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What Should Software Start-up CEOs Be Thinking About As Inflation Risk Rises

Nate Lentz
May 3, 2021

Two of my kids are studying economics as part of their majors or areas of concentration and in the past couple of weeks, each has raised the issue of inflation with me.  Inflation seems to be a front and center topic in university economic departments these days and probably with good reason.  I am not going to make an economic argument for whether we see short term or sustained inflation or whether it will be modest or extreme, but there do seem to be a number of factors that are driving greater inflation concern including:

  • A combination of pent-up savings and stimulus dollars, which will shift the demand curve
  • Continued COVID related supply chain disruptions, such as the backlog of ships waiting to unload at ports, which will shift the supply curve
  • Global stimulus and infrastructure spending, which will drive up input costs for industrial commodities
  • A ”Buy-America First” policy, which will make certain resources needed for infrastructure even more supply constrained
  • A war for talent, which will only intensify as businesses reopen and as talent acquisition is no longer constrained by geography as a result of the increased acceptance of remote work for knowledge workers
  • And of course, the high levels of deficit spending that has and is occurring and the loose monetary policy of the fed – which some “traditionalists” believe has an impact on inflation (or at least it used to.)

Maybe it is time to take the inflation discussions out of the classroom and into the board room and the conference room and to discuss how to manage the primary risks that will impact software start-ups.  Here are some things to consider:

  • Input costs – The good thing and the bad thing about the cost structures of software companies is that their primary cost is people. In an inflationary environment, it is more of a bad thing than a good thing.  When you combine a war for great talent with inflation, cost structures can rise quickly as employees start feeling the pinch of higher prices while in parallel their awareness of their marketability grows.  What can you do?
    • Focus even more on stock based compensation and re-upping people who are most vested – make it expensive to walk away and valuable to stay. Do this now – it is good practice anyway.
    • Be fair and communicate – let your teams know that you are indexing salaries and they can expect adjustments based on the index
    • Be realistic and expect churn – some roles are really appropriate for people zero to three years out of college and not worth paying what a person with five years of experience can make. Expect the churn and keep a funnel of new hires.
    • Create a training and development pathway that shows employees that you are investing in them. Programs like those offered at our portfolio company, ExecOnline, provide certificates from top universities at start-up affordable prices and a three-year plan for a mini-virtual MBA will keep people in place
    • A high growth rate, professional development and investment in the team, a mission people believe in, and a strong culture will all reduce churn on the margin and will slow the inflation impact on cash compensation
  • Revenue and Pricing
    • If you are signing multi-year contracts, the best thing to do is to build in annual price increases plus a CPI or other index adjustment. If you can’t do that, at least build in a CPI or other index adjustment – preferably an employment cost index given your own cost structure
    • If you have annual contracts or simply bill monthly, communicate price increases and put them in place. If you are reasonable and they are based on indices, most customers will complain but won’t walk.  Put volume discounts in place as well, and maybe even increase them.  Give your customers the incentive to use you more, at a higher level of revenue for you but lower per unit cost for them.
  • Debt
    • I started out my career in banking when the memory of the high inflation period of the early 1980s was still painful. When we ran scenarios for companies to pay back our debt, we had to run projections at 15% interest rates.  That certainly made it hard for companies to take on too much debt.
    • Almost all business debt is variable rate. The prime rate today is about 3.25% and most debt is based on prime plus something.  In 1984 it was at 12.5% down from 21.5% in 1980 when the Federal Reserve set the rate at that level to finally try to stop inflation.
    • Debt in an inflationary period is a terrible thing. CEOs – go home and refinance your houses to a fixed rate mortgage if you have not, and then start thinking for your business about the correct use of debt and what risks you are building into your capital structure.  Fixed rate debt benefits the borrower in an inflationary environment because the principal is reduced on a real basis but floating rate interest can become a very painful and an unanticipated, large, monthly expense.
    • As interest rates go up, cash flow is impacted, and those bank covenants such as interest coverage ratios quickly come into play, as cash flow gets reduced and interest costs rise. Fortunately rates have been so low for so long that many of these covenants have been left out of loan agreements – but watch out for them going back in as your banks renegotiate your annual renewal.
    • Last – exits to private equity will slow and prices will come down because PEs use debt in many financings and expensive debt slows down their investing cycle and can kill some of their existing portfolio companies

2021 is likely going to be a great year for software businesses and 2022 may even be better, but even in a high growth year, inflation can take a lot of oxygen out of the tank when assessing overall performance if costs rise and unit revenue drops.  Be prepared, plan early, and be pro-active.  Smart companies with pro-active leadership can be even more profitable in a market with high inflation.  Let that be you.