The recent difficulties of growth players like Wework or Uber generated a lot of interrogations about startup strategy: should you target Growth or Margin?
In fact, Growth and Margin are 2 faces of the same coin.
And this coin is Value creation! This article will explain you why…
Historically, the first people concerned by this choice between growth and margin are stock investors.
Value investors, like Warren Buffet, were focused on stable and undervalued stocks. While growth investors looked at bets creating value through growth, as Amazon, Facebook or Google.
PART1: Growth vs Value investing, the birth of a dichotomy
The distinction between the two classes of investors is so strong that fund data providers, like Morningstar or MSCI, use this distinction between value & growth funds.
If you think that one investor category is better, please look at data (performances in USD according to MSCI):
The last 10 years, growth investors had an additional annual performance around 1,5%. Before value investors performed better than growth investors.
Both strategies created value: around 10% yearly.
The Gordon-Shapiro model (1956) is the first valuation model to reconcile both strategies in one formulation:
You can improve your valuation by increasing your Margin or your Growth.
The Gordon-Shapiro formula is a specific case where the growth is constant. If the growth is higher than the average return required by investors, you can use a decreasing growth framework like the H-model (Fuller and Hsia 1984):
Finally, if the long term growth (reached at the horizon H) is set around the GDP growth, value creation depends on increasing your initial Margin or your initial Growth.
PART2: Startup translation
How do you translate these valuation models in a startup world?
The specificities of startup valuation are:
- the necessity to fuel growth with “Customer Acquisition Costs” (CAC)
- a high uncertainty related to unit economics and traction
- the presence of initial development costs
In practice, venture capitalists will adjust the revenue multiple to your growth level:
The linear regression could be different depending on your vertical.
The hypothesis behind this valuation methodology is that the Value of the New Business (VNB) depends on the number of future customers you could acquire in the scenario s:
LTV is the LifeTime Value of future cash flow of a customer and CAC the Customer Acquisition Cost. Acq(t) is the number of customers acquired in t and WACC the Weighted Average Cost of Capital.
Forecasting N growth scenarios is a way of dealing with uncertainty. And initial development costs can easily be deducted from the Value of the New Business in the different scenarios:
You will notice that the VNB depends on your margin per customer and your growth:
– The discounted value of the future cash flow a customer will generate less the Customer Acquisition Cost (=LTV-CAC) represents the margin per customer.
– The discounted value of the future customer acquisitions represents your future growth.
A scenario without margin per customer (LTV=CAC) has no VNB. Also, a scenario without growth (the right part of the VNB equation) has no value also.
Thinking that you should choose between growth and margin is an illusion. They are both levers to value creation.
To go further, as Growth and Margin are negatively correlated, maximizing value creation means to understand the trade-off (you are implicitly doing one) between margin per customer and future growth.