Tag Archives: Growth

Startups, growth, and valuation multiples

When you invest in a startup, you invest at a very steep valuation multiple.

It isn’t possible to justify the valuation at which you’re investing using traditional multiples like revenue, gross margin, EBITDA, or net income. The latter two are almost always negative, and depending on the stage at which you’re investing, the first two range from small to non-existent. Your reason for investing is that you believe that the startup will grow to produce revenue, gross margin, EBITDA, and net income in the future. It is this growth that you pay for.

However, even if the startup is successful in growing to produce these figures, the relevant multiple at which it is valued in the future is very often lower than that which you invested at. The reason is that even healthy businesses are eventually valued at traditional multiples that reflect a lower growth trajectory.

As a result, for an investor to make money in a startup investment, the increase in the company’s valuation which is produced by the company’s growth needs to offset the decline in the company’s valuation which will take place as a result of the lower future valuation multiple assigned to it.

This is why growth is so important for startups. If it stops or declines, even if the company is able to manage its costs so as to achieve break-even, the decline in valuation multiples makes it very difficult to achieve a return on your investment.

Managing for profitability rather than growth

When a startup with a history of growing with external funding finds that it is unable to raise a new round in its expected timeframe, many founders’ initial reaction is to panic. Since the company’s growth so far has been fueled by external capital, they can’t imagine how to survive, let alone grow, without it.

In reality, there are several options available for a company to generate the cash necessary to either break-even or significantly increase its runway while accepting a lower level of growth. These include:

  1. Raising prices or commission rates
  2. Renegotiating the terms of variable cost sources
  3. Cutting less effective marketing channels
  4. Renegotiating employment contracts or downsizing
  5. Moving to a cheaper office
  6. Ending external consultant and agency contracts
  7. Improving the company’s cash cycle by collecting sooner and paying later
  8. Improving the company’s cash position by selling fixed assets and inventory

The availability of each of these sources of cash depends on the context of the company. But, very often they are available.

And sometimes these measures aren’t enough to save the company. But, often they are.

Rather than panic, or more accurately after you’ve panicked for a while, you have to take the painful short-term actions that are necessary for your company’s long-term survival. You have to manage for short-term profitability so that you can hope to have another chance at long-term growth.

Feeling the pain

It’s relatively easy to evaluate a repeat entrepreneur whose first company was successful. Although luck is always a contributor to a company’s success, the fact that the entrepreneur built a successful business shows that they also likely have a good feel for market opportunities and are able to build and lead a team to take advantage of these opportunities. You’re more likely to do something well if you’ve already done it well before.

But what about a repeat entrepreneur whose first company failed? On one hand, they have the experience of running a business and the learnings that come from that. On the other hand, the fact that the business failed might suggest that they’re not good at identifying market opportunities and executing. To understand the signal that the fact that they’re a repeat entrepreneur carries for their chances of succeeding with their new venture, you need to understand the reasons why the company failed. Was it the lack of a market, the entrepreneur’s inability to build or lead their team, luck, or something else? Your view on the reasons for the failure will determine whether the fact that they’re a repeat entrepreneur makes them more or less likely to succeed in the future.

While building up to this view, it’s useful to take into account one more variable. And that’s the extent of the entrepreneur’s reaction to the pain resulting from the failure. All failures are painful, and you can argue that some failures are more painful than others. For example, all else equal, a failure where you lose more time or money hurts more than one where you lose less time or money. And a public failure hurts more than a private failure.

However, what’s more important than the objective pain resulting from the failure (if there is such a thing) is the subjective pain that the entrepreneur feels. Depending on your character, you might feel much more pain from a private failure that you worked on for a couple of years than that which someone else feels from a public failure that they worked on for over a decade. Some people have such an aversion to the subjective pain of failure that they will go to tremendous lengths to avoid experiencing the same pain again.

This line of thought also extends beyond business failures. For example, the subjective perception that you have of some personal failures as a child, which is influenced by how those who raise you make you feel about your role in and responsibility for these failures, can also cause you to take action to avoid experiencing the feeling of similar future failures at all costs.

There’s a saying that “the harder you fall, the stronger you rise”. I think it’s actually “the harder you think you’ve fallen, the stronger you rise”.

Many great entrepreneurs think that they’ve fallen to tremendous personal or professional lows in their past. They’ve felt the pain so strongly that they will go to great lengths to avoid feeling it again.