A couple days after Christmas in 2016 I stepped into the Elk Run Lodge atop Vail Mountain and answered one of the most important calls of my life. Over the last 6 months I had talked to a dozen people interested in buying my business. Finally we had a deal on the table that I liked. 80% cash and no golden handcuffs. In other words I could sell, transfer the assets and management procedures and move on. After talking about the transition process for about 30 minutes we reached a verbal agreement. Three weeks later, while waiting in line for coffee at a cafe near my office, I checked my bank account and saw more money than I’d ever seen in my life. The deal went through and I was free to enter a new phase of my life.
From the first moment that someone at Dealflow, a business brokerage service, approached me and asked if I was interested in selling my business I dismissed it as unlikely. Simpledata, my business, was only a year old at the time and while it turned a good profit every month I never thought it was possible to sell such a simple business. I had grown revenue from $0 to $30,000 per month within the first 6 months, but it always felt like a house of cards ready to fall. In my mind I thought of Hollywood style M&A with billion dollar companies acquiring companies with hundreds of employees. I thought it was more New York black suit and tie than Colorado grey t-shirt and jeans. But I failed to consider a simple fact of business: all earnings have value.
Unlike many of my peers in the technology industry, I focused on building a profitable company from day one. Within the first couple months it generated a couple thousand dollars in profit. In the sixth month it generated $17,000 in net profit.
It was at that point, in December 2015, that a business broker approached me and asked if I was interested in selling my business. He told me that it could sell for 1x earnings. In other words, I could cash out 12 monthly paychecks right then and there. I told him I wasn’t ready to sell, but 6 months later I talked to another broker who valued the company at 2x earnings. I told him I was interested and we began the process of talking to potential acquirers and investors.
Over the next 6 months I’d get an email from my broker every few weeks saying he had found an interested party. We’d get on a call and I would answer the same questions: how’d you start the business? Why are you selling? What are the biggest growth opportunities? After talking to about 10 potential buyers we found an investor willing to pay 2x earnings in an 80% cash deal.
In the months that followed I reflected on my experience building SimpleData. During this period I thought a lot about the mistakes I made that prevented me from selling for a higher multiple. Below I’ve tried to outline the biggest mistakes I made, what I learned, and how you can avoid these mistakes.
How does a company get valued?
Valuations have always been a mystery to me. I never went to business school or worked for a big consulting firm. Everything I’ve learned about business, I’ve learned from building them myself, reading books, and seeking advice from mentors.
I knew that technology companies often get valued based on odd things like how many software engineers they have or which VCs are in a deal. I also knew that public companies get valued based on multiples of their earnings—for example, as of writing, the average price for an S&P 500 company is about 20x earnings. I had heard about terms in real estate like a “Price-to-rent ratio.” It wasn’t until I sold my business that I learned about the simple equation all investors use to value an asset.
Investors value everything from stocks, real estate, and private companies based on their expectations of future earnings. If an investor thinks that Google is going to continue to grow its profit—for example, by expanding to new markets, launching new products, or reducing its costs—they will buy its stock for a high price. If they don’t expect growth in earnings they will want to pay less.
Therefore Price (P) = Earnings (E) x Multiple (M)
The Multiple represents the value of a company beyond its earnings, which begs the question: what makes a company valuable?
Think about the Multiple of a company like a scorecard that shows how well its performing on a series of important metrics or key performance indicators (KPIs). For example, investors like to see growth so a company’s month over month or year over year growth rate is important. They also want to see high retention of customers so the retention rate or churn rate is also important.
So that M in the value equation above can be broken down further:
M = growth rate + % of revenue that is recurring + factor 3, factor 4, etc.
Of course, each factor has a different weight associated with it. How much weight, or if a factor is even considered depends on the investor. As my Dad likes to say, at the end of the day the price of anything is based on what someone is willing to pay for it. This equation simply helps you figure out what the average investor—call it “the market”—is willing to pay for an asset.
Every asset and industry has a different formula. But for technology companies here are some factors investors consider:
Revenue growth rate
Gross margin growth rate
Lifetime value of a customer (LTV)
Customer acquisition cost (CAC)
LTV to CAC ratio
% of revenue that is recurring
% of cash collected upfront
Website traffic and growth rate
Email subscribers and engagement rate
Website conversion rate
Social followings by channel
Brand (difficult to measure)
My mistakes and the lessons they taught me
Had I understood these simple concepts I believe I would have made very different decisions in building my business. I would have likely focused less time on maximizing profit (E) and more time investing in future earnings and value (M). The mistakes I made are not uncommon in business. In fact, I made many of them because of the same biases that prevent people from saving for the future or losing weight.
Below I’ve tried to share some examples of mistakes I made that hurt the business’ valuation when I sold it.
Example 1: Content and SEO
I’ve been a strong believer in content marketing for my entire career. In my first job at Highfive we saw success building a a blog audience of hundreds of thousands of readers, many of whom signed up for a free trial of our product and later purchased it. I’ve witnessed companies like Groove, Buffer, and other bootstrapped companies generate millions of dollars in revenue through content marketing alone. So when I started SimpleData I told myself I wanted to invest heavily in content.
Once I was generating consistent profits each month I started looking for an SEO and Content Marketing agency and after a few Google searches found one that seemed good enough. I interviewed the team and committed to spending $2,000 per month. But after the first month I got cold feet and pulled out. Once again, the allure of short term profits prevented me from investing in future growth and value.
At the time I recall rationalizing my decision by telling myself that many agencies over charge their customers and don’t produce results. That logic would be fine if what followed was a backup plan to still achieve the goal. I could have interviewed 5 contractors or asked friends for recommendations on trustworthy agencies. Instead I think that my lower brain felt fear (What if it doesn’t work) and then my upper brain rationalized a bad decision. (More on the lower and upper brain below).
Example 2: Pricing
Another obvious mistake was my failure to sign customers into contracts and generate recurring revenue.
When I started SimpleData I knew that month-to-month pricing was the fastest way to acquire new customers. I heeded the advice of VC Tom Tunguz, who says that startups should start with month-to-month contracts in order to learn. He argues that churn isn’t a bad thing early on because it is the best feedback a company can receive on whether or not it has product-market fit. I failed to listen to the second part of that advice, however.
He said that as a company grows it should transition to longer term contracts and eventually begin collecting money upfront. It can start as small as 3 month contracts, then go to 6 month, then annual contracts. Collecting money upfront can progress incrementally too. You can start small with 25% upfront, then 50%, and then ideally collect 100% of an annual contract upfront.
But no one likes contracts and I don’t like conflict, so I didn’t ever transition to long term contracts. Again my lower brain (fear and the desire to be liked) took control and I decided to stick with month-to-month contracts. Then my upper brain came up with convincing arguments and justified this decision by saying I had created a “customer-friendly” pricing model.
If I had the courage to change our pricing model I would have either increased the percentage of recurring revenue or I would have been forced to re-examine our product offering and seek customer feedback.
My lizard brain
These mistakes are easy to see in hindsight. However, as I’ve learned in building Campfire Labs, even knowing how to create value and invest in growth doesn’t change the fact that it’s difficult and requires discipline.
Often times creating value is in direct conflict with maximizing short term profit. Most savvy business people know that investments (i.e. forgoing short term profits) generally leads to more profit and value later. Yet, so many leaders don’t make the logical decision to invest in the future. Reading books on psychology over the last few years has helped me understand why.
In these books I learned that there are essentially two parts of the brain: the lower brain and upper brain, also referred to as System 1 and System 2. In our evolution as humans the lower brain developed first. It’s what helped us determine what threatened our lives and so it’s where “fight or flight” decisions happen. It’s also where most of our emotions, like fear and love get processed. The upper brain developed later in our evolution. This is the area of the brain where logic and reason take place. (For a proper explanation of all this, I recommend reading Jonathan Haidt’s books and research, or Thinking Fast and Thinking Slow).
While we tend to think that most of our decisions are made with reason and logic, the truth is we often don’t. Instead, as Jonathan Haidt has argues in his research, the lower brain– what he refers to as the “elephant”— often makes decisions, and then our upper brain—“the rider” in his analogy—comes up with good reasons for that decision. In other words the elephant goes one direction and then the rider seeks to justify its actions.
Being aware of these biases and limitations of the mind are the first step in solving the problems they create. In the field of debiasing this is referred to as “Changing the person.” But even awareness has its limitations. You can be aware that your lower brain is overriding your upper brain whilst eating an entire carton of Ben and Jerry’s ice cream and still do it. That’s why it’s important to also use a second tactic in debiasing and “Change the environment.”
One of the best examples of changing the environment I’ve come across is “Pre-commitment.” As the authors of a Wharton paper called A User’s Guide to Debiasing write, “A classic example of pre-commitment comes from the story of Odysseus who tied himself to the mast of his ship (thus relinquishing control of his vessel) before encountering the enchanting music of the Sirens – sea nymphs famous for luring sailors towards deadly rocks.”
A more practical example of pre-commitment is separating money into different spending pots. For example, I could have told myself that I would take home 50% of the profits each month and invest 50% into growth. Then the process of deciding if I should invest would have been separate from how I should invest, and I could have avoided lower brain rationalizations like “All agencies are a rip-off” and instead sought the most efficient channel to invest in given a fixed amount of money. This same principle has proven to help countless individuals save for retirement in their personal lives.
To conclude this story I want to provide 3 suggestions on how you can avoid making the same mistakes that I did:
Find a broker who will value your business
I encourage entrepreneurs to spend time learning how businesses are valued. The easiest way to do that is to actually value your business. Business brokerage services like Dealflow, FE International, and Empire Flippers offer free valuations. Having someone valuing your business is a great way to show its weaknesses and areas that you can improve.
Plan your exit strategy
Even if you plan to run your business until the day you die, I think planning an exit strategy is one of the smartest things you can do as an entrepreneur. That’s because the process of creating an attractive business for someone else to buy naturally makes it a better business to own. It will force you to consider things like how to improve retention, increase margins, and grow faster. All of that will mean more profit for you while you own the business.
One simple way to create an exit strategy is to do the same exercise I wrote about in the last story in this series: Imagine it’s 1-2 years from now and make a presentation explaining why your business just sold for $10 million. Doing this will force you to consider how someone would value your business and give you ideas for how to improve its efficiency.
Learn about bias
As I’ve shown above, one of your biggest challenges in creating value will be overcoming biases that prevent investment in the future. I’ve hardly scratched the surface of these biases and how to overcome them in this article. I encourage entrepreneurs to educate themselves on this concept and find effective ways of making better decisions. If you’re looking for a good place to start, read Ray Dalio’s Principles.
About the author
Hi! I’m Michael Thomas. After selling SimpleData I wrote stories for magazines like The Atlantic, FastCompany and Quartz and helped start a code school for refugees. Now I’m on a mission to fund ambitious social impact projects and help companies tell stories that inspire with new company, Campfire Labs.