Stagflation Threatens SaaS in 2022

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The single biggest threat I see to SaaS companies for the remainder of 2022 and into 2023 is stagflation. In an informal survey, I was surprised how many CEOs were not familiar with this term. Let’s break the stagflation definition down, explain the threat, and discuss how to beat stagflation.

What Does Stagflation Mean?

First, we need to understand stagflation’s definition. The term “stagflation” is the combination of two terms, “stagnation” and “inflation.” Stagnation refers to a reduction in demand (a.k.a. a recession). Inflation refers to rising prices for raw materials, durable goods, and labor. In stagflation, you have a decline in demand while you have an increase in your labor costs and the cost of goods sold.
Stagflation Graph
Stagflation Graph

This means that your profits and cash flow get squeezed from two directions.

It is the worst of all worlds, economically.

Here’s why.

Why Is Stagflation Bad?

Now that we understand the stagflation definition, we can talk about the threat that it poses.

With a recession, you lose customer demand. Your revenue comes down. However, your suppliers and employees are worried about losing business and their jobs. In a severe recession, your costs typically go down.

Vendors offer promotional pricing. Many companies undergo layoffs, thereby reducing labor costs. Employees who were going to ask for raises are suddenly quite grateful to still be employed… and they fear asking for a raise, lest they get included in the next round of layoffs.

At the same time, the prices your employees pay for their goods and services in a recession go down. So even though they don’t get a raise, their buying power is still good.

A recession ends when companies and consumers overcorrect in pulling back on their spending. Companies laid off too many employees and don’t have enough people to acquire or service new clients. They slowly ramp up hiring because they know they will get a return on their investment.

Consumers who deferred fixing the leak in their roof realize, “If I keep deferring that expense, I’m going to damage the whole house. Okay, I can’t put it off forever…” So, they buy. That nagging health issue that they were hoping would go away hasn’t. That delayed doctor visit can’t be delayed forever, so they pay the doctor’s bill.

This is how a recession ends.

Inflationary periods are a different animal altogether.

Inflation occurs when the following ratio increases:

Total $ in the Economy / Total Goods + Services Sold in the Economy

To oversimplify, imagine there are 100 oranges bought/sold in an economy, and the economy has $100 in circulation. The price of an orange is $1.

Now let’s assume that due to low-interest rates (allowing customers to borrow money), the central bank (a.k.a. the Federal Reserve Bank in the United States) decides to “print” more money, and there is now $200 in the economy.

There are still only 100 oranges bought/sold in the economy. Now, with $200 in circulation, the price of an orange is $2.

This is inflation.

The cure for inflation is simple. The ability to borrow money must be reduced significantly. If prospective home buyers can’t get an affordable mortgage (nor can they afford the remodeling services, Home Depot repairs, or IKEA redecorating purchases), they don’t buy a new home.

If a SaaS company’s line of credit is frozen, they can no longer spend money they don’t have access to.

In other words, the single sure-fire way to end inflation is to… wait for it… it’s to…

CREATE A RECESSION.

Imagine for a moment that all credit card limits were frozen. All new car loans, house loans, and venture debt financing were frozen overnight. Three things would happen:

  1. Consumers and businesses would freak out.
  2. Consumer demand would be decimated. Business-to-business demand would soon follow.
  3. Inflation would be over.

This is what happened to end inflation in the 1970s in the United States. It was, in a word… brutal.

The principal mechanism to reduce the availability of credit is to raise interest rates… and raise them significantly.

The rise in rates must be dramatic enough to freak everyone out and convince them to stop spending money.

There’s a special term for when the increase in interest rates is only moderate. While the availability of debt is slightly curtailed, it isn’t reduced enough to stop inflation. However, the decline in the availability of debt is enough to cause a recession of a modest to a moderate degree.

When this happens, it is known as…

Stagflation.

How to Beat Stagflation

So, let’s talk more about how to beat stagflation. For guidelines on how to tackle the inflation part of stagnation, see my detailed guide on How to Survive Inflation as a SaaS Business.

Everything you do to run a business during inflation, you still need to do (or at least try to do) during stagflation.

However, you need to do some additional things to deal with the recessionary part of stagflation.

In response to stagnating demand, you need to significantly increase your operational efficiency.

This means a few things:

  1. Be profitable within 30 days (if you aren’t already).
  2. Remove underperformers and investments that have generated no ROI (regardless of your profitability).
  3. Improve your efficiencies (do process improvements, eliminate redundant steps, automate work so less labor cost is required, question every expense, switch from monthly to annual contracts for vital services in exchange for a discount to improve margins).
  4. Only invest in the things with the highest returns on investment. This step is hard to do, psychologically, because it may come to a point where you have to cut things that are working okay… in order to protect the investments that are working exceptionally well. There is a time to innovate, experiment, and “go big or go home.”
     
    This is not that time for reckless investments.
     
    This is the time to fund the proven winners — the proven lead generation sources, the proven top performers, the proven products, the proven channels.
     
    [However, it is still possible to invest in downside-capped market experiments that are heavily scrutinized. So instead of throwing $1M at an opportunity, you throw $1,000 to test the opportunity with a small ad purchase, a focus group, a beta, or something similar at the small scale first… where a failure has very little cost to the business and doesn’t threaten its existence. If that works, then you increase the investment to see if it still returns… and work your way up incrementally.]
  5. Stockpile cash. Cash on your balance sheet provides you with resilience and optionality. When there’s macroeconomic uncertainty, you need to be adaptable.

Two things are needed to be adaptable:

  1. The proper flexible mindset
  2. Enough time (a.k.a. cash on hand) to make adjustments to adapt to prevailing market conditions

Stagflation can drag on for years. An extreme case was the Japanese economy in the 1990s, which underwent nearly a decade of stagflation.

While I don’t think the U.S. economy will endure a decade of stagnation, I do think several quarters to a few years is increasingly likely.

I think of what the economy is to companies as similar to what the weather is to sports teams (that play in outdoor sports arenas). Whether it’s raining, hailing, or snowing, someone still wins the game. Whatever impacts your company also impacts your competitors. So, winners will still emerge.

The key is to be prepared for what lies ahead and be proactive sooner rather than later.

Additional Resources

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