The global economy appears to be on the brink of another recession for the second time in as many years. This time, the culprit is inflation as Covid-recovery spending, both public and private, runs head-on into draconian Chinese lockdowns, trade disruptions from the war in Ukraine, and other supply chain constraints.
In the past several weeks I’ve been on the road, both virtually and physically, meeting investors and discussing what makes a great tech business in an inflation-driven downturn. It seems that there are a number of key ingredients...
1. Don’t rely on a premium for ESG, convenience or cachet
Many tech businesses have a business model that assumes that consumers will ultimately be willing to pay a premium for their products and services. This could be an ESG premium in climate tech, a convenience premium in fintech or simply a premium for cachet in consumer tech.
The quest for a premium doesn’t just apply to consumer goods, but also up the value chain. For example, climate tech for green steel manufacture assumes that auto makers will ultimately be able to charge a premium for vehicles made with green steel, whether they are selling them to end consumers or corporate and logistics fleets looking to bolster their climate credentials.
Although prestige, convenience and the planet will obviously remain long-term drivers of tech adoption, willingness to pay a premium today is likely to diminish during the downturn. To thrive in the current environment, tech businesses must offer products and services that are cost competitive with existing solutions now.
Where ESG may matter more than many realise is as a mechanism for consumers to emotionally justify moving to cheaper alternative. Vegan leather, recycled PET-based fabrics and vegetarian ‘meat’ are particularly well positioned in this regard.
2. Don’t expect to carry on until Series Z
The latest cycle saw VCs demonstrate a newfound willingness to fund businesses with a need for multiple additional rounds of private funding before they reach profitability. Although I haven’t seen a Series Z yet, Series G and H became commonplace. Now that financial conditions are tightening, VCs cannot be confident that these further rounds will be available, so they are looking to fund rounds that are able to provide the business with a clear path to profitability and permanent capital.
3. Don’t expect to be able to drive adoption by giving away dollar bills for 50¢
There is a saying in Silicon Valley that many tech firms succeed at building their user base by “giving away dollar bills for 50¢”. This can take the form of selling the product at a loss, operating marketing operations with excessive customer acquisition costs or offering a freemium model without a clear path to revenue. In many cases, this is justified on the basis that the product will achieve network effects that will allow the company to increase the price of add-premium features.
But, in a difficult funding environment, businesses will need to be much tighter about managing their user acquisition, retention and progression. VCs will expect software companies to carefully manage customer acquisition costs, develop north star metrics to identify problems early, and obsessively track lifetime value and cohort behaviour. Retention applies to much more than just SaaS. In every industry, aftersales service, lifecycle management and repeat buyers/retained subscribers will take on a greater importance.
4. Demonstrate unit economics early
Many hardware tech businesses use their early funding rounds to conduct sub-commercial scale pilots and POC (proof of concept) trials to demonstrate their technical ability, confident that technical feasibility will enable them to attract the funding they need to reach commercial scale. The hope is that a combination of learning effects to bring down cost and, especially in the case of climate tech, an ESG premium, will lead to viable unit economics when they eventually do reach commercial scale.
That approach is not viable in a world with uncertainty about both future funding and the ESG premium. As such, hardware tech companies now need to demonstrate attractive unit economics early, and pilots and POC trials are as much about demonstrating economic feasibility as they are about demonstrating technical feasibility.
This dynamic should favour solutions that focus on widespread deployment of relatively small individual units, enabling cost-effective prototyping and POC trials with commercial scale and specification devices. This is good for distributed energy systems and edge computing, but bad for centralised solutions like nuclear – even so-called small modular reactors are enormous in these terms.
5. Don’t assume accelerated depreciation and replacement
Many tech companies assume that the technical superiority of their solution will cause customers to accelerate depreciation and replacement of their existing tech, whether that existing tech is a home boiler, a vehicle or a piece of enterprise software.
But, in a downturn, we cannot rely on accelerated replacement of older technology with new tech. Indeed, the inflationary nature of the current downturn makes that particularly unlikely. In previous downturns, fiscal stimulus could target accelerated replacement both through tax incentives and targeted schemes (eg cash for clunkers). Today, fiscal stimulus risks stoking the fire of inflation.
VCs will expect tech companies to show how their solution can be integrated into their target customers’ existing procurement schedule and decision-making processes.
6. A strong value proposition and brand value matters more than ever
Entrepreneurs will be tempted to remain competitive by simply cutting cost and/or adding functionality. This makes the mistake of assuming that customers, whether B2B or B2C, will become more focused on a narrow cost-benefit calculation in the recession. In fact, recessions tend to prompt a flight to quality brands. Consumer don’t want to take a risk with their more limited spending, and corporate buyers will resist change on the basis that “nobody ever got fired for buying IBM”.
To succeed in this environment, new entrants need to develop a comprehensive value proposition, including functionality, economics and brand, to enable them to win. Often, this may require greater focus to find a minimum viable audience or a tribe around which this value proposition can be constructed.
And, connecting with the discussion of retention above, entrepreneurs need to remember that their brand is a result of the full life-cycle experience of the product or service. How you support the customer matters as much as how you sell to them in the first place.
7. Inflation-protected business models will win, and beware commodity price risk
The impact of inflation on the business model is now a key part of any investment decision. Agriculture tech businesses that are taking commodity price risk may find it much harder to raise capital. By contrast, investors are likely to favour businesses with revenues that are linked to inflation-protected prices, like power markets, or that have a disinflationary impact. The latter will be particularly important as policymakers seek to contain inflation without reining in growth.
The path to success
There is clearly a path to succeed as a tech innovator in this economic environment:
Don’t rely on an intangible premium to justify an otherwise uncompetitive offer.
Reach revenue and profitability quickly, and don’t rely on financial conditions to remain benign forever as you execute multiple funding rounds.
Have a clear strategy for driving adoption that does not rely on freebies and focus on retention as much as adoption.
Conduct commercial-scale POCs that demonstrate economic as well as technical viability.
Adopt a business model that can roll-out in line with demand, without assuming accelerated replacement.
Remember that a strong value proposition and brand matters more than ever.
Ensure that all price exposures are inflation protected, limit commodity price exposure and, ideally, have a disinflationary impact through your service.
Companies with core innovations that can support this model and leadership that can pivot decisively to embrace it will thrive during the recession and lead the recovery.
When he isn’t writing for Tellimer, Paul is the CEO of Enoda Ltd, a climate tech start-up that is currently raising its Series A. Hat tip to my Enoda colleague, Jacqui Porch, for her insights about B2C consumer behaviour.