Recession, inflation, and layoffs - what’s next?

Slowly, the layoffs we’re seeing in the US is now creeping in the Philippines as cost pressures continue to rise, so how should you prepare for the coming wave?

Last year, startups globally raised venture capital funds more than ever with reported data hitting a high of $621 billion globally (source). Earlier forecasts that the pandemic-induced recession will hit us in 2020/21 was not felt so much until cracks started to appear this year.

The US inflation reached 8.6% last June 2022 (for May 2022) as markets brace for more impact as June inflation data gets out this week (source). In response, the US Fed hiked policy rates by 75 basis points (bp) last month and is expected to continue to hike rates further. From startups’ perspective, total layoffs tracked by layoffs.fyi reached a high of 50,023 (source) this year.

So how are we affected?

Understanding the impact of inflation, rate hikes, and recession is not as simple as it sounds. While we may have certainly felt the impact of rising fuel prices and electricity costs, unless you go to the market regularly, it’s unlikely that you may have felt the impact of inflation in other parts of our life.

While we can get a trip down the memory lane of high school or college economics, it might be much easier to understand these from its real-life impact on businesses that we’re seeing today.

Fundraising got a bit trickier

When interest rates increase, investors start to reconsider saving money instead because savings now generate a higher return with a much lower risk compared to investing in businesses. That’s the easiest way to think about it.

While the ongoing rate hikes at 75 bp (or 0.75%) seems low compared to the normal interest rates that we see in the loan or mortgage market, policy rates are far lower at less than 1.00% in normal times. Policy rates, as can be seen in the chart below, started at just 0.25% in January 2022 before it suddenly shot up all the way up to 1.75% last June 2022 (source).

Today, we are already seeing the impact of rate hikes on several funding rounds of well known startups. Investors are beginning to pull-back from being an overly zealous investor to a much more careful caretaker of LP monies. In the latest report from Crunchbase (source), Q2 2022 suffered a significant drop in total venture dollars raised from the highs in 2021.

But don’t mistake this as investors are shying away from investing in startups. It’s really about finding the right entry timing while building the dry powder to strike when opportunities arise. Things are yet to get trickier as markets continue to spiral downwards before it stabilizes at a much lower point.

Valuations are on a downward slope

The unique situation of rising costs together with an increasing interest rate can have a massively detrimental impact on the value of a business. If you still remember how your business valuation is determined, it’s based on the projection of cash flows and discounted using a discount rate. Now, both of those elements are being hammered.

The rising costs directly affect cash flow projections especially with the rapidly rising compensation packages in the tech sector. With the “Great Resignation” and the ease of capital raise last year, tech companies had raised compensation to a level of exuberance through the pandemic to attract and retain talents. In a report last year by the Wall Street Journal (source) tech salaries increased by 5–10% for most tech talents while top talents commanded as high as 20% increase.

This phenomenon is quite consistent even in the Philippines as benchmark cost savings used for offshoring decisions increased as well. With rising costs in developed countries, surpluses are passed on to the outsourcing industries in the country. Many tech companies opted to hire freelancers or established a foothold in the Philippines last year to cope with promised growth to investors.

While salaries are probably the primary cost of most startups, the startup sector that saw one of the largest growth during the pandemic were cloud kitchens (a.k.a., ghost kitchens or dark kitchens) and dark grocers. These inventory heavy startups are taking the hit of rising cost of goods as inflation reaches a new high with the latest number at 6.1% (Philippines) for the month of June as announced last week (source).

At the other end of the spectrum is rising discount rates. While explaining discount rates is a bit more technical, think of it as the return your investors are expecting your business to generate before deciding to invest. With interest rates increasing and a negative market outlook, investing in businesses (or equities in general) doesn’t make much sense unless either:

• The business is valued too low to forego the opportunity
• The probable exit value is high enough to take the risk

Just recently. Klarna, one of the high profile BNPL (buy now, pay later) companies, dropped its valuation from $45.6 billion to just $6.7 billion in just a year’s time as they raised fresh capital of $800 million (source). This is just one of the many down rounds that we’re seeing in the market as the global economy slumps in the face of a looming recession.

Given that we’re expecting an even higher inflation rate to be announced this week, the US Fed is expected to release another mega-sized rate hike in the coming months, if not this month.

Peso takes a beating as dollar strengthens

While everything looks US centric, we are living in a more globalized world than ever. Most Philippine-based businesses must already be feeling that US dollar denominated expenses such as subscriptions are getting a tad more expensive.

As of this writing (12 July 2022), the US dollar hit a high of 56.40 which is the highest at least in the last 5 years. To get a closer feel of how the strengthening dollar is affecting us, the chart below provides a good feel of the steep rise in exchange rates in the past few months as interest rate hikes are being pushed by the US Fed (source).

In monetary terms, this would mean that our US dollar denominated subscriptions (e.g., Google Workspace, Notion, Airtable) of say $1,000 was previously just Php50,000 (at Php50.00:US$1.00) is now Php56,400 (at Php56.40:US$1.00). That is a whopping 12.8% increase in our total subscription costs.

So why is the US dollar strengthening? While there’s a lot of economic reasons to consider, one of the key indicators is the effect of interest rates. In gist, countries with higher interest rates will attract more investments into the country pushing its exchange rate to be stronger than countries with lower interest rates.

It may sound like the Philippines simply need to increase interest rates to boost exchange rate parity, but it’s not a simple decision to make. While the weakening Philippine peso makes paying sovereign debt more expensive, it also makes the country’s exports more attractive. Managing our foreign exchange rates is a two-sided blade that our national economic managers will have to balance in the coming months.

How do we prepare for it?

The Philippines generally enjoys a delayed onset of inflation and recession impact allowing us some time to watch how developed countries are addressing these issues. Given a short window to anticipate, there’s quite a few things that we can start preparing to brace for impact.

Hang on till macro stabilizes

Most startups live on an extremely short runway of between 9 to 18 months in the hope of closing a funding round before hitting a runway excursion. While the pandemic era allowed such leniency in runway management, the current cycle might take a few quarters before funding cycles go back to normal.

While we think of recessions as generally bad, startups somehow enjoy the aftermath of a recession if they can withstand the harsh winds. Unlike traditional businesses, startups generally have less baggage in general due to lower operating leverage (might not be true these days) and leaner structure.

A low operating leverage means that fixed operating costs represent a lower percentage of total costs. Fixed costs for the purpose of decision making would include those expenses that are relatively fixed (i.e., stable) and unavoidable (i.e., would affect business operations). An easy example would be rental payments for your office space and a more subjective example would be salaries of core employees (i.e., employees who can directly affect the operations of the business).

I said core employees rather than key employees. Some key employees are hired to focus on growing the business, managing a larger pool of employees, or nice to have roles. At a time of survival, business focus will need to shift to where it matters.

The cautious period of capital preservation does not generally last that long. As VCs and investors get a fuller grasp of the macroeconomic environment and interest rates begin to fall back, dry powders will be deployed to capitalize on distressed fundings. When funds are redeployed, it’s likely that we’ll see high interest again on riskier investments such as investing in startups.

So for cash burning startups, it’s a good time to step back and revisit where costs can be minimized as needed. Some companies might need to take urgent actions to survive right now while others might have a bit more leeway to prepare. Overall, it’s a good time to begin simulating and preparing before the eye of the storm really begins to hit.

Knee-jerk layoffs might not be the best decision

While massive layoffs are a natural part of a recessionary economy, it’s often done as a knee jerk reaction to a drying warchest. Payroll costs for most startups potentially is the single largest expense line item in the profit and loss. And when you need to strip out costs, employees often become the target of a haircut. But is this really a wise decision?

It all depends on the replaceability of the talent. We’ve seen a lot of companies prioritizing laying-off those with higher salaries to save the business. While it’s logical to do so from a financial perspective, it might be much more costly to hire and train for the same role in the next 12 months. This is especially for tech roles and product managers who hold institutional knowledge on the product.

So, while slashing costs are definitely needed when facing economic downturns, layoffs shouldn’t always be the first option. There’s no sense in having a surviving company without the necessary talents to keep it going.

Review contractual clauses

When getting investor funding is crucial to survive, accepting down rounds can make sense instead of just killing the business or laying off core employees. However, this is where things can get trickier.

After the Global Financial Crisis (GFC), many VCs have started to embed ratchet clauses within their investment agreements. It’s a protection clause that protects investors from dilution in cases when, yes you guessed it right, a down round occurs. This allows existing investors to increase their pro-rata share to the current valuation which ultimately dilutes the founders and other investors without such clauses agreed.

Another common investor clause to watch out for during distressed periods are liquidation preferences. While often overlooked in good times, liquidity preferences can make bad times even worse, especially if your first investors are your friends, neighbors, and relatives (i.e., the 3Ks — kaibigan, kapitbahay, and kamag-anak). In an Asian business environment where relationship (or guanxi) matters, giving preference to latter investors might break a harmonious affair.

Other than investor contracts, revisiting borrowing agreements is another important exercise to prepare for a possible liquidity event. Most borrowing agreements in the Philippines for startups and MSMEs generally include substantial surety and guarantee clauses to protect the banks’ interest. When these clauses strike, founder/s can become personally liable for the loans beyond the limited liability of the corporation.

So if you think that the financial headwinds are not in your favor (be honest to yourself), start to look deeper into the contracts. Should you need to seek advice later on when in a crisis state, your advisor will need to have a clearer understanding of the chess pieces to play on.

Know your options

During challenging times, there’s quite a few options available depending on the stability, tenure, and status of the business. Despite rising interest rates to dampen rising inflation, debt should generally still take preference over a down round to keep the business afloat. From a realistic perspective though, most startups won’t even qualify to borrow from financial institutions due to poor cash performance.

One thing to take note though is never fall into the trap of usurious borrowings. Nothing’s worst than making a stupid mistake of borrowing monies at an usurious rate that the business cannot sustain. If formal lending is not available, opt for a down round instead. You can never predict how hard the tailwind will hit.

If liquidity goes too tight, there’s a few alternative paths to consider:

• Austerity measures to drastically reduce costs and expenses
• Suspending business operations in full until opportunity to reopen emerges
• Calling it quits before things go to awful

While it appears that these options can be taken in sequence, it’s generally not a good idea to do it in sequence. It’s better to be decisive right off the bat to minimize the bleeding.

Austerity measures are meaningful only if recovery can happen relatively quickly (i.e., less than 6 months). Pulling off austerity measures for more than 6 months is way worse than just suspending the business in full and reopening when opportunities arise. There’s no reason for continuous bleeding when recovery is not imminent.

Calling it quits sounds easy but it can be a very costly legal battle that can drain your life away. If worse comes to worst, calling it quits should only be an option just before incurring massive debts from all over (esp. unpaid salaries to employees).

Post scripts:

1. Philippines announced a massive off-cycle 75 bp rate hike on 14 July 2022, the largest yet this year, signaling the urgent need to curb fast rising inflation (source).
2. US announced June CPI at 9.1% on 13 July 2022 in line with expectations of a higher inflation in June considering higher costs during early days of the month. This is the highest CPI in the last four decades since November 1981 (source).