I spent a recent afternoon eavesdropping at the Starbucks on University Ave., in Palo Alto, Calif.
While I didn't go there with the intention of being nosy, I couldn't help but overhear the conversation among the founders of technology company start-ups. This particular Starbucks is perfectly positioned for picking up Silicon Valley gossip. Facebook headquarters is across the street. The venture capitalists leave their Sand Hill Road offices and stop in on their way to San Jose for meetings. Stanford's MBA students work on their business plans over Americanos.
Trying not to look obvious, I listened in.
“I think we can get four times.”
“Are you kidding? We're at least five, maybe six.”
I knew they were talking valuation, and I assumed they were using the standard formula most people use to value a business: a multiple of earnings before interest, taxes, depreciation and amortization (EBITDA). These days in Canada, a clean offer of four times EBITDA is a pretty good deal. Five times would be very good, and six times is almost unheard of for a business with a total value of less than $10-million.
What became clear as the conversation unfolded was that these Silicon Valley entrepreneurs were talking about a multiple of revenue, not earnings.
Were they dreaming, misguided or just totally out to lunch? Not necessarily any of these. Being in Silicon Valley, they probably ran a technology business. The one ingredient technology companies usually have that makes them so valuable is the ability to scale. With scalability comes the potential for hyper-growth in the future. Buyers pay for what your business can do in the future. Having a scalable model can increase your valuation exponentially.
So how do you know if you have a scalable business? Here are the three criteria:
For a product or service to scale, it needs to be something you can teach relatively inexperienced people or machines to create. If delivering your product or service is reliant on the dynamic decision-making of you or a senior, very experienced and educated employee, your business is going to be tough to scale. Focus on creating an operations manual so a relatively inexperienced employee (or machine) can deliver the same product or service. Design it once and stamp it out. Said another way, build once, sell many times.
Having a scalable product or service doesn't guarantee you have a scalable business. For that, you need to have customers who want to buy what you're selling. The business graveyard is overflowing with scalable products that nobody wanted to buy. Compare, for example, the Apple Newton with the Apple iPhone. Newton (originally called Message Pad) is the failed personal handheld organizer Apple launched in 1993 to great fanfare. It was a scalable product the company could assemble inexpensively, but customers didn't find it valuable. Its handwriting-recognition software was unreliable. Scalable, yes. Valuable, no. Graveyard.
For a business to scale quickly, it needs to rely on both winning new customers and earning the repeat business of existing customers. It's too costly and time-consuming to build a business on new customers alone. You need the compounding effect of new customers joining a loyal group of existing customers—that's when you get the snowball effect. Here's where Apple starts to earn its market capitalization. Not only is the iPhone a scalable product that customers want, it has a consumable long tail of content in the form of music, TV and applications that customers buy regularly.
Teachable, valuable and repeatable—that's your valuation trifecta.
Special to the Globe and Mail
John Warrillow is the author of Built To Sell: Turn Your Business Into One You Can Sell . Throughout his career as an entrepreneur, Mr. Warrillow has started and exited four companies. Most recently he transformed Warrillow & Co. from a boutique consultancy into a recurring revenue model subscription business, which he sold to The Corporate Executive Board in 2008. He is the author of Drilling for Gold and in 2008 was recognized by BtoB Magazine's “Who's Who” list as one of America's most influential business-to-business marketers.