Startup Valuation: The Price-to-Getting-Away-With-It Ratio

It’s natural to separate a company’s activity into two parts: the stuff they do to grow their competitive advantage, and the stuff they do to monetize it. For example, a company like Amex might run TV ads to make the Amex name more recognizable and synonymous with prestige—so when they send someone a targeted piece of direct mail, they’re less likely to throw it out. And Google pushes their free browser and mobile OS in order to get marginally more searches, each of which generates a sliver of revenue.

Startup investors (as startup investors) don’t care much about the first part. Two companies in the same industry can see an order of magnitude difference in valuation models, because one has invested more in its market position (e.g. LinkedIn at 22X sales) and another has comparatively cranked up monetization (.99X sales).

Startup investors don’t need to care about profits. They can care about what a company can get away with. Facebook had a lower valuation when they insisted on turning a profit early in their existence; investors were willing to price them higher when they invested in growth and products. And that paid off; Facebook’s current business model is something closer to a proof of concept than a finished product.

And “what they can get away with” extends to valuation, too. Like currencies, startups’ momentum tends to be self-justifying. Part of the reason is, in fact, the currency-like nature of options: going back to the LinkedIn example, LinkedIn generates 22X as much market value from each marginal dollar of revenue they generate. They can afford to rapidly cannibalize Monster.com’s business, cut price points, and even shrink the total size of the industry—while still generating more market value, some of which will find its way into the employee option pool, where it could be used to poach knowledgeable industry folks from, say, Monster.com. But a broader reason is that a CEO comfortable demanding a ridiculous valuation is probably a CEO who can convince people to give up promising jobs and empty weekends in order to contribute to a venture that will almost certainly fail.

What can a company get away with? If they’re a succesful technology company, they can get away with charging for at least one valuable thing they do. But that’s not always what excites investors. Investors especially in the early stages, and particularly when they’re looking at ideas that could potentially change some aspect of human behavior. In later stages, investors still care about how much a startup can change the world—into a world where they’ll make even more money.

Perhaps this trend explains why Wall Street doesn’t get startups. Fundamentally, everyone on Wall Street wants to turn an investment into something hedgeable, bondlike, and with a definable correlation to everything else. But that completely misses the point of a startup; it would be like quantifying an actor’s career prospects by tracking the tips he earned waiting tables.

(Incidentally, this goes both ways. This VC’s walk through of a valuation model, would give your typical LBO maven a heart attack.)

Looking at the “price to getting-away-with-it ratio” is probably good career advice, too: most people advise taking a pay cut in exchange for greater “opportunity” (especially if they’re making the job offer), but a better plan might be taking a job that offers more future excuses for uncoventional behavior.