Why Sky-High Valuations Can Make it Difficult to Actually Run a Business

WSJ carries the news that Twitter raises $100 million on a $1 billion valuation . We use Twitter at Zoho heavily, and we love connecting with users over Twitter; that does not give me any insight into whether the valuation is "justified" or not. But having watched silicon valley for several years, one thing I do know: high valuations make it very difficult to actually run a business. Here is a quote from Bill Gates (sorry, PDF!) in 1995 (emphasis mine):

One challenge Microsoft did face, and that Netscape now faces, is coping with a high market valuation. Netscape has little income, but investors have valued its stock at more than $2 billion. When a company's shares have a high value, expectations from investors, including employee-owners, are correspondingly high. Failure to meet those expectations can be damaging. If you're giving share options to employees so that they can participate financially in the expected success of a company, a high valuation hurts. If the market's already anticipated the great work those people are going to do, then their stock options won't appreciate much in value, if at all. This can make the options worthless. Many times in the past I have felt that Microsoft stock was higher in value than it should be. Subsequently I was proven, in a sense, to be wrong. Controlling expectations—whether about deliveries, product features or stock value—is often wise in a technology business. It's a lot better to under-promise and over-deliver.
In Microsoft's case at least, Bill Gates turned out to be absolutely right: Microsoft's valuation was too high in the late 90s - the stock is trading at about the same level it was in 1998.

While Bill Gates addresses the problem of high valuation for public companies, I believe a lot of his critique applies even to private companies. That may seem counter-intuitive at first: who doesn't want a very high valuation? The conventional theory on how a high valuation helps a firm is that it enables the firm to raise a lot of money, which, assuming it is invested wisely, generates a good return for the shareholders. The problem with that theory is that a) investing large amounts of money is a lot, lot harder than investing small amounts of money b) companies driven by software do not need large amounts of money to begin with, making (a) even more relevant. The upshot is that it is hard not to waste money as a software company when large amounts of it is suddenly handed to you.

The key problem is that a very high valuation is primarily useful if the world ended today, or to put it in a different way, the company gets acquired right now. In that case, the high valuation is still a problem, but thankfully, someone else's problem. But if we want to actually continue to run the business, high valuation isn't necessarily a blessing. It can seriously get in the way of doing productive work. A company can go from an engineering culture to a spreadsheet culture - obsessively modeling, forecasting, projecting growth, more growth and evermore growth. Back in the real world, growth isn't so easily projected or tracked and spreadsheet models almost never conform to reality. Admitting that is difficult for any company, all but impossible for a company that creates sky-high expectations driven by sky-high valuations. I respect what Twitter has done as a company, but I don't envy them in this context.


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