Fail Factors - Why Startups Fail: Revenue versus Valuation

There are 3 core "legs" a business must stand on to survive, and hopefully, thrive.  They are Sales, Engineering, and Marketing. There are a ton of other important areas within a business, of course, but these stick out as keys to life or death, in my experience.  Rarely does someone fail because of poor facilities management or toilet cleaning or even accounting.  It just doesn't happen anymore.

Engineering is critical - lest we have nothing to sell or market.  Most technology companies start as engineering exercises and treat sales as secondary - and often treat marketing as evil.  Engineering-dominant companies often have the problem of building a solution to a problem that doesn't necessarily exist.   More on this later.

Sales is critical - but startups often overinflate the value of revenue.  Don't mistake my comment - I love revenue.  What I mean is that it is far more important early on to gain knowledge about the market versus revenue from it.  Knowing why the customer buys or doesn't has much more meaningful leverage points for the business in the future.  Boards and VCs will shoot you for thinking like this, but they are part of the problem (more on this later as well).  If the board isn't loaded with idiots, they would rather have you figure out what happened last quarter so you can accelerate REAL revenue acquisition.  No one will care that you missed your $1M target last quarter if you can hit $10M two quarters from now.  Getting it right faster is much more valuable in the long run than hitting flawed numbers.

Marketing is perhaps the most misunderstood leg in the stool.  It's the most underinvested and as such tends to be a place where the mediocre reside.  Marketers have done a poor job in enterprise technology by following instead of leading.

In order for the 3 legged stool to remain stable, all 3 legs have to be growing at the same relative rate.  If one leg grows too fast, the stool will tip over.  If one leg grows too slow, the result is the same.

Think about this:  Engineering is a cost center.  Sure,  you need a product to sell to garner revenue, but that revenue is indirect - or not directly associated with Engineering.  Sure, we praise the engineering team at our sales meeting for giving us great stuff to sell, but who are we kidding?  The sales folks get the credit, the money, and the glory 99% of the time.  No matter what you build, the way that you build it is treated as a cost center.  Cost centers are the first to get squeezed when anything negative happens.

Sales gets the glory because revenue is the easiest means of judging our success.  Rarely do we have brilliantly engineered products that sell themselves - outside of consumer markets, that is.  In "enterprise" technology companies, things have to be sold.  Only when you are a runaway success, or virtual monopoly, can you start "taking orders" instead of selling. Thus, like the president, sales gets too much credit for success and too much blame for failure.  Since $$ is easy to metric, boards and VCs will always push it.

Marketing is nebulous in enterprise technology markets.  It's a cost center, but it doesn't produce products.  It can't normally metric against $$$.  All the problems, none of the glory.  That's why it's been easy for CEOs to overlook marketing as an afterthought or for the VP of sales to treat marketing like second class citizens who "can't sell," and thus are banished.  Those who can't, teach, as it were.

The Facts of Business Life in Enterprise Technology:

1. Engineering is a mandatory investment.  We need something to sell.  It would be great if it's the best thing ever, but it's not that important.  What is important is that it solves a legitimate, ubiquitous problem that people will spend money to solve.
2. Revenue is NOT the most important metric.  Revenue matters a lot - but it's not the most important.
3. Valuation is the most important metric.  Valuation is based on a set of enormously unscientific principles, emotion, and feeling.  Revenue, if you have it, plays a role as ONE metric to be applied against the VALUATION MULTIPLIER.

What functional "leg" represents the biggest impact to valuation?  Marketing.  This is a fact.

Until you are an established public company placed into a "bucket" (that you can often never get out of regardless of its applicability), you have the opportunity to enhance your valuation multiplier.  The way to do that is to increase the value of the multiplier. Duh.  Your revenue is your revenue - your earnings your earnings.  Those can go up or down, but neither will have the ability to dramatically increase valuation like the multiplier can.

$1M x a multiple of 10 = a value of $10M bucks.

$1M x a multiple of 100 = a value of $100M bucks.

Same revenue - much different valuations.

See where I'm going with this?  CEOs focus on revenue too heavily early on because it's what the board (and themselves) uses as the metric for success or failure.  What they should focus on is valuation.  Valuation has a lot more, well, value than just revenue.

EqualLogic was running at about $70M in sales, almost break-even when Dell paid $1.3B clams for them.  Dell's multiple on revenue is about .5.  That means Dell sells $60B of stuff, and is valued by Wall St. at around $30B.  For every dollar of revenue, Dell gets $.50 of valuation.  If you use earnings instead of revenue, they are valued at around 20x.  That means for every dollar of bottom line earnings, they get a multiplier of 20.

EqualLogic was valued at 200X revenue versus Dell at .5x revenue - or 400 X higher.  Since EqualLogic had no earnings, their multiplier on that metric is infinite.  Infinite versus 20.

At the end of the day, a dollar is a dollar and a Euro a Euro.  How can one be worth so much more than the other?  Marketing. Until you are captured and put into a box by the Wall St. analysts, you have limitless perception boundaries.  It's not what you are - it's what people think you represent.  It's the opportunity for you to possibly do great things - not the things you actually do - that matters.  Why was EqualLogic's dollar so much more valuable?  Marketing.

Data Domain sold to EMC for $2.4B for doing about $200M in revenue.  12X revenue was Data Domain's value multiplier.  EMC's revenue multiplier is about 2.2x (4x larger than Dell's).  EMC's earnings multiplier is 35x (2x Dell's - a dollar really isn't a dollar apparently).  Data Domain's earnings multiplier was in the stratosphere, because they didn't have much.

Why was Data Domain so much more valuable for each dollar it brought to the party?  Marketing.

Engineering is table stakes - it has to be there.  Sales, I would argue, are equally table stakes.  Marketing is the great variable.  Marketing can jack a valuation much faster - and much higher - than any revenue number.  Marketing can cover bad engineering.  Marketing can drive sales - sales rarely drives marketing.

If you want more proof simply look at the low value exits that have occurred over the last decade.  I contend that LeftHand had as good as, if not better, stuff than EqualLogic - but HP bought them for $350M or so.  Why 1/4 when all else were on par?  You guessed it - marketing.  LH could have, and should have, positioned itself as a software company.  They were addicted to REVENUE, however, and it cost them.  They were under the absolutely incorrect illusion that they couldn't go public without a bigger revenue number, and as such stayed firmly planted in the hell hole that is hardware.  Do you think HP valued them higher for being in hardware?  Of course not.  They penalized them.  LeftHand listened to their board and bankers - who still believe in the 1978 mantra of revenue as the only metric.  They didn't focus on optimizing valuation - even though it's how they make a living - because that would have meant going against the common wisdom - and it cost them.

True low value exits tend to happen when there is perhaps great engineering, and absolutely no marketing.  I made this point in my Israeli rant recently and it holds true here.  Great products are meaningless unless the world values them. How many times do we need to see a company with $50M invested sell for $10M or less before we figure this out?  The buyer saw value in the IP - but didn't see any multiplier factor - a direct result of improper or non-existent marketing.

Final point - value isn't transferable.  As soon as Data Domain and EqualLogic were integrated, their value shrank down to the levels of their acquirer, making a dollar a dollar once again.  Too many people forget that.  The only acquisition that makes sense is done based on the valuation of the acquirer - not the acquiree.  EMC did NOT become worth $2.4B more by buying Data Domain on day one - they were worth less.  As Data Domain adds revenue and earnings to the EMC pile, that value is multiplied back.

Read Steve's other blog entries at The Bigger Truth.