Thanks to those that read and played the startup
valuation game in one of my previous articles. If you have not yet
read the article, I encourage you to do so. The information below won’t
make much sense unless you do.
Also, I received some great responses, but wanted to
acknowledge two individuals that both emailed in the correct answer (and an
accompanying detailed analysis).
- Dean Fragnito
- Alex Hofsteede
There were several other people that had the answer right
(but left comments in other Internet forums where the article was discussed, so
I have no good way to acknowledge them). Congrats to you too!
Basically, the simple answer is that given that it is an
even distribution of valuations and the bottom end of the range is zero, Google
should offer nothing. It cannot win this game. Basically, what we
have here is an “adverse selection” problem. For any offer
higher than zero, Google’s issue is that the only companies that would
accept the offer are those that have a lower or equal valuation (and they know
it, Google doesn’t). What we have here is also a case of asymmetric
information. If Google makes an offer, on average, they lose money. The
best companies (with valuations higher than the offer), won’t take it. The
worst companies (with valuations lower than the offer), will take it. Overall,
Google loses if it plays this game.
What does this pathetically simple and contrived example have
to do with software entrepreneurship? I’m glad you asked. The
larger message here, for software entrepreneurs is this: You know more
about your company than other people do (asymmetric information). In many
cases, you may by the fact that others are facing the adverse selection issue.
Lets take a look at an example: Lets say you are
raising venture capital (or some other type of external capital). Your
job is to then provide credible signals to the investor that you are not one of those 9/10 companies that they
know is going to fail. Here are some tips and ideas that flow from this basic
concept:
- Do not send your 100 page
business plan to all the VCs you know. Reason: The VCs
think: “Only startups that don’t have any contacts in
the industry (and hence will have a hard time getting employees, partners
and customers) would do this. Well connected startups would know someone that knows us. This
is a losing deal”.
- Do not hire an “investment
broker” to help you raise money. Reason: Same as above –
if you need to hire a broker, there’s a problem. VCs
think: “The best
startups with really cool ideas wouldn’t need to hire a broker.”
- Find a great co-founder that
believes in the company: Reason: VCs think: “Here’s
someone that gave up their cushy job in a big company to join this startup
as co-founder. They know the business better than we do. They
wouldn’t take on this risk if the startup were really crappy. Maybe
this is a company worth investing in”.
The intent here is not to get into a detailed analysis of
how to get VCs to invest in you (I’m not a big believer in venture
capital for early-stage software startups anyways). The point here is a
little broader:
Moral Of The Story: There are many situations where
people you are dealing with are faced with the “adverse selection”
problem. Though you may think you have the coolest idea since sliced
bread, they don’t know
that. Further, their experience indicates that every startup thinks they have a cool idea – and their
experience also indicates that 90% of them will die. Your job is to
figure out a way around this problem. Somehow demonstrate that you are in that 10% of companies that
actually will succeed. This applies to investors, partners, employees and
customers.
In a future article, we’ll look at the issue of “The
Lake Wobegon Effect for Software Startups”. Why all startups think
that they are “above average” (which obviously, cannot be true).