Profit Maximization V. Survival Maximization

A lot of criticism has been aimed at venture capitalists the last few days. The VCs are telling their portfolio companies to get ahead of the curve and conserve cash right now, and companies are starting to take their advice.

The criticism is coming from people who don’t understand that the world has changed in the last week and that companies need to change with it. And so they’re asking why VCs waited until now to tell everyone to conserve cash. Others are saying the boom is the VCs fault, and for them to lecture companies on conserving cash is ironic.

Fred Wilson wrote about this issue today and says VCs have a responsibility to give their best advice to their portfolio companies: “It’s all about acting responsibly and making sure we all survive to fight another day.”

But he doesn’t address the issue head on. I will. What we’re talking about is the goal of profit maximization, which is what every for profit business needs to aim for or go out of business. In the good times, that means growing intelligently. In the bad, it means maximizing your chances of survival.

Irrational Argument No. 1: The VCs Made This Happen

First, the downturn has nothing to do with the venture capitalists (in fact, it has nothing to do with Silicon Valley, this time). They have one job: generate the best return they legally can from their investors’ money. In boom times deals get competitive and VCs make independent decisions on what deals to bid for. Companies also have to pay more for people, resources, office space and advertising in boom times, which means they spend more money and have to raise more money. If you think venture capitalists are being irresponsible (or worse, evil) by investing money in those companies that they think are good bets, you’re just not getting how the whole system works.

Let me put it this way – if VCs ignored the economy and always invested super conservatively so that no one could accuse them of being irresponsible, they’d go out of business after their first fund failed to return capital to investors.

Irrational Argument No. 2: VCs Should Have Told Companies To Conserve Cash All Along

This is another argument that ignores the fact that people try to adapt to a changing world. At all times companies need to profit maximize. That means maximizing revenue and minimizing costs. Those goals are not aligned, however. Sometimes a company spends money on research and development to create future revenue streams. How much they spend is based on their own rational decisions on their financial health, the state of the economy, and their projections for the demand of a new product.

In good times, when core businesses are relatively safe, it makes sense to expand by hiring new people and developing new products. Or spending money on advertising and PR.

When times are tough, companies have to change strategies. They’re still maximizing profits, but they need to plan for tighter capital markets (really important to unprofitable startups) and harder revenue as advertising and other spending decreases.

Just like a bear in the woods (I imagine) has to slow its activity in the Winter as food supplies dwindle, startups need to go into cash conservation mode to increase their chances of survival when the market slows. They need to be prepared for a hit in revenue, and they know they can’t necessarily go to the capital markets to get money to stay in business.

But to argue that a company should always cut costs to the bare minimum is the same thing as asking that bear to act like it’s Winter in the Spring, just because someday Winter is definitely going to happen. All you end up with is a dead bear.