How should a founder or CEO strategize to get their company higher valuations?
Few start-up entrepreneurs really know (or care) about their company’s valuation in the early days. Rightfully so, since they’re knee-deep into their product development and go-to-market strategies.
But, like with the butterfly effect, every little strategic decision a founder makes has a big impact on the company’s future valuation. Some of these important decisions are made early on, such as the company’s legal structure, business model, niche, and cap table.
What’s your company’s valuation?
Have you ever wondered why one company sold for 2x revenue while another, in the same sector, sold for 6x the revenue? Or how your competitor just raised 100 million dollars with revenue in the low 10s?
(For the sake of clarity, I’ll be talking about valuation in terms of revenue multiples, but you should know that there are other ways to put a price tag on a company. For example, you can use EBITDA multiples or Discounted Cash Flow, although start-ups rarely use the latter since their cash flows are often inconsistent, if not negative.)
The above chart tells us Netflix’s valuation by the public market as a multiple of its sales receipts. This graph can tell you a lot. At the moment I write this, their valuation is 8.128x their receipts. But the first thing you probably noticed is that the ratio varied a lot over time. Most dramatically, in 2018 the valuation spiked from 8x revenue to 14x in June and then dropped back to 8x again. This was due to a number of factors, both internal and external to the company.
The same thing happens to private companies. You won’t see it charted in real-time, but with every funding round or liquidity event, a buyer and a seller need to reach a new agreement about the valuation.
There are 6 big qualities your company needs in order to attract higher valuation multiples. You can use this article as a checklist to guide your strategy if your objective is maximizing your company’s valuation.
Multiple Boosters 1: Scarcity
“Scarcity” means that your company owns or does something that others don’t or can’t. It means you produce something that is scarce — or in the best case, that you only can provide.
This concept is known by different terms, but the key elements are:
- Defensible intellectual property (like patents, copyright, or trade secrets).
- A wide moat keeping competition from entering your market.
Companies with these qualities attract higher multiples — provided what they produce meets market demand.
The same concept applies to companies that are first to the party meeting considerable market demand. They enjoy the benefits of temporary scarcity (and higher multiples) as long as they are the only ones serving that particular need. When others recognize the need and join the party, multiples drop.
A recent example is Beyond Meat, the public company in the booming “plant-based meat” market that has seen a recent drop in its valuation, due in part to its growing number of competitors and a low barrier to enter (low defensibility).
- Build something unique. Innovation drives multiples higher.
- Try to be the first (or among the first) to the party, anticipating rather than following market demand.
- Build a moat if possible and defend your advantage.
- Communicate why your product is unique. Strategic marketing plays an important role in positioning a product as a leader.
Multiple Booster 2: Market size growth
Building something unique doesn’t mean anything if what you build doesn’t also meet market demand. Trust me, in the next 10 seconds I could come up with 10 unique ideas that nobody wants or cares about. I guarantee you that they won’t make me rich.
The size of the market a company operates in matters.
What’s even more important, though, is market size growth.
When I founded my company in the cybersecurity education niche, the cybersecurity market was growing 13% CAGR (Compound Annual Growth Rate). Yet the revenue of the biggest player in that niche was probably only in the low 20’s. We were playing in a tiny, fast-growing niche of a fast-growing market and that was enough to succeed.
Investors want to see that the problem your product solves is not only felt by a large number of people but that this number will grow in the future. Why? For two main reasons:
- A fast-growing market will drag your revenue up even with a sub-par product.
- Buyers today will be sellers a few years later. These investors bought something with room to grow, and they will want to sell something that still has room to grow.
- Choose your niche/market carefully. Research and verify the expected CAGR. If it’s higher than 7 or 8% it’s a good market to be in.
Consider pivoting to a different niche if you don’t see growth.
Multiple Booster 3: Perceived value
There is real value, and there is perceived value.
While real value is based on things like market growth, fundamentals, quality of the team, IP, and the competition landscape, perceived value is based on purely psychological factors.
Investors who got sucked into the Dotcom Bubble know this very well. The valuations of internet companies between 1998 and 2000 were driven up almost entirely by Fear of Missing Out on this new thing called the internet. Right until the bubble burst, investors were still buying stock in over-valued companies because their perception of the worth was even higher than the ridiculous multiples they were trading for on the stock exchange.
The perception of value is probably the biggest factor in the price of a company. It can take a company valuation from nothing to billions.
What few realize is that the perception of value can be easily manipulated by start-up founders (and sometimes VCs) who the media holds up as visionaries and heroes of our times. Think of Elizabeth Holmes or Adam Neumann. The value that they created in Theranos and Wework, respectively, was purely in the eye of the beholder.
I’m not encouraging you to engage in shady, manipulative behavior to goose your company’s value — far from it. (Holmes will stand trial this year for fraud; Neumann is defending a lawsuit by his angry shareholders.) The useful lesson to take from this is that founders who know how to attract media attention and shape their companies’ reputations, can drastically increase their companies’ valuations.
- Understand how to attract media attention early on.
- Understand how to control the narrative around your brand proactively, rather than reactively.
- Use social media wisely to increase the perceived value of your business.
- Be careful not to over-promise.
Multiple Booster 4: Growth
Of all the things you can control as a founder, growth is by far the most powerful way to boost your multiples.
Nothing is more appealing to an investor than a company that is growing fast — except, maybe, a company whose growth rate is accelerating.
That’s why I believe the time for founders to raise funds isn’t when they’re in need, but when growth is accelerating. When growth is accelerating, you’re in an ideal position to negotiate the best terms or the best price for your company. Most importantly, this is when you will have competing bids from investors, driving the price up further.
Once things start to slow down or go south, it’s virtually impossible to raise funds or exit at good valuations. Investors (if you can find any) will have endless reasons to slash their bids and there won’t be much you can do about it.
That’s why it’s a huge strategic mistake to try to sell your company when things get flat or turn downward. Growth is the launchpad for your valuation.
- Focus on revenue growth. It’s the most important metric, even more than the EBITDA. With outstanding growth, you will always be able to raise more funds or find a buyer. With a big EBITDA but no revenue growth, you may not need to raise funds but you’ll have a hard time selling your business for an attractive multiple.
- When you have a streak of 3 years of increasing revenue growth (say +10%, +45%, +70% YoY revenue growth) start considering your options: raise growth capital for further growth? sell some or all of your stocks? This is the moment when you have the best cards in your hand. Ask yourself: can I do even better next year? If the answer is no, this could be the optimal time to sell at least part of your stake in your business.
Multiple Booster 5: Scalability
Fast growth is made possible by good scalability.
Scalability is your business’s ability to accommodate fast growth efficiently, without disruption (keeping your margins under control, for example).
Let me give you an example of a scalability problem. If your fashion company gets featured by the Kardashians on Instagram, but you only sell through a few retail stores in Europe, you probably won’t be able to exploit the sudden surge in interest in your products. If instead, you’re selling items online, you manage your inventory efficiently, and you ship items worldwide, you would hit the jackpot by translating this new attention into sales and rapid growth — thanks to your scalable model.
Even more scalable are digital companies that can automate every process, from customer onboarding to product delivery, letting them scale virtually ad infinitum. Hardware is easy to scale; people are not.
Could your business successfully onboard 1,000 new customers tomorrow morning, without having to hire a single person? If the answer is yes, you are going to attract a higher multiple.
However, scalability does not need to come at a very early stage for a company. Scalability derives from the business model and is obtained through process automation. It’s okay to have unscalable processes while you are validating your product on the market. You don’t want to optimize too soon. It is imperative, however, to embed as much scalability as possible by the time you approach VCs or an investment banker to sell your business.
- Focus on automating every process in your company, from marketing to product delivery.
- Make sure that you involve the smallest possible number of humans in each process. Humans make mistakes and are hard to manage. Code is more reliable and never asks for a pay rise.
- Constantly measure your scalability metrics by asking yourself, “What would 1,000 new customers tomorrow do to my business and infrastructure?”
Multiple Booster 6: Predictability of revenue
It’s hard to demonstrate revenue predictability when you are pre-revenue, or when you’re only in Year 2 of revenue generation. In that case, you can substitute product-usage metrics to demonstrate the “stickiness” of your product.
When revenue is there, investors like to see that it’s predictable and not just due to a flash sale or other extraordinary event.
You need to focus on showing that your customers are buying from you repeatedly. A company that can only sell to a customer once won’t have great chances to survive, let alone attract high valuations.
Companies with subscription business models and low churn rates attract higher multiples by demonstrating that, once they get a customer, the customer will continue to pay for a long time. Think of Dropbox, for example.
- Consider adopting a subscription business model. Only if it makes sense though.
- If a subscription model doesn’t make sense, make sure the customer has a chance to upgrade or buy another product from you. Building a product family instead of a single product is extremely important.
- Pay close attention to metrics such as churn.
- Also, pay close attention to product usage metrics, and encourage your customers to use your product. Without product usage, it’s hard to get repeat business.
Companies are products
I was in the third hour of a so-called management meeting (one of those meetings you have with people interested in buying your company), in the huge glass room of an investment bank in New York, when I had this epiphany:
Companies are products
When you talk to a potential buyer for your company, they ask you the same questions a customer would ask about your product. It’s because they’re looking for the same things from buying your company that they would look for in buying a B2B service or product:
- An opportunity to save costs. Maybe you are doing part of what they are doing, but more efficiently.
- An opportunity to increase revenue. If you are in synergy with them or with a company in their portfolio, the revenue post-merger will be greater than the sum of the revenues of the two companies pre-merger.
When you look at your company as a product, you will focus on the areas that make your product-company more appealing to buyers and investors.
Hopefully, this article has given you a few ideas on how to get started doing that.
After all this talk about getting your multiples up, you might assume that higher valuations translate automatically into a more solid company. Unfortunately that’s never been completely true.
Founders who only focus on pumping their companies’ short-term valuations do a disservice to their shareholders, their employees, and themselves. Even without taking it to an extreme, raising funds at unrealistically high valuations means lower dilution, but also sets a higher bar for your next round of funding. If you’re not careful, you might grab a short-term advantage that leads to disaster later on.
So, apply this advice carefully, and enjoy the ride.