Anyone with basic financial knowledge knows that some cushion is needed for hard times. This includes businesses.
Companies should prepare for a dip. In the modern age, the economy has grown an average 58 months before a downturn. Since the 2008 financial crisis, we've seen 76 months of growth.
A company's profits are more than what boosts the bottom line; rather, they are insurance for when the going gets tough.
During downturns, markets thin as people spend less and conserve funds. Considering that some of today's most buzzworthy start-ups are related to industries with narrow margins, tightened belts could mean their demise.
Smart CEOs can learn from past mistakes and ensure they're stocking away cash for the next decline. As part of a broader strategy, they may want to cut some expenses but also spend strategically. By acting carefully, and with less competition after the downturn, start-ups and investors may even have a chance to come out ahead.
Thick margins keep companies afloat during tough times
Consumer retail usually operates on thin margins, and it's one of the more vulnerable sectors during a downturn because people have less money to spend. When money gets tight, consumers tend to reduce purchases of material goods, especially clothes and household products, and they'll cook instead of eating out or ordering delivery.
On the 2015 roster of unicorns, e-commerce companies made up 36% of the list. They were on average worth 8 times the capital raised (the lowest ratio on the list), and had thinner margins than other sectors.
Some unicorns that may be affected in another downturn are Blue Apron, a food-delivery company that measures, packages, and delivers all the ingredients of gourmet recipes; Instacart, a grocery delivery service; and Warby Parker, a glasses company. These three consumer-goods start-ups valued at over $1 billion were founded post-Great Recession. Their margins are narrow, partly because of cutthroat competition in their verticals. If customers start to feel a financial pinch, their business may suffer.
At the same time, it would be wrong to issue dire predictions. These companies' high valuations mean intelligent, experienced investors believe in their potential.
Victims, Winners of the Last Downturns
If sales aren't strong during boom years, the weeding caused by a recession is natural. But start-ups can be doomed even when armed with great ideas and high potential because capital markets may dry up just when more money is needed.
According to the American Enterprise Institute, from the last quarter of 2007 to the first quarter of 2009, there was a 79% increase in business bankruptcies. From 2007 to 2008, angel investments dropped by 16% and total funding dropped 9%. During this time, small businesses had an especially hard time finding loans, causing this lending segment to decline by 40%.
If a business has a tight margin, a recession makes capital harder to come by. Steve & Barry's is one example of a company whose razor-thin margins bled it to death during a downturn. The clothing retailer rarely charged more than $10 for a product, and during the 2000 recession, it went under because of a liquidity squeeze.
Yet, it is important to note that there are plenty of companies that have survived downturns. Zappos survived the dotcom crash, and Jo-Ann Fabrics thrived during the Great Recession. However, what is most striking is that many of today's unicorns launched during the Great Recession. They were born out of the necessities that came with hard times, and they'll likely be able to weather an upcoming storm.
Essentials of surviving economic downturns
Harvard Business Review studied the strategies that businesses took to survive the dotcom crash and gleaned some crucial tips that can be applied before a recession to help companies thicken their margins and create more cushion.
They found that companies who had fewer layoffs, but took the time to identify potential savings in other aspects of their business, while also strategically investing and expanding, did best.
That makes sense for a number of reasons. First of all, employees are more productive when they aren't threatened with imminent layoffs. Secondly, identifying and cutting out fat helps streamline finances. Thirdly, continuing to invest in research and development, or needed hardware, gave companies the edge during recovery.
Companies that cut back on all expenditures and laid off the most employees did not fare well; neither did optimistic companies who kept spending without decreasing costs. The businesses that averaged out better than most were those that chose to lay off some employees and reduced the cost of goods sold, while expanding promotions, sales, stock and research.
But the clear winners were firms that cut fewer employees and expanded promotions, sales, capital expenditures, and research, while identifying savings in their costs of doing business. Compared to the competition, they saw sales and profits grow by 10% in the years during and after the recession.
These businesses took advantage of lower prices during the downturn to purchase property and hardware at discount prices, priming them for success during the upturn. They pivoted their marketing strategies while identifying areas where they could cut costs. For example, in Staple's case, this included closing badly performing stores. Additionally, by retaining employees, they saved money long-term by avoiding the expense of training new hires once recovery began, and maintained loyalty, morale, and productivity since workers weren't worried about losing their jobs.
The market operates in cycles, and start-up CEOs can start employing these essential strategies to prepare themselves to survive, and even thrive, during the next slowdown. Keep team morale high, invest in expanding your company, cut costs and save some cash to take advantage of lower prices when things become bearish. An economic correction can be healthy as bargains emerge and frothiness settles. Entrepreneurs just need to take the necessary steps to protect their companies.