The algebra of VALUE for startups

I’m pretty excited about this — VALUE is not just an acronym here; it’s an equation!

The villain Jafar laughing, from the Disney animated movie, Aladdin.
From Disney, via giphy.com. (Giphy terms of service)

Maybe I’m too excited… But still, this is based on established financial analysis practices, expanded to put cold, hard math around the guts & heart aspects of startup strategy. So, it’s pretty rad.

VALUE = (Valuation — (Assets — Liabilities)) * User Experience

You’re thinking, “sounds sexy, MB, but wtf are you talking about?”

We can inspect the elements of the equation, but first, we need to establish that brand is everything. This is not hyperbole. This is a mathematical fact in many cases — particularly for startups.

The financial analysis I refer to is the calculation of goodwill, an intangible asset on a company’s balance sheet.

The calculation of goodwill

Under generally accepted accounting practices (GAAP), goodwill is calculated as P — (A — L), representing fair market values of a company’s Price, Assets, and Liabilities. If you had a buyer willing to pay one million for your company and you have a hundred grand worth of inventory and also a hundred grand in debt, the calculation is:

1,000,000-(100,000-100,000) = 1,000,000

The practical implication is that they’re paying that mil for the goodwill.

But, c’mon, “palue??” I swapped out the P for a V, which also sets us up nicely when we talk about private market Valuations.

Goodwill may not be a common topic for startups, but it’s a very big deal. We’re not talking about the second-hand store. Look at it as putting a price on the value of a brand.

The principle of goodwill has been around for a looong time — ye olde contracts preserved in England referred to it in the 15th century. Later it became codified. John Scott, 1st Earl of Eldon and Lord High Chancellor of the Empire (actual title), summed it up as “the probability that the old customers will resort to the old place.”

Oil painting portrait of John Scott, former chancellor of Great Britain.
Image from the National Portrait Gallery, London, public domain

This dude is obviously terrifying — he chose to have his portrait painted in the dark (maybe some blood flowing in the bg?) — but I like the quote. The gist: you can buy a store and its inventory, but existing customers will only keep coming back if you uphold the value that the name on the front conveys.

Reality check:

“Goodwill — the amount Amazon paid for beyond what’s valued on Whole Foods’ balance sheet — accounted for $9 billion, or roughly 70 percent, of the $13 billion acquisition price.”

–CNBC

How it applies to startups

Big brands have big goodwill. Some companies will list goodwill as an intangible asset on their balance sheet. Coca-Cola (KO), a long-time poster child of brand value, reports goodwill and other intangible assets at $33.6B, just 13% of its $260B market cap.

If the calculation was carried out to the T, it might look something like Apple’s (AAPL) $2.5T price — ($50B “tangible book value” assets — $100B “net debt” liabilities) = $2.55T. In other words, if like, God, or Thanos, were to swoop down and make an offer for Apple, they’d have to pay more than the market cap.

This explains why actual transactions pay a premium for brand, like the Amazon-Whole Foods example above. The CNBC article also mentions that “companies that don’t own a lot of tangible assets, like software makers, tend to draw higher goodwill.”

Startups have even fewer assets. If they have debt financing they may still have steep liabilities. Successful exits for startups will often prove out the math that the promise is worth more than the profit (if any).

Brand is a promise, and it represents the entirety of a startup’s value.

The key to our equation is how a startup can live up to that promise. The solution is not through incremental features but through user experience.

A old piece of brown paper with the VALUE equation superimposed.
Equation superimposed on a photo by Dan Cristian Pădureț on Unsplash

V is also for Vague

There is no universal standard to determine the valuation of a startup.

In many cases, it comes down to supply and demand — what’s the quality and quantity of pre-seed startups on offer to a pool of investors and capital. The marketplace is fractured so an identical startup will have a different price depending on location and network, among other factors.

At later stages of venture capital, there is more rigor, but it still falls short of hard science. In researching “methods of startup valuation,” I found listicles with 3, 4, 5, 6, 8, 9, and 10 different methods (I recommend the last one for further reading).

They mostly overlap. Here’s a rough synthesis:

The preferred valuation methods rely on multiples of projected revenue metrics. The “VC Method” and “Discounted Cash Flow Method” hone in on potential gross profit or positive cash flow (taking into account operating expenses), respectively. They “discount” the valuation by accounting for both risk and their required rate of return (which is a lot).

Simpler, pre-revenue valuation methods consider a bunch of risks. The “Berkus Method” has five unweighted risk factors. “Risk Factor Summation” scores 11 risks. The “Scorecard Method” is in the middle and looks like this:

  • Team – 30%
  • Opportunity – 25%
  • Tech/Product – 15%
  • Competition – 10%
  • Distribution – 10%
  • Burn Rate – 5%
  • Quality Plan – 5%

An investor or analyst will score a startup from 0 to the upper end of risk-factor range, then the total percentage can be multiplied against the valuation of a similar startup at a similar stage.

A person raising their hand from under water.
Photo by Stormseeker on Unsplash

Valuations under water

Raise your hand if you have any concerns.

The takeaway that pops out to me is that valuation methods are all based on possible future earnings and a combination of the team, market opportunity, and product. Product and reach are barely considerations…

Let’s make the leap that a valuation is equivalent to the fair market price of a company. The valuation is entirely based on potential profitability; the value now is entirely in the brand. Ergo:

Brand value today is equivalent to future financial value.

A startup is not converting brand into cash flow. Far from it, at the next round of financing, the valuation will again be roughly equivalent to the brand value. Therefore brand value must increase.

In the upside down world of incrementalist thinking, the management team will try to reverse engineer revenue gains (revenue promises, based on that projected profit). Customer acquisition and revenue via new customers are often seen as too expensive or too slow to hit these aggressive targets.

The nonsensical solution is to extract more revenue from existing customers and to rush new features to market to miraculously make this happen. Not only does it rarely work, but another error of this way is that the growth curves of compounding return and incremental upsell go in opposite directions.

Simple line chart showing an upward curve for “required rate of return” and a plateauing curve for the growth from incremental upsell.

A startup should not ask “how can we generate more cash flow,” it should ask “how can we enhance the brand value.” I can hear some quants in the audience scoffing, what do you propose, hand out strawberry ice cream cones?

Of course not. The premise of your business is to solve a customer problem and to deliver more value to a user than the resources they put in. Do that, better.

How do we leverage brand value to drive compounding growth? The multiplier is User Experience.

Putting * user experience in the value equation

Brand represents the entirety of a startup’s value. It’s by far the biggest asset on the balance sheet. Yet, a startup doesn’t entirely control it. Ultimately it’s determined by the market’s opinion. A subcomponent of the market is the startup’s user base, which is comprised of… users.

Each one of those users will decide if a startup is worth a lot or worth nothing. They’re each shareholders of the cumulative goodwill that is inevitably larger than the stake of the equity shareholders.

User experience is a multiplier of the brand value — it’s either a positive integer or a fraction that reduces the value.

The startups.com valuation article offered this unique method:

“The ‘customer-based corporate valuation’… incorporates the most important determinants of corporate valuation — customer acquisition, retention, and monetization — directly into the valuation model, while traditional models do not.”

— Daniel McCarthy (co-founder of Zodiac, acquired by Nike)

Customer acquisition, retention, and monetization are all direct outcomes of the user experience across branding and marketing channels, onboarding, and the product experience, respectively.

We can get even more precise in the math of user experience.

  • Registration rate will be a direct result of the consistency and quality of the brand experience across channels, with a bonus for organic growth via word of mouth.
  • Activation rate depends on the new user experience and their ability to capture the value proposition in the product.
  • Retention rate requires efficient user flows, engagement for the benefit of the user, and thoughtful error handling and support.
  • Income per user will be impacted primarily by a positive exchange of value for the user, not just of dollars but of time, effort, and cognitive resources.
  • Time, measured in quarters or years, will be a multiple of income and is a result of the ongoing value delivery and a progressive experience.
  • Yield will be a function of the ROI on the customer acquisition costs, with the brand experience both reducing acquisition costs and protecting the profit margin.

A startup will always have competition, pricing will often be comparable, few products can differentiate on robustness of feature sets alone. In the end, a startup will win with user experience.

Putting the proper investment and analytics into the user experience is a R*A*R*I*T*Y.

It pays off.

Read the full article here

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