Valuing a Business

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Last night EO Atlanta had an event on positioning a business for sale including how to value it. Typically a business that is bought by an acquirer actively browsing is worth more than when a company shops itself around to other companies. Let’s look at a few more factors in valuing a business:

  • Concentration of customers (e.g. one big customer or lots of little customers where more customer variety usually is worth more)
  • Gross margins (percent of revenues after only product/service costs are taken out with high gross margins being more valuable)
  • Recurring revenue (percent of revenue that comes from monthly or annual fees with higher percentage of recurring revenue being more valuable)
  • Profits over the last twelve months (a simple formula for an average company is that the company is worth 4-6x the previous year’s profits)
  • Growth rate over the last twelve months (faster growth rate is more valuable)
  • Liquidity of the shares (more liquidity like with publicly traded companies is typically much more valuable e.g. 50%+ more valuable)

As you can see there are many different factors in determining the value of a business. It comes down to what another company or person is willing to pay for it with the more profitable and faster growing businesses being more valuable. An example would be a company with $1 million in trailing twelve months revenue with $200,000 in profit (assuming founders and management had market rate salaries) might be valued at 5x the profit, or $1 million. Some companies with no profits are bought for many times revenue due to their strategic value whereas other companies with significant revenues are bought for only a fraction of revenue due to significant debt, losses, and a decline in the business (e.g. Newsweek for $1).

Valuing a business is tough as the market of buyers is usually very small. These guidelines can help you come up with a rough idea of what a business might be worth.

Venture-Backed Zombie Startups

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There’s a term used to describe startups that have raised money from venture capitalists (VCs), been around for several years, built sustainable businesses, but don’t have the hockey stick growth necessary to raise more money or provide a venture quality return: zombies. Zombie startups are actually more prevalent than you might think and represent one of the more difficult situations for VCs. Here’s a few reasons why these are so tough:

  • VCs often have more money than time and can only sit on a limited number of boards and still be effective
  • Once a VC believes an investment is a zombie they want to sell it and move on
  • Valuations are down significantly compared to three years ago and companies that try to sell themselves often don’t command as much money as when a strategic buyer comes knocking
  • The VC still has a personal reputation and brand to maintain thus needing to provide significant energy to sell the company and get the highest price as part of their fiduciary responsibility to the limited partners in the fund

Now, if the startup was bootstrapped and in the same position it could still be a great business for the managers and employees to continue indefinitely. It is very unlikely for a VC to sell his or her stake back to the company or co-founders due to the difficulty of the buyer coming up with enough money. Zombies are part of the startup community and should be understood by entrepreneurs.

Customer Service as a Competitive Advantage

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Customer service as a competitive advantage is one of the more difficult ones to sell as most people are jaded by companies that say they have good customer service but don’t deliver on the promise. Great customer service has to be experienced for people to believe it and therein lies the challenge: you have to convince them enough to even try it out. More tangible differentiators like we’re the only company with feature X or position Y are easier to defend and point to, but are also easier for competitors to adopt. Customer service is difficult to do well if it isn’t built into the culture from day one.

What companies do you think of when it comes to great customer service? Zappos.com, USAA, Amazon.com, etc. It’s really hard to do customer service well and the handful of companies that do it well are perennial growth stories.

Here’s what I’ve found works for making customer service a competitive advantage:

  • Mention that you pride yourself on customer service but don’t spend too much time on it as people won’t believe it
  • Work hard to get existing customers to do video testimonials and have them articulate why your company is so good
  • Think of ways to get qualified prospects to use your support team as part of your customer acquisition strategy (e.g. proof of concepts, trials, etc)
  • Track your net promoter score and use that to gauge your success
  • Know that the benefit of high quality customer service will come from long run customer retention and employee satisfaction (employees want to work in organizations that truly care about their customers)

What else? What are other things to keep in mind when using customer service as a competitive advantage?

The Best Exit Strategy is to Not Have One

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Much of the tech startup media is obsessed with big exits, which make for fun-to-read stories. In a blog post today Jason Cohen writes about his new WordPress startup and provides a good answer as to his exit strategy in the comments:

Success for me is defined as: Creating a company that generates at least $30k/month in profit after paying everyone reasonable salaries, while it’s still growing.

Jason is building his company to last, as most entrepreneurs do, and will likely sell his business if the right offer comes along. The key is that he defines success as getting to a certain level of profitability while still growing. Today I brought up that blog post with three entrepreneurs and asked about their exit strategy. Every single one said they don’t have an exit strategy and want to build up their company to a point where they can hand it over to someone else to run it while still growing. That sounds like a great plan.

Atlanta Startups Should be Moneyball’s Oakland A’s

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Earlier this week my friend sent me a quick email saying he had just finished Michael Lewis’ 2004 book Moneyball and that I should read it. Right away I replied saying that was one of my favorite books and that all startup founders should read it.

The short gist of the book is that professional baseball players were historically measured against traditional stats like batting average, on base percentage, etc. The Oakland A’s didn’t have the resources of teams like the New York Yankees but perennially did well in their division despite a significantly lower cost structure. They were able to do this by being scrappier with their players, farm system, and trades looking at long tail statistics and really focusing on past performance as the best predictor of the future.

Atlanta startups should be like the Oakland A’s in the book Moneyball.

Here’s how Atlanta startups can do just that:

  • Focus on areas that other companies aren’t paying attention to, especially small, fast growing markets
  • Be scrappier than the next startup by taking using of all the cost advantages Atlanta has over other major technology hubs
  • Take advantage of the farm system of young professionals, of which Atlanta has had the most growth of any city in the country

My recommendation is for Atlanta startups to be like the Oakland A’s in the book Moneyball and focus on long tail areas of strength to succeed.

What else? What other ways should Atlanta startups be like Moneyball’s Oakland A’s?

How to Help When it is Time to Shut Down a Startup

The Business End

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At least once a quarter I meet with an entrepreneur that is at the end of their ropes and should shutdown their startup. Giving up is hard. During these meetings the entrepreneur is seeking help, chronicling the many different things they’ve tried, talking about when they’ll run out of money, and doing everything but coming out and saying they need to give up. Inevitably, we talk about everything except how to go about shutting down the startup.

Here are some tips when having a conversation with an entrepreneur that it is time to shut down his or her startup:

  • Clarify when the startup will run out of money and explain that it is better to shut down sooner and retain some funds to properly unwind the business, pay legal bills, return money to investors, etc
  • Reiterate that a business idea failing isn’t the end of the world, even though it might feel like it, and that there will be plenty of additional opportunities
  • Make sure and communicate twice as much as you think necessary with employees, customers, investors, and any other constituents as the entrepreneur’s reputation is at stake
  • Try to find a home for the product, if you have customers and revenue, by reaching out to competitors or complementary companies

What else? What other tips would you provide to an entrepreneur about to shut down his or her company?

Ask the Right API Questions

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In yesterday’s post on saying ‘no’ to most opportunities, I mentioned that API integrations, assuming no custom work, are fine. An API, or Application Programming Interface, is a way for two software programs to communicate with each other in an automated manner. The challenge with most startups is that they don’t have a robust API. Yes, they often have a primitive API, so as to check off a box in a features comparison matrix, but the reality is that early on most APIs aren’t very good.

Of course, it is hard to know in advance how mature an API is as the documentation is usually also lacking. Here are some questions to ask when considering using a startup’s API:

  • What features in the product are NOT available via the API?
  • What are some limitations we should know about?
  • What percent of customers use the API?
  • Will you share the API documentation with us?

What else? What other questions should you ask when evaluating a startup’s API?