What a rising inflation environment might mean for startups

Last week, New Zealand saw its biggest increase in inflation in 31 years—up 5.9% from last year.

Caused by a multitude of factors from the cost of managing pandemic and rising construction costs (+6.8%) to higher rents (+3.8%) and skyrocketing prices at the pump (+30%), prices are increasing and yet are not matched with proportionally increased pay packets. 

With higher inflation occurring on a global scale, some financial prognosticators have suggested that rising inflation is the greatest risk facing startups in 2022.

With this in mind, how might this new environment impact startups, their founders and their employees? Additionally, what can we do to help manage and alleviate the effects? 

Running your business may get harder

Inflation occurs when the price of the value of a commodity or service increases and yet the cost of labour cannot keep up with the inflation rates, thus reducing purchasing power.

In turn, businesses cannot sell enough products, leading to reduced profits and an overall slowdown in the growth of the business. Financial losses can mount up and businesses become more fragile.

With the cost of raw materials increasing the price that you will need to charge your customers will increase. You may see greater attrition and churn rates within your customer base and longer sales cycles for those prospects in your pipeline.

Supply chains will become a bottleneck

We have already seen the dramatic effect that COVID-19 has had on our global supply chain with goods and components taking months to arrive. With our borders closed, we are also facing a skills shortage, especially in the technical and product management fields.

If you are a hardware startup, this will likely already be a major headache for you. The worst case is that you lose customers as you cannot complete orders on time (if at all). An equally challenging situation is the tying up of funds in inventory-in-progress, leading to losses that you have to pass onto the customer in your pricing.

Borrowing money is going to become more expensive

Somewhat fortunately, startup lending in New Zealand is pretty limited so the increased price of debt caused by inflation may not affect your startup as bad as other businesses.

If you can obtain inventory financing or venture debt, expect the interest rates to rise in a higher inflation environment making it harder to seek financing.

Your wage bill is going to go up

Some governments mandate businesses to raise the salaries of their employees along with inflation, generally measured by the CPI (consumer price index). Even if the law does not force you to increase salaries, your employees may ask for a raise (their input costs will rise too). If you do not want them to leave you, you will have to make some concessions.

We recently read an article from the BBC about a growing trend amongst employers who are using the excuse of a larger remote workforce to reduce salaries. We do not advocate this approach and would rather see our portfolio companies embrace the previously hidden positives that may emerge from a mobile workforce as opposed to docking salaries because they aren’t parking in the building.

Taxes

Another knock-on effect of higher inflation is the rise in taxes. If your costs rise, you will have to raise prices, too. That means increased revenue and, if you are fortunate enough, higher income. Any tax on revenue, such as sales tax, will rise accordingly. If you pay progressive income tax rates, you may move to a higher bracket. Sadly, this isn’t because you are earning more, it is just the effect of inflation. But, if the government does not amend the tax brackets, you will end up paying more taxes in real terms.

Ok. Enough doom and gloom. What can you do to counter these things?

Supply chains

We would recommend you undertake an urgent assessment of your current supply chain, identify any risks and come up with a mitigation strategy. Some ideas might include:

• Ensure you are not tied to one supplier for any part of your inventory. By diversifying your supplier base you decrease over-dependence and you might also lower your unit prices as a result of the exercise.

• Ask your suppliers how much of their cash flow is dependent on your business. If any one supplier represents more than 30% of their revenue then you have created a single point of dependency. With this comes the greater risk of supply chain disruption and reputation damage if you were to pull your orders.

• If you have highly perishable goods in your supply chain maybe reevaluate your product strategy and evolve your product lines to include those with more durability.

• Take another look at domestic supply chains, not just international ones that have traditionally been cheaper.

Take a good long hard look at your pricing strategy

Marc Andreesen, legendary startup investor and co-founder of Andreesen Horowitz, was interviewed in 2016 by Tim Ferriss for his “The 4-Hour Work Week” show. He asked Andreesen what words he would put on a billboard to reach the greatest number of people. His two words of advice was “raise prices”.

Nearly every startup we meet is undercharging for their goods and services. Whether it is because the company doesn’t feel they have earned the right to charge a higher price or because they think that lower prices will lead to quicker market penetration, they both lead to the problem of “too hungry to eat”. By this, we mean that because your price is too low you now cannot afford to market your product effectively.

A high inflation rate may be the perfect driver for you to have a good reassessment of your pricing strategy. This doesn’t necessarily mean that you jack your pricing up by 50% but maybe your customers are getting enough value from your product that they may consider a higher price.

Assess your payment terms and receivables

inflation affects sellers and buyers in different ways. Therefore, shorten your credit cycle if you are the seller. The value of your credit will decrease over time, so your aim should be to get paid back pronto. This is different if you are the buyer. The longer you wait, the higher the price of the same product could be in the future so close out your transactions ASAP. Negotiate credit with your bank for the long term; it may be easier to pay off your debt in the future, thanks to rising revenues from inflation.

If you have clients who are bad payers then look into the services of factoring companies that are experts at reclaiming unpaid bills. Just be aware that there will be finder's fees for their services.

Love balance sheet optionality.

In low inflationary times, I hear myself asking founders why they are budgeting buffers in their use-of-proceeds models. When money is abundant it seems questionable to leave some of it lying around.

In the current environment, this advice is not useful. Having $200k sitting in a bank account could be essential if you are faced with rising costs. One thing to note is that your $200k might be worth $180k in a relatively short space of time if inflation continues to spike. To counter this, ask your bank about inflation-protected securities or short-term treasuries as alternative options to store your buffer capital.

Make sure you have good advisors on hand

Now is not the time to cut your startup accounting partner or financial controller. This is the time to spend more time with them to ensure you truly understand the financial levers that exist within your business so that you can grow during this time.

Equally, this is also a time to ensure your legal advisors are up to par and give you the best advice when it comes to contracts and procedures.

Finally, we believe the greatest driver of a startup team’s success is having a positive state of mind and overall health. Cutting back on initiatives that raise the performance of you and employees should either remain at the current level or be enhanced during these times.

Conclusion

The bottom line is that inflation is a natural and sometimes painful way to ensure healthy financial markets. When economists add in the effect of COVID-19 things get hazier. The reason being that the last data point for a global pandemic is over 100 years old and many things have changed since then. That being said, higher inflation is here and we recommend you plan and react accordingly, now.

Startup venture capital has never been more abundant and there are more funds than ever, especially in New Zealand, who are looking for good investment opportunities to park their capital. This doesn’t mean that more startups are necessarily funded but instead, there is more capital available for those that fit a VC’s bill.

If you are a business with strong fundamentals and a product that is breaking new ground in your field, your chances of success are good and, most importantly to us, we would like to hear from you!