat revenue—cutting expenses is the only way to survive. Cut now, cut hard, and figure out something different to do with the rest of the cash.

However, there will be many companies that have a great product and have early revenue traction but still need capital. For every Google, which spewed cash once it locked on the right business model, there are five others that will continue to consume cash for an extended period, even after developing a clear and validated business model. This is a point worth repeating. There is a lot of nonsense spoken by venture capitalists about getting by without spending more, and I am guilty of it, too. Of course it would be great if our companies could build great technology businesses without investing in research and development or sales and marketing. It would also be great if we could build cars without using steel. But we cannot. The system is called capitalism because making it work requires capital, and often a decision not to invest is a decision not to grow.

Winning Bets in a Downturn

Consider some of the top venture-backed exits since the last recession. Many have created huge value, but could not have done so without the foresight and perseverance to keep investing in the face of the 2001-2002 recession. Wireless carrier MetroPCS (PCS) endured bankruptcy, software provider Salesforce.com burned through $70 million in equity capital as a private company, and medical device maker Kyphon certainly did not have cash flow while the Food & Drug Administration was determining whether to approve its therapy. All these required equity capital and thus investors with the guts to finance big ideas in a tough market. Although it went public in 2000, RIM burned through more than $219 million building the BlackBerry business. Amazon's bonds were downgraded in 2002 as "likely to default" by many investment banks because the e-tailer was still losing money. Many of those investment banks are no longer independent, and some have failed; Amazon continues strong. Not only did all these companies continue to invest in the downturn, but there was no way to build them without the investments. An earlier focus on profit at the expense of growth would have resulted in a less exciting and, ironically, less profitable outcome.

Startups are still getting money—but for the right idea, with the right execution. Although the world is bleak, venture investors will plow $28 billion into 3,500 different companies this year. Many of the firms that are talking gloom and doom are also raising large new funds. You may need their money, but remember they also need your idea. It is precisely when mediocre deals are failing that investors most need great ones. If you can show your existing money has been well-invested and that new money can accelerate the upside rather than simply postpone the downside, the chances are greater you will get funded. If you create healthy competition for the deal, then you will more likely get funded on attractive terms. If you are just fooling yourself about how far along you really are, then you will not be able to raise the money. Then again, that is the way the system is meant to work. Recessions just make it real.

Rory O'Driscoll, a managing director of Scale Venture Partners, is a veteran venture capitalist who focuses on mobile, Internet, and enterprise software and services. He has contributed to the evolution of business models at companies such as Frontbridge, Omniture, and PlaceWare. O'Driscoll holds a bachelor of science degree from the London School of Economics.