The shock waves of tech stocks crashing are headed straight for startups

Some employees at the online auto retailer received an email on May 9 instructing them to work from home the next day. One former employee in the operations department (who spoke to Fortune on the condition of anonymity to discuss a sensitive matter) received no such instruction. The following morning, she poured a cup of coffee and sat down at her desk at 6 a.m. Some minutes later, an email from Carvana CEO Ernie Garcia III landed in her inbox.

“I know this is a lot for everyone to take,” Garcia wrote in his email, which Fortune reviewed and which he sent on the same day Carvana announced a $2.2 billion acquisition of a car-auction business. “I am extremely sorry. You put your faith in us and we let you down. I hope you can find it in you to forgive us.”

Garcia, the scion of a Tuscon developer who pleaded guilty to bank fraud charges in the 90’s Lincoln Savings & Loan scandal, then informed workers they would learn in the next few hours whether they still had a job or not. By day’s end, Carvana would lay off 2,500 workers, or roughly 12% of company staff, most of them in the operations department, which handles matters like paperwork after a car sale.

The next couple of hours were, understandably, tense. “It was like whiplash for everyone in my department,” the ex-employee tells Fortune. “It came out of nowhere.” Once higher-level managers showed up at 8 a.m., they were peppered with questions by their reports, yet had no additional information. Soon, some of those higher-ups were even seen escorted out of the building by security. “That was really concerning to us,” she says.

Eventually, groups of several dozen workers at a time were summoned into a room and told they were laid off. “There were maybe 70 or 80 people in the room with me,” the woman says. “When they started talking about severance, a lot of people just started getting up and then throwing their badges on the floor and cussing the person out. It was really intense.”

Other Carvana workers who were laid off complained on social media about receiving the grim news on a Zoom call. “We wish you all the best, and know that we’re here to support you, thank you,” a TikTok video of the call showed a Carvana worker reciting in a joyless tone. A Carvana spokesperson told Fortune the company “did our best to aim for clear, timely, compassionate communication” to the workers it laid off. The “difficult decision” to cut operations staff came after Carvana’s growth fell short of the rate it anticipated for 2022 because of “recent macroeconomic factors [that] have pushed automotive retail into recession,” the company said in a statement.

For much of the past decade, layoffs have been something of a scarcity among tech startups. Now, that’s starting to change. Rising interest rates and nagging inflation are precipitating a painful selloff. After reaching a record peak six months ago, the Nasdaq Composite has fallen 29%, led by tech giants like Facebook and Nvidia, both down 42% so far this year, and mighty Amazon, down 36%. Snap fell 30% after announcing disappointing earnings on May 23. More declines could soon pull the S&P 500 Index, already down 18.9% from its peak, into a bear market.

Meta, Twitter, and Uber are instituting hiring freezes or cut backs, while 68 tech companies tracked by layoffs.fyi have announced layoffs—not just Carvana, but Better.com, Peloton, Netflix, Robinhood, Vroom, Doma Holdings, and Blend Labs.

Companies are seeing their valuations fall, to paraphrase Ernest Hemingway’s quote on bankruptcy, in two ways: Gradually, and all at once. The crash of publicly-held tech stocks, say experts, has already begun to trickle down tech’s food chain. This mirrors exactly what happened during the last bear market in 2008, when VCs saw the writing on the wall for startups they funded, issuing stern prescriptions of harsh medication. Sequoia Capital created a now legendary presentation titled “R.I.P. Good Times” that instructed startups of navigating lean times. Now investors like Y Combinator and Andreessen Horowitz are offering similarly sober advice for the months ahead.

In outlining its “framework” for navigating down markets, a16z noted that valuations of public software stocks have fallen nearly 60%, while those for fintech and consumer internet companies are down 70% to 80%. “It can take 6+ months before we see what impact the public market downturn has had on venture funding,” A16Z partners Justin Kahl and David George wrote. On May 19, Y Combinator followed suit with a letter to portfolio founders with blunt news. “The safe move is to plan for the worst,” the letter said. “If the current situation is as bad as the last two economic downturns, the best way to prepare is to cut costs and extend your runway within the next 30 days.”

Cautionary Tales

Private startups are sometimes shielded from the vagaries of the public stock market—but only for so long. “What we’re seeing now is the degree to which the startup ecosystem is tied to public markets,” says Sabrina Howell, an assistant professor of finance at NYU. “There’s a lot of dry powder in capital that’s been raised by VCs, and it’s not being deployed in new deals as fast it otherwise would because of the pullback in public tech companies.”

History suggests any pullback in venture financing may hit early-stage startups the hardest. Howell co-authored a paper that showed early-stage VC activity fell 38% in the first two months after the Covid-19 pandemic, a trend that also proved to be the rule in the previous four decades of VC financing. That pattern may be playing out yet again, she says with VCs preserving cash and shying away from riskier startups to focus on later-stage companies closer to becoming cash flow positive.

But given that, according to Factset, global VC investments more than doubled in 2021 to $612 billion, this may not be entirely a bad thing. “2021 was a crazy year, with too much money chasing too few good deals,” she says. “It’s probably a good thing for this sector to return to something closer to normal.”

Already the IPO market is slowing down, with 34 offerings raising an aggregate $3.9 billion this year (versus 397 IPOs raising $142 billion for all of 2021), according to Renaissance Capital. Data from PitchBook suggests that, while deal sizes and pre-money valuations for many startups held up in the first quarter, “investor sentiment has changed.”

“Some companies are still being funded, but we’re also seeing capital drying up as VC’s take an assessment of what’s going on,” says Vieje Piauwasdy, director of equity advisory at Secfi, which advises startup employees on equity planning and financing. “From a company standpoint, the understanding among the companies we work with is that this is just an awful time to be fundraising right now.”

The shock waves may eventually be felt beyond startups themselves. “The poor public market performance of tech companies significantly impacts VC investing,” Y Combinator wrote in its letter. “VCs will have a much harder time raising money and their LPs will expect more investment discipline.”

And employees seeing their employer’s valuation slump tend to grow demoralized and more likely to jump ship. Research also shows that experienced VCs will back risky startups in boom times, even if they’re more likely to go under. With that higher risk tolerance comes more innovation: Companies funded in hot markets also file more patents and have more citations to those patents. Workers, too, are more likely to shun earlier-stage startups in down markets.

None of this is welcome news for innovation in startups. Contrary to the conventional wisdom that startups (from Microsoft to Airbnb) founded during recessions are better poised for long-term success, research suggests they are the exceptions proving the rule that boom times are much better for innovation, says Richard Townsend, a professor at UC San Diego.

“R.I.P.” Redux

Startups still flush with capital from recent financing rounds may have more flexibility in coming months. For those without that luxury, it may pay to revisit Sequoia’s “R.I.P Good Times” presentation, published when the inevitability of the Great Recession was sinking in back in 2008. The presentation started off memorably with images of a tombstone and a porcine corpse with a knife plunged into it.

Citing reporting from a 2008 Fortune story on VCs retrenching, Sequoia’s sobering presentation warned startups that any “recovery will be long” and to expect the “new realities” of smaller rounds, lower valuations, slower customer growth, inevitable cuts, and, above all, the “need to become cash-flow positive.” The recipe for survival: A must-have product, an established revenue model, preservation of cash, and a demonstrable path to profitability.

“All of those points are absolutely still relevant,” says Jake Moseley, head of relationship management for technology banking at Silicon Valley Bank. “Companies have become much more rigorous in their forecasting, digging into numbers and understanding the levers they can use. The entrepreneurs who can manage their burn appropriately will be the ones that come out of this the strongest on the other end.”

The options for startups forced to raise money in down markets are so much thin gruel. They can raise a down round, which involves complications such as anti-dilution provisions for existing investors. They can turn to debt financing, a prospect that grows riskier in an environment of rising interest rates. Or they can choose the do-more-with-less route, extending their startup runway by eking out growth while slashing the burn rate to extend the length of time before they run out of money.

“Those are the main levers available for startups to pull,” Townsend says. “The alternative is just to go under, which unfortunately happens even to some good companies.”

Secfi’s Piauwasdy notes that his conversations with startups indicate more layoffs lie ahead, as well as potential down rounds. “The messaging from VCs has shifted toward managing your burn rate and free cash flow,” he says. “It’s all about surviving now.”