Valuation vs. Value
There is no question that tech valuations are frothy (to say the least) at the moment. People however try to argue that ‘this time it’s different’, amongst other reasons a commonly cited one being that tech companies today deliver ‘real value’, have real revenues, scale etc etc.
Firstly : there’s never been a bubble in history during which a certain few were not convinced that ‘this time it’s different’. Unfortunately for the rest of the people those ‘certain few’ are often the influencers and not surprisingly the ones with the biggest vested interest in profiting from the inflated valuations that they so help drive. In the subprime mortgage bubble it was the same: a certain few convinced themselves that ‘this time it’s different’, fundamentals don’t matter, and that people could be handed mortgages way above their affordability , no matter if they couldn’t repay them, because ‘this time it’s different’.
It’s easy to cook up why this time is different. It’s harder to de-clutter the noise and figure out why the fundamentals still remain the same (as they always do).
Whilst I don’t disagree for one second that todays tech companies do actually deliver real value (after all I am a tech entrepreneur myself and I see that both in my products – PeoplePerHour.com & SuperTasker.com and the ones I use so avidly), whilst I don’t disagree that the way we live and do business is rapidly changing and being disrupted by tech, I think the ‘Valuation vs. Value’ argument is intrinsically flawed for a few reasons
- Value is not enough
Its not enough to just deliver value. You need to do it in a way that’s sustainable in the longer term and builds on fundamentals. You can shoot for the moon overnight and fall to ashes just as fast if you’re building a business without fundamentals. Many examples come to mind, from Fab.com, Colour, Joost to more recent from our space – HomeJoy – who filed for bankruptcy a few months ago after raising ca. $100m. All of these were once amongst Silicon Valleys darlings, had multi billion valuations and some achieved hundreds of millions in revenues. Yet that wasn’t enough.
Unfortunately with the exception of long term value investors like Buffet and others in his category, or angel investors who manage their own money with a long term perspective who can afford to sit on their investments and are happy to get rich slowly, most investors in today’s tech world don’t really have time for fundamentals. They need to beat the fundamentals to get rich fast. They need to defy gravity to sky rocket. Turns out, gravity is a fundamental constant. You cant defy it for ever. You may for a little bit but eventually you fall to the ground.
Fundamentals in business are things like: profitable user acquisition, unit economics that improve over time (due to growing brand awareness, repeat business, growing product stickiness and better funnel optimisation), strong repeat business, high customer satisfaction, high NPS (Net Promoter Score) and high frequency of transaction. Low dependency on a few high value transactions is another I would include in fundamentals. You can schmooze and charm a few large clients if for example you are building Enterprise software, or you may be great at playing Golf and closing big deals – who knows!- and you can therefore seemingly build a large business fast. But you can lose those few large customers just as fast and be back to ground zero.
So in as far as value is taken to mean ‘we’ve found a product that people want to pay for’ – not an insignificant achievement and certainly more than most people achieve – then value alone is not enough. Sustainable value is what matters and for that I’d look at fundamentals like the ones (and more) that I mentioned above.
- Valuation can destroy value
Even if you have the fundamentals mentioned above and you are delivering sustainable value, excessively high valuations can destroy a business. We learnt that the hard way at PeoplePerHour.com – and thankfully managed to stay just an inch to the right side of that fine line.
High valuations set a much higher expectation for investors. Where they may have expected 3x returns in say five years they now want it in one or two years. Few, if any, will say that when they are paying up; it’s considered implicit (is it ?). They over pay, and they expect you to over deliver – or in most cases, deliver a miracle. If you do, all is good and everyone’s happy. But miracles don’t come about that often and they certainly can’t be engineered. Hyper growth is not a strategy, it’s an outcome. Unicorns cannot be designed top down with a plan. They either happen or they don’t. Whilst businesses with sustainable fundamentals, continuous momentum, value creation and innovation can be engineered. You can build an Amazon with excellent execution like Jeff Bezos did but you can’t build a Google, Facebook, Instagram or Snapchat that way. It takes much more than good execution (and in fact some do get created despite bad execution)
In that wake of over expectation entrepreneurs will be pushed to do things that they otherwise wouldn’t. Optimising for ROI on each decision (as tends to be the case in the early days when every dollar you invest comes out of o your own pocket) gets replaced by a metric of euphoria: how can we build faster, bigger, bolder, at all cost. Whenever that ‘at all cost’ mind-set kicks in you know it’s the beginning of the end. It’s a matter of ‘when’ not ‘if’. Unless of course you pull a miracle.
- You cant optimise for both
Alas the issue is that, even if you deliver real sustainable value per point 1), and even if you don’t let valuation destroy value per point 2) by remaining sane, disciplined and level headed, you still need to optimise for one or the other. You can’t do both.
Optimising for value means constantly ‘optimising around the margin’. Constantly chipping away at waste, keeping cost and unit economics in check, and doing everything you do a little better each day. Its what the Japanese call ‘Kaizen’ or continuous improvement. Its how the Japanese built the most sophisticated industrial ecosystem in the world and disrupted western manufacturing.
Optimising for valuation means trying to drive step change at each interval, so that by the next funding round you have someone else drooling over you more than the last insane guys did. It’s the greater fools theory: valuation is driven by emotion, ‘irrational exuberance’ as Alan Greenspan called it, or hype. So very simply if you are optimising for that you need to build enough of it to beat the last one. Naturally as you keep moving up there are disproportionately fewer and few ‘greater fools’ as the price and ticket sizes get larger so the jumps you need to make keep getting larger. Before you know it you’re optimising for vanity rather than sanity metrics.
Maybe you’ve opened a few new offices around the world, hired a bunch of C-level superstars across all of them, all of which will be ‘game changers’ in the business of course, you spent an arm and a leg to forge a partnership with Google or some other big name all of which is still speculative, you’re about to start TV ads, or you launched another 5 product lines all of which will be disruptors. Mean time you got kick ass offices with a few spare floors for expansion, an in-house chef, masseuse, a couple of dog-sitters, a gym and foot rests for your employees with variable rub speeds.
Your costs have shot through the roof, revenue may not be following dollar for dollar but… that’s what you need the new money for! And there’s so much money left on the table for that new investor because all these bold moves you’ve taken will just create a tsunami that will kill everyone in the market. No brainer. Bring in the dosh!
Of course for the vast majority of those cases we know where the story ends. Even if some of those things (I may have omitted to include a pet chef) are the right things to do, that’s only true if they are done in the light of optimising for value creation NOT for valuation. The rationale matters more in this case than the act itself. And that because it highlights what you are optimising for. In 99% of the cases they are moves the CEO does because the No1 thing niggling in his mind is how to beat the last rounds insane valuation and attract the next greater fool. What does the new consortium of ‘blue-chip’ VCs who will scoop up the next round want to see next? And they build backwards from that.
Brands and technologies that we interact with daily, from Apple, Intel, IBM, Amazon, and brands outside of tech like WalMart, IKEA and a myriad others have been built by a few visionaries who were obsessed with dreaming up the future and working backwards to build it. Too many of today’s entrepreneurs are dreaming up their next valuation and work backwards from that instead. The former optimised for ‘Value’ and built long term sustainable businesses and products that stood the test of time and ultimately became household names. The latter, more often than not, built (successfully) large ponzie schemes that were glorified for a short while until they exploded or withered, often taking down many others with them. Systemic risk does not just apply to financial markets, it applies equally in todays world of tech. The entrepreneurs who built those bubbles may have get out in time to make themselves a fortune (remember Bebo?) but it doesn’t change the fact of the matter. In the end what matters more than making money is making a small dent in the universe. As Steve Jobs said ‘ I don’t want to be the richest man in the cemetery, I want to be one who built the coolest stuff’
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