The last 10 years have been an entrepreneur’s dream; we haven’t had to worry about the inflation impact in startups. After the brutal downturn in 2008-2009, the world economy embarked in one of the longest economic expansions in history. Low interest rates and abundance of cheap money have provided entrepreneurs with significant fuel to fund their business plans. At the same time, the technological revolution has slashed the costs of starting a business; once upon a time, you needed to get real estate, machinery, and sales people. Now, assuming that you or someone in the team can code, you can build your service from your bedroom. Then you can market it through social media.
Another factor that incentivized so many people to start a business is the low unemployment rate. Before the current crisis, it was 3.5% in the U.S. (a bit higher in the European Union at about 7%). With such a strong labor market, many of us felt confident that, would things turn sour, we could have joined back the corporate world quite easily.
Interestingly, throughout the years inflation has remained low (below 2% in the U.S. and close to zero in the European Union). Economists tell us that with such rock-bottom levels of unemployment, inflation should spike. Yet this has not happened. Entrepreneurs found themselves also with the upper hand in hiring workers, which did not demand sharp increases in salary, as economic theory would have suggested.
As I said, an entrepreneur’s dream.
However, things may be starting to change. With the massive fiscal and monetary intervention in the wake of the COVID-19 pandemic, money printing and government deficits have exploded. If economic theory is still worth something, these factors should lead to the return of inflation. From the perspective of startups and small businesses, there are three things to consider:
- The inflation impact on startups
- Whether your business is inflation-winner or inflation-loser
- How to protect your business from inflation
How Inflation Can Impact Startups
First of all, what is inflation? The most straightforward definition is a relentless rise in the price of goods and services irrespective of economic activity. If you are a small business, inflation will affect you in three ways.
First, your input costs will soar. I am referring to anything that you buy on a recurrent basis for your business, from general expenses such as electricity and real estate, to anything specific to your industry. If you are a food maker it will probably be commodities such as meat and vegetables; if you sell machinery it could be the price of metals.
The second spike in costs will regard salaries. 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 oblige you to do so, your employees will 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.
A third, somehow hidden, cost of inflation is the rise in taxes. If your costs rise, you will have to raise prices, too. That means higher turnover and, if you are lucky enough, higher income. Any tax on turnover, such as a sales tax and value added tax, will rise automatically. If you pay progressive income tax rates, you will probably shift to a higher bracket. Unfortunately, you are not really 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.
A big problem with inflation is that it is almost impossible to know if and when the vicious circle of rising prices will eventually cool down. The inflation impact on startups is even more instability and uncertainty; a startup needs to make plans years in the future without the knowledge that a more established company might have.
Is Your Business Inflation-Winner or Inflation-Loser?
In every crisis there are winners and losers. COVID-19 almost bankrupted airlines, hotels, and energy companies, yet technology firms have never seen more customers than now. That is not different in an inflationary scenario. The big advantage is that you can know in advance whether your business will thrive or suffer from rising prices. And it is not that hard to do it either.
First, we know that inflation will increase your costs. As such, your business should have at least one of the following features:
- Be capital light: A shoe factory will most likely see every cost rise; whereas a consultancy firm should probably suffer only a rise in the price of paper and of the office rent. If the price of goods soar, the business who can employ the lowest amount of goods is the winner.
- Command pricing power: If the price of wheat doubles, your neighborhood bakery will be hurt. Yet, if the same happens to the price of leather, the luxury boutique downtown will raise prices even more, and perhaps will even sell more too. The business who can charge the cost of inflation to its customers without repercussions on volume is the winner.
Is there a business that encompasses both features? I would think of the online marketplace; it is capital-light, as it just needs the infrastructure to make the platform work, and, if it is widely used, should have the bargaining power to raise the fees it charges to its users.
You might be inclined to think that technology businesses in general should perform well with high inflation: this may be correct, but if you sell a SaaS and have an army of IT engineers and customer service employees, mind that their salaries will rise too. So, at the end of the day, it will depend on how much you can use technology to make your company more efficient and save on some costs, or how much you can charge to your customers.
Good Practices to Protect Your Business From Inflation
Whether your business is better or worse positioned to stand inflation, there are a few good practices that anybody can implement to defend themselves from the inflationary vortex.
First, inflation affects sellers and buyers differently. 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 as soon as possible. This changes if you are the buyer. The longer you wait, the higher the price of the same product could be in the future so settle transactions immediately. Negotiate credit with your bank for the long term; it will be easier to pay down your debt in the future, thanks to rising revenues from inflation.
Second, conservative businesses, even startups, always keep some money in cash. If inflation spikes badly, you will have to protect your money somehow: 100,000 USD is worth just 90,000 USD after a year with 10% inflation. The best options are short-term treasuries or inflation protected securities, i.e. treasuries that will adjust your principal with the level of inflation.
Another possibility is that you sell abroad. This should help you, as inflation is generally associated with a weakening of your domestic currency. An issue could arise if you are selling to somebody whose domestic currency is weakening. It may be better to use a reliable currency such as the U.S. dollar, the Euro, the Japanese Yen, or the Swiss Franc.
The Bottom Line
Nobody knows the future, and we all hope that, after the pandemic is over, the economic conditions that made this golden age of startups possible will persist. However, high inflation is a real possibility, and, giving its detrimental effects on businesses, it is worth thinking about the inflation impact on startups.