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Startups and VCs should be preparing for the possibility of stagflation

June 23, 2022, 12:32 PM UTC

The last time stagflation hit the U.S., “startup” was a niche term, VC an obscure cottage industry, and private equity firms managed a collective $2.4 billion. But as a song from that bygone era said, everything old is new again, and so startups may soon confront a challenge that has no direct precedent in the era of venture financing.

Today, 60% of CEOs surveyed by the Conference Board foresee a recession by the end of 2023 and 55% expect inflation to stretch into next year. Some economists think a mix of both could be in the cards. 

“Stagflation—a period of very low growth (usually less than 2%) and high inflation (greater than 2%)—if prolonged, could result in a longer or deeper recession,” the Conference Board said in its mid-2022 outlook. “In our view, a short period of stagflation, either globally or in select major economies, is of greater likelihood than recession over the next year and a half.” 

For startup founders and their investors who may not have lived through what Treasury Secretary Janet Yellen, speaking before Congress, called “that terrible period” which “no one wants to see again,” let’s take a trip in the time machine back to the era of high inflation and sluggish growth in the 70s and early 80s.

To recap, an oil shock caused inflation to reach 12.2% in 1974 in the thick of a recession. After cooling for a few years, inflation rose again in the late 70s, prompting the Fed to dramatically push up interest rates in October 1979. The result: Inflation peaked at 14% the next year, but unemployment rose during another recession, peaking at 9.7% in 1982. 

As for the impact, “terrible” isn’t too far off the mark. Middle-class families applied for food stamps and dined at soup kitchens. For those closer to poverty, new clothes became a luxury and refrigerators were empty. Food co-ops became a thing. Cars idled for hours in endless lines stretching from gas stations. Pension plans (remember those?) were imperiled and nest eggs shrank by the month. 

Many Americans began to question the American dream itself or grew bitter as monthly bills ratcheted upward. And small businesses run by entrepreneurs? Then, as now, small businesses employed half of private-sector workers and created most new jobs. Many were forced to close as larger competitors with higher margins undercut them on prices. Others were pinched, first, by high interest rates, especially those with floating-interest loans. Then, when a credit crunch hit, banks restricted loans to only the stronger companies. 

Data on small businesses was scant back then, but anecdotal evidence suggests the damage from stagflation was significant. “’We have no incentives for growth,” an executive at a small-business association said. “Small business cannot grow in this climate.’” One banker at Wachovia, noting that banking was “not fun,” vowed to remain disciplined: “We’re not going to contribute to bad business decisions,” he told the Times.

As a result, suppliers and distributors shut down, inventories built up, and the ranks of the jobless grew. While the second recession ended in November 1982, the fallout continued for years, with business bankruptcy filings continuing to rise through 1987. 

Of course, there are key differences between small businesses 40-plus years ago and startups of 2022. This was long before software would eat the world, so most small businesses were brick-and-mortar retailers or manufacturers, which face higher startup costs. And instead of today’s robust private-financing market with networks of venture and private equity firms, most small companies relied on debt financing from commercial banks.

So what can this history lesson tell us about how stagflation could affect today’s startups? A report this month from KKR (one of the few private-equity firms founded in the 70s) warned that, should stagflation endure long enough to cause a full-blown earnings recession, the S&P 500, already down 21% from its January peak, could fall another 14% to 3,250. The bear market has already sent shock waves through the startup ecosystem.

“The current backdrop likely means that we should all be dusting off some pages from the 1970s stagflation playbook, an investing game plan that we think includes overweighting pricing power, upfront cash flows, and collateral,” wrote Henry McVey, KKR’s head of global macro and lead author of the report. “It also means not over-leveraging as the volatility around a company’s cost of capital is likely to go up, not down.”

McVey also hinted at something that startups can do to ameliorate the impact of any stagflation: keep boosting productivity. Until now, he says, productivity has acted as a buffer against inflation, thanks to automation and other tech innovations. Should productivity fall off, further inflation would weigh even more heavily on corporate profits.

“In 2023, when base effects start to reduce the overall level of inflation, it is hugely critical that productivity gains, including important advances in innovation, automation, and digitalization, continue to flow through the system,” McVey wrote. In other words, tech startups need to survive stagflation to play a key role in ending it.

And that brings us to one common thread that extends all the way back into the last stagflation era: Entrepreneurs responding to setbacks with a can-do spirit and a determination to move forward. Richard Marshall, the owner of a machine-repair service in Trenton, N.J., said in a 1974 interview that when inflation had left him on “the ragged edge,” he took initiative to find a solution. 

Marshall passed on higher prices to his customers, mostly larger manufacturers, and hired his banker to be his vice president. The biggest factor affecting small businesses, he said, was  “the individual manager’s initiative, imagination and ingenuity, and as for me, I’m going to sell, sell, sell and teach, teach, teach, and I intend to lead my employees safely through any economic situations which may occur.”

Kevin Kelleher
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