It’s Worth What!? Pressure-testing Companies with Sky-high Valuations

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Are the sky-high valuations that have put companies like Uber and Airbnb constantly in the headlines proof of their staying power? Not necessarily, says Derek Lidow (Twitter: @DerekLidow), author of Startup Leadership: How Savvy Entrepreneurs Turn Their Ideas into Successful Enterprises, who teaches entrepreneurship, innovation and creativity at Princeton.

In this opinion piece, Lidow, who was the founder and former CEO of iSuppli Corporation, offers a four-part test for how companies can evolve from “top draft picks” to “wily veterans.”

Uber recently set a record when it was valued at $17 billion. The transportation start-up both disrupts and leverages the incumbent infrastructure of taxis and town cars. Airbnb, the home room rental start-up, was recently valued at $10 billion, giving it a greater worth than most of its larger traditional hotel rivals. Sky-high valuations have become commonplace. The question is: Are these companies really worth it?

Some start-ups hit upon the right idea at the right time — though almost all must iterate several times before they perfect their offering. Some get the imprimatur of a savvy investor with a strong track record. Others catch the fancy of the media. Each of these can boost a firm’s valuation; but none is a guarantor of ultimate long-term success.

The most critical factors to assess in a start-up and its long term potential for success are what stage it has reached on the journey, and whether its leaders are likely to navigate each of the remaining transitions successfully.

As an entrepreneur, investor, and professor of entrepreneurship, I have learned that every start-up must traverse four distinct stages as it matures. No stage can be skipped and each has its own leadership and strategy imperatives. The most critical factors to assess in a start-up and its long term potential for success are what stage it has reached on the journey, and whether its leaders are likely to navigate each of the remaining transitions successfully. Few entrepreneurs have the natural gifts to excel at all four stages; they can, however, learn how to master them either through personal development or by supplementing their skills through other members of their team.

These four stages must each be navigated in turn as a company evolves from what the founders think to what they know. Stage One is customer validation. The entire focus is to find a customer willing to try your minimum viable product or service. Stage Two is operational validation. In this stage, your strategy focuses on execution to satisfy that customer and find more people willing to try the product. You begin to understand who will buy your product, on what terms and what it will take to deliver it. Stage Three is financial validation, when you discover if your business can survive in the hurly-burly of a competitive market place. Your strategy focuses on scaling. Stage Four is self-sustainability. At this stage, the strategy focuses on innovation as you introduce new products to attract new customers. Your business demonstrates that it is viable beyond the original concept.

Companies rarely get large valuations at stages one or two — for good reason. PayPal is now a well-documented success story and a great example of what it can take to make it through these first two stages. PayPal is actually the third iteration of a business that would create financial returns for the combined talents of the founders. The first attempt offered encryption technology to enable ultra-secure programs for personal digital assistants (PDAs). No takers. Repeating stage one, the team behind PayPal then developed the technology to turn PDAs into digital wallets. Cool. They attracted $4.5 million in venture financing. Few customers, however, were interested, so stage two could not be completed. It was only by cycling again through stages one and two that they got it right — a technology to enable secure payments over the Internet.

A majority of these seemingly successful entrepreneurs did not go on to invest time and talent to understand how to continually reinvent their businesses….

Entrepreneurs and investors involved in stages one and two should be laser-focused on three questions:

  1. What can be offered to attract real customers?
  2. Are there enough customers? This requires evidence, not conjecture.
  3. Can the company reliably serve all these customers? Again, ground the answer in experience-based evidence.

Stage three is often where a company makes headlines for its product or service — and for its valuation. It gets large enough to attract attention and may be well on its way to an initial public offering. Just demonstrating explosive growth, however, is not enough. Look at the recent high-profile downfall of artisan cupcake company Crumbs. It went public in 2011 with a valuation of $66 million; three years later, the chain unceremoniously shuttered its stores and “investors took a bath” according to The New York Times.  The company has reportedly found an investor but it remains to be seen if it will be able to move into stage four.

In a recent study of businesses five years after they had appeared on the Inc. magazine list of the 5,000 fastest-growing companies, the Ewing Marion Kauffman Foundation found that more two-thirds shrank or were sold, disadvantageously. Virtually all of these firms were enormously successful in establishing and managing the stage-three processes and controls that allowed them to achieve scale — otherwise, they could not have grown so quickly. But a majority of these seemingly successful entrepreneurs did not go on to invest time and talent to understand how to continually reinvent their businesses before their initial customers drifted away. Financial success is just a prerequisite to having the resources and leadership bandwidth to be able to take the final step to complete stage four and become self-sustaining.

All markets change, at times abruptly, and most customers eventually depart. That is why every enterprise with staying power learns how to develop entirely new products for new customers. Companies like Uber and Airbnb have not yet demonstrated this ability — neither have Zynga or Groupon as of yet. For now, these firms are still completing stage three. Without processes in place to continuously reinvent itself, a company — even a hot start-up — is on a slow trajectory to irrelevance and failure. Only after completing the fourth stage of maturity is an enterprise truly self-sustaining.

A stage three company is a top draft pick, full of potential; a successful company at the end of stage four is a wily veteran.

Stage three is where most companies are sold and where many go public. At the end of stage four is where they show whether or not they fulfill their promise. A stage three company is a top draft pick, full of potential; a successful company at the end of stage four is a wily veteran.

Why do many entrepreneurs and their companies fail to make the transition? Some remain too dependent on the founder or founders, which increases risk and fragility. Others get complacent; they think that their current good fortune will last forever and see no need to invest the considerable time, money and effort needed to innovate beyond obvious incremental improvements. Others see too much risk in pivoting from ramping up the initial offering to, in parallel, developing or acquiring innovative products and customer relationships, exploring new business models and otherwise disrupting themselves. In short, fear and/or greed traps them in what they’ve created — they are limited by what exists.

Stage four is both frightening and perilous. You and your team have struggled hard to create something of significance. How do you reinvent yourself without putting all of that at risk? As a stage-four leader, you have to create a culture that equally and simultaneously values the competing ideals of innovation and efficiency. This tension can pull teams apart — and shatter financial value — as each activity requires a distinct mindset and skill-set. The leader must act as a bridge: championing projects that push hard against the company’s own incumbency, while supporting and rewarding the people and processes that keep the current customer base happy. They must think and act both radically and incrementally. Many founders and CEOs never even attempt stage four — it is simply that challenging.

Those that do attempt this delicate dance too often mistake the challenge as an organizational one. They set up an R&D group or acquire a hot start-up as a way to stimulate fresh thinking. However, organizations tend to temper new ideas and fresh acquisitions to fit either the demands of current customers or existing processes and systems. They seek lower risk and higher levels of certainty as they allocate personnel and capital. Redrawing the org chart rarely changes this.

The challenge is actually cultural. The company must make heroes both of those who conceive a fresh breakthrough, and those who diligently pursue efficiency and effectiveness. Cisco, in its early days, stayed fresh through acquisitions and became adept at integrating new companies without killing what made them attractive in the first place. Google has shown itself skillful at creating new products while simultaneously honing existing ones. In each of these cases, the company valued what would make it better.

The companies that deliver superior long-term value have leaders who are selfish enough to be selfless. That is, they will do whatever it takes for the business to succeed even if it means giving up being indispensable and their total control over products and culture. They will not be afraid of stage four. When examining Airbnb or any other sexy new venture, look for signs of selfish selflessness, a willingness by leadership to challenge themselves and adaptability with both new and current offerings. Those firms are the bets worth making.

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