Building To Sell vs. Building It Well

By Dharmesh Shah, OnStartups.com

Guess I”m a poet and didn”t even know it”

There are many people that believe that you should not try and create a company simply with the mindset of selling it someday. I happen to be in this pool of people. However, entrepreneurs often make the mistake of confusing “I”m not building this company to sell it” with “I don”t care about the exit value of the company”. I have found that the overlap between the decisions you would make when “building it to sell” and decisions you would make to “building it well” is generally pretty high.

Lets look at some of the common dangers of “building it to sell”. For the purposes of this example, lets day you are planning on selling the company sometime within the next 18 months.

You decide you”re not going to make an investment in that QA person. Your reason is simple. Hiring this person decreases your earnings (and hence the valuation of your company) and you”ll never really see any “credit” for this investment, because by the time the positive impacts show up, the company has already been sold (or the valuation has already been locked in).

You decide to stop what little investment you were making in marketing (stop going to trade shows, stop writing blogs, etc.). This creates an “uptick” in your bottom-line (every dollar you save has a multiplicative effect on valuation), and the negative impacts (if there were any) won”t show up in time to hurt valuation anyway.

Most of the mistakes entrepreneurs make when making these kinds of decisions is failing to invest in long-term things (with the notion that it won”t really matter, because the company will be sold in the short-term). Definitions for what is considered long term and what is short term vary, but are not particularly important to understand the concept. The danger lies in the fact that you can”t really control your exit. You can influence it. You can make the price attractive. You can talk to tens of potential acquirers. You can do many, many things to help the deal along. But in most cases, you can”t make someone buy your company. In fact, even when you have a potential acquirer, you can”t control when they will actually get the deal done. The net impact is that the decisions you were making based on your “sell it soon” model will start to create a negative impact on valuation. This is a negative feedback loop (your company is now even less likely to sell than it was before). Eventually, all of your short-term decisions start manifesting themselves in terms of angry customers, reduced sales, low employee morale, etc. (based on who you short-changed at the time you made the decision).

On the other hand, there is absolutely nothing wrong with making decisions that just happen to also increase the value of your company should you decide to sell it some day. In fact, the decisions you make that would increase your value for an acquirer are mostly aligned with the decisions you”d make to build a great company. This is what I call “Building It Well”. Simplistically, you can think of the value an acquirer places on your company as an equation that looks a little like this:

AV = TV + GS ” BS

Where:

AV = Acquisition Value (what an acquirer will pay)

TV = True Value: a complicated concept, but for now, lets assume this is based on sound financials. This is the value that any acquirer would get by buying you (think discounted cash flows or a multiple of earnings)

GS = value of “Good Stuff” that this acquirer gets as a result of buying you (I”d use the word synergies here, if I didn”t hate it so much). Examples are a list of raving fan customers that they want to reach, but haven”t been able to before. Or a reputation for building great products (the idea is that some of this reputation rubs off on the acquirer ” in some circumstances).

BS = value of “Bad Stuff” that reduces the goodness that the acquirer is getting. Examples include constants (like transaction costs). Or, that your entire code base is written in Ruby On Rails and the acquirer is a die-hard ASP.NET shop. They”d have to figure out how to extract value from your “stuff” (regardless of how good it is). Interestingly, it doesn”t really matter that your platform is better than their platform (I”m not making any judgments on either platform, the example is for illustrative purposes).

In a future article, we”ll look more deeply at how you can increase the GS and decrease the BS (without compromising your morals, and falling into the “Building It To Sell” trap).

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Dharmesh Shah is a serial software entrepreneur. He”s currently working on his third Micro ISV, hubspot.com which is building a hosted software platform for VSBs (very small businesses). When Dharmesh is not writing code or running software companies, he”s a graduate student at MIT in Cambridge, MA.

Comments

  1. This series looks promising although I hope that it increases in sophistication.

    I think that your arguments against investing in a QA person or in marketing are straw man arguments: your readers aren’t that dumb, even if they believe in “build to sell”. They’re going to make more realistic (insidious) trade-offs. I encourage you to find deeper insights into things that look smart on the surface but turn out badly. You can assume that readers have some amount of business sense and understand basic business principles and basic business reality.

  2. Always good to hear fair, objective critiques.

    Will agree that the article could be a little deeper with respect to more insightful examples where the tradeoffs are more subtle and the decisions more nuanced.

    Will try harder next time.

    Though I could try and respond more fully, I’d risk sounding defensive, so its better to leave it as is and address deeper issues in a future article.