So you’ve started a business: you’ve made a great product, achieved product-market fit and have an extraordinary road map laid out. But to build a scalable business you need more than just product-market fit. There’s more to your business’s success than how great your product is. How your company works operationally, and the financial concepts that help you measure performance, greatly impact the ultimate success of your business.
There is a myth among first time tech founders that product is everything. Many lack intuitive financial sense that can help them build a great company once they achieve product-market fit.
Here are five financial concepts that every startup founder should know to build an everlasting company.
1. Asset valuation
The concept of asset valuation may seem counterintuitive, but it is an important idea. Compared to Accounting, Finance is ruthlessly forward looking. Most financial valuation formulas value an asset by discounting the asset using the cost of capital (interest rate) to the present day. When it comes to true asset valuation, what really matters is how much money that asset can make in the future not how much is making currently or made in the past. It also depends on how much your investors believe your products will perform in the market.
This highlights the importance of positive company messaging and communicating that you have a forward-thinking road map. For example, there’s a reason today’s investors value Tesla more than Ford. Even if you bleed cash, showing confidence in your product and communicating that you have a concrete, compelling plan for growth will increase the marketplace value of your business.
The basic lesson that founders can learn about asset valuation is that Accounting is past and Finance is future. The valuation of an asset or business is totally dependent on the expected cash flows that it will make in the future. Any actions you can take to increase real or perceived future cash flows can increase the value of your business.
2. The Power of Compounding
Compounding is the ability of an asset to generate earnings that are reinvested in order to generate exponential revenue growth. If, instead of paying dividends to shareholders, money reinvested in the right opportunities can reap enormous rewards down the line.
Let’s take a look at an example of how this plays out. Amazon’s current market cap is $990 billion. It has never paid out dividends, and clocks around $200 billion in revenue. On the other hand, Walmart’s current market cap is $327 billion, it pays a dividend yield of 1.85%, and makes approximately $500 billion in revenue. By reinvesting the cash Amazon has created a range of business ventures, services and products enabling the company to be richly valued at three times that of Walmart.
The take-away rule of thumb here is that as a startup, learn to invest early, then reinvest the profits when you find a good opportunity. To maximize the power of compounding, defer taxes as long as possible. The only time you should return money to stockholders is when you can’t find a good investment opportunity for the cash you have to spend.
When a company acquires another business, they often pay a lot more than the book value of the company. That’s because the parties that acquire companies look at more than cash value; they look at other less tangible characteristics that make a company worth money. This differential is often referred to as “Goodwill” and it is an idea plays out a lot in the software market.
In 2017, Atlassian paid $425 million to acquire Trello, even though Trello only made about $3.5 million in revenue at the time. The main value Atlassian saw in Trello was that they supported about 19 million free users. If you do the math, Atlassian paid about $20 for each free user they acquired. This is a classic example of Goodwill: Trello’s accounting statement doesn’t justify their $425 million acquisition, but its strong user community and reputation does.
From this, founders can learn that Goodwill impacts acquisition pricing in conjunction with current revenue rates and profits. Items like the size of your user community, network effects, brand name, strong team and so on can ultimately lead to better acquisition pricing.
4. Alpha generation
In finance, people use the term “generating Alpha” when they talk about creating value for their company that goes beyond market expectations. If an executive aims to only meet market expectations, they have not really generated Alpha. There is a best practice for companies that going for an IPO is to have the “first quarter in bag.” What it really means is that the executives need to meet or beat the first quarter market expectations.
The reason Salesforce market multiples are quite high compared to its competitors is because they have consistently exceeded the market expectations in the last 20 quarters. That is a big achievement. To some extent you can manage the revenue for a quarter or 2. But doing it consistently is simply impossible. For Salesforce, the edge comes from the network effect, brand name, plethora of integration and the name recognition.
To create Alpha, you need a market edge. This edge may come from deep knowledge of a vertical, discovering a loophole in the marketplace, or from possessing insights into the market that nobody else is privy to. The basic lesson here is that you need to ferociously safeguard your edge if you want to generate Alpha. If you want to maintain returns, protect that edge, refine it consistently, and hammer messaging into potential investor’s heads about your mission.
The basic lesson here is that you have to create and ferociously safeguard Edge if you want to generate Alpha.
5. Debt and leverage
Try to translate the concept of debt into a concept of acquiring leverage. Without leverage, innovative, high-risk projects will never come to fruition. If companies never took a risk with debt to create leverage, there would be no Tesla, Netflix, Uber or even Amazon.
Even the best of the growth plans will fail. But don’t obsess over the morality of debt or a sense of obligation to repay. If you are confident there is a chance to turn debt into market leverage, you should embrace it. And keep in mind that the market sometimes punishes companies that don’t have debt in their balance sheet since it implies that you’re not pursuing growth. When it comes to borrowing money, the basic lesson here is to not think of it as debt, think of it as leverage.
You have to play to win
Every business’s success comes and goes. But if you understand the financial concepts behind the underlying psychology of the investor market, you can position yourself to weather the ups and downs of the market and set your startup on a path for long-term growth.
By Venkat Ramasamy, COO, FileCloud
Venkat Ramasamy leads operations, business development, sales and marketing functions at CodeLathe. He has over 15 years of experience as a Product Development Manager at Schlumberger and as a Product Manager at Garmin.He holds an MBA from the University of Texas at Austin and a Master of Science degree in Information Systems from Texas Tech University.