Derivative Risk

The concept of growth hacking – and the techniques used to attract customers and achieve rapid growth – is nothing new. The same tried and true methods have been used for decades, especially when it comes to finding those eager and fast moving customers willing to take a chance on a new company. Back in the late 1990s, B2B startups sold much of their products and services to other venture capital-backed companies, while the lighthouse customers of B2C startups were often individuals also in the tech industry.

This growth hack - relying on other VC-backed companies and their employees as the primary source of revenue - has once again become a common startup strategy over the last decade. Go to the website of any private, VC-backed B2B startup between Series A and Series D of funding. You’ll likely find 20-50% of their named customer logos to be other private, VC-backed startups with a similar maturity and financing. Our internal research and investing diligence confirms this: B2B VC-backed companies have revenue exposure to other VC-backed startups in the range of 30-60%.

This is known as derivative risk, a lesser issue at the top of the cycle, but a serious problem when startups find themselves reliant on other startups for significant chunks of their revenue during a downturn.

As VC-backed companies face immense challenges and cut back on spending in response to the current economic climate, about half of a typical B2B company’s revenue is at risk in 2023.

Larger and more established companies are not immune from the knock-on effects that arise from VC-backed companies’ lack of a diversified customer base. As these companies cut employees as a method for reining in costs, they also cut SaaS subscriptions. We watched a similar scenario play out in the dot-com crash.

The Curious Case of Cisco

Consider Cisco. In 2001 alone, Cisco’s revenue declined by almost 20% because its venture-backed customers started to dry up. Worse, the revenues from these customers accounted for all of Cisco’s marginal profitability. In March of the previous year, Cisco, at $555 billion, was the largest public company by market capitalization. Adjusting for inflation, that’s well over $1 trillion, which puts it at a similar size to Apple, Amazon, and Microsoft today. However, the market punished it brutally, and by 2001, Cisco’s capitalization was around $151 billion and it was described as “a dazed prizefighter.”

With more than 150,000 people laid off since the start of this year, we’re likely to see a similar cascading effect across the marketplace, which will cause epic damage to the B2B ecosystem.

If the top end of the market weakens and exposes what is going on under the water, it will be much worse for the smaller VC-backed businesses. Somewhere in the order of 50-80% of tech companies in the private market will fail in the next 12-24 months. However, that number shouldn’t be shocking, as the long term failure rate is around 75%. In a sense, we are just reverting back to the mean.

What to do?

So what can you do as a founder, team member, or a board member to mitigate this derivative risk?

1) Understand your customer base

Performing a quality assessment of your largest customers should be a top priority so that you can sort them into two buckets. The top tier is for immediate action, and the second can be worried about down the line.

When did they raise their last round? If it was in the last year, they probably have 18 to 24 months of runway left, so you can move them to your tier two priority list.

Any customers that raised capital more than 12 months ago need to be a top priority because they probably only have 12 months of runway remaining.

In addition to this, you should evaluate their investor base. Companies with smaller investors or ones you have never heard of mean their investors may not be prepared to continue to back their companies. If that’s the case, these customers will run out of money sooner than others.

2. Be proactive and make yourself top-of-mind

After you’ve finished your assessment, reach out to your customers. Don’t lay low until their contracts expire. Ask them about their financial situation to determine how likely they are to continue to be able to purchase your products. Find out if you can negotiate a longer-term contract in exchange for discount pricing. Try to get them to make a commitment now rather than later.

Being proactive pays off. One place founders can look for inspiration is the warranty business - companies that provide warranties on consumer electronics and durables. Warranty businesses that consistently remind customers that their products are under warranty perform better than those that wait to reach out until the time of renewal. It turns out that if customers had the warranty top of mind, they not only used it more often, but were also more likely to renew.

3. Focus on channel partnerships

As Peter Thiel pointed out in Zero to One, distribution can matter more than the quality of the product. Quality channel partnerships can remove the heavy lifting of acquiring all of your customers yourself. Think about how you can improve the leverage of your distribution strategy by incentivizing channel partners with amazing economics. At this stage in the market cycle, any new customer that generates more cash than they cost is a good customer, regardless of the channels they’ve gone through to find your product.

4. Recognize that your product might not be as mission critical as you think

When we are surrounded by our teams and believers, we can sometimes feel an inflated sense of importance. This happens at the top of market cycles. Ask yourself, “what if we aren’t that critical?” and “how can we spend all of our engineering and customer success resources on making ourselves indispensable?”

5. Be customer-centric for durability

Above all else, be customer-centric. Spend time with your customers and try to understand their concerns and pain points. The more integral you are to their business, the more durable your revenue is.

6. Prepare for the worst - so you can come out the best

That said, be prepared to see many of your customers go out of business and manage your own budgets accordingly. Plan as if 75% of your VC-backed customers will not survive the next 18 months. If you plan accordingly and survive this downturn, you are almost guaranteed to come out stronger and face less competition on the other side.