Why do Internet startups that aren’t showing a profit wind up with astronomical valuations?
The idea is that the startup will eventually find a system to make some money and by virtue of being Internet-based, that system will lend itself to being cost-effectively scaled up. And by “cost-effectively” I mean that it can produce a “multiplier effect” during a small business scale up.
I’m oversimplifying, but if you have a good Internet-based business model, scaling that business can be done by adding more servers. For example, you could even expand overseas that way. Your developers could still be about the same in number (again, I’m simplifying) and located in your home office, but your business could have an increasing presence over seas. You would be able to leverage the same intellectual capital to an expanding market without increasing your overhead in “lock step.”
Other business models, on the other hand, don’t scale up as efficiently. Let’s say you have an accounting firm and want to expand overseas. Essentially every direct and indirect cost (overhead) that you have to pay at home, will have to be replicated and paid overseas.
If you want to create real value in your company, the first question you need to ask is how to scale your business and at the same time improve (or at least not destroy) your margins. If you don’t, you’ll find that as you grow, your profit margins will shrink, and that’s not a formula for creating value. If you have to spend one dollar to increase revenue one dollar, you’re headed toward a dead end. If you have to spend 95 cents to increase revenue one dollar, you aren’t much better off.
You need to start with a product or service that is:
- Repeatable, and
- Consistently delivered.
Those elements position you to be able to scale up your offering. But as you begin to grow, you need to create efficiencies in your small business that allow you to support greater sales with less (proportionally speaking) overhead as well as marketing expenses.
Think about mergers and acquisitions in reverse. When two companies merge, they enter into a phase where they consolidate redundant departments. Essentially the hope is to be able to support the sales volume of both companies with the infrastructure and marketing of just one. Note that usually a stronger company buys a weaker one.
The weaker company didn’t plan on being weaker, but decisions management made along the way, put it in that position. The stronger company paid more attention to efficiencies as it scaled up and did a better job in sales and marketing. The point is that if you don’t relentlessly manage costs as you grow, your efforts at scaling your operation can easily backfire and put you in a weaker position in the end, despite the growth you have experienced.
Here’s one more warning for any small business owner who wants to achieve scalability and create impressive additional value: If your business depends on you, it’s not scalable. You need to look at that list of three points above and find ways to make the source of your revenue stream “teachable” and “repeatable” so it continues on successfully when you’re out of the equation.
It’s likely that someday you’ll want to sell your small business and take away a tidy sum that will fund your retirement or your next venture. If you can demonstrate a successful small business scaling strategy, it will command a much bigger price tag than if it seems your business has reached the limits of its profitable growth.