How to Build a Valuable Company

A Valuable Company

If you’re starting a company, how do you go about building a valuable one? What makes a company valuable in the first place? In today’s blog post, we’ll explore why the measure of a great company is all about how much value it creates and what fraction of that value it captures, and why successful startups often start in small markets and expand.

Value Creation and Value Capture

To build a valuable company, creating value is not enough; you also need to capture some of the value you create. Peter Thiel has a very simple formula for this relationship: a company creates $X of value for the world, and it captures Y% of $X. $X and Y% are entirely independent variables that have nothing to do with each other, so $X can be an intermediate size, and if Y% is reasonably big, you can still have a very valuable company.

To illustrate, if you compare all the airline carriers in the airline industry with Google in the search engine industry, you could say that the former is more valuable than the latter because it creates hundreds of billions of dollars of revenue each year (see below). Measured by revenue, airline carriers had $195.6B in revenues, and Google had just $50.2B.

However, even though Google only created $50.2B in revenues, it captured 21% of those revenues as profits – nearly 100x the airline carriers’ profit margin of 0.2%. By these numbers, Google (a big piece of a small pie) is much more effective at capturing value than the airline carriers (a small piece of a big pie); so much more that the combined market capitalization of all the airline carriers is only a quarter of Google’s. Google creates less value but captures far more, and the ability to capture value is crucial to build a valuable company.

Start Small and Expand

So a counterintuitive idea when starting a company is to go after a small market on day one. This way, you can take over the entire market and then find ways to expand it over time. Google is valuable because it owns 90.8% of the search engine industry and has expanded to other products and services beyond that.

Almost all successful startups started in small markets and expanded. For example, Amazon started with just an online bookstore in 1994, then gradually expanded into all sorts of ecommerce. The Facebook version of this is that their initial market was around 20,000 students at Harvard, and then they expanded beyond college campuses.

In business schools, the way a startup gets analyzed is always if it’s in a small market, it can’t have any value. So the business school analysis of Amazon or Facebook early on would be that they have little to no value. This would have been true had their markets stayed small, but it turned out that Amazon and Facebook found ways to grow their markets concentrically, and that’s what made them so valuable.

A systemic mistake that many business school students and even investors make is that they’re obsessed with the market size today, but they don’t think about how the market will expand. Or they think about the growth rate of the startup, but they don’t think about the growth rate of the market. A good investor will always choose a startup that’s going after a small but rapidly growing market rather than a big but slow growing one.

You want to go after a market that’s going to be huge in ten years, and you need this sort of tailwind to make a startup successful. The exciting thing is that there are more of these tailwinds now than ever before. As Marc Andreessen said, “software is eating the world.” Software has incredible economies of scale, low marginal costs, and fast adoption rates which is critical for taking over markets. This is why software has been so valuable.

Start Big and Shrink

A common mistake when starting a company is to go after a big market on day one. This typically means there’ll be too much competition – so many that you don’t even know who all the competitors are.

Almost all the failed startups in the last decade started in a massive market. To illustrate, every cleantech company during the cleantech bubble touted how the energy market was measured in trillions of dollars. Or, if you measure the market size of the restaurant industry, it seems that restaurants are a fantastic business to go into because it’s also a trillion-dollar market. But large existing markets make it very hard to differentiate from your competitors.

You don’t want to be the tenth solar panel company or the hundredth restaurant. You want to be a one-of-a-kind company, the only player in a market so small that people won’t even think that it makes sense. That’s where you can get a foothold and scale into a valuable company, and why I think these small markets are very underrated.

Founders often think that their startup needs to sound really big at the beginning, but it doesn’t. When Facebook first started as a social network limited to students with no money, most people thought it was insignificant and that Myspace had won. Or when Airbnb first started as a way to stay on strangers’ couches, most people thought it was pointless all around. If these startups had sounded really big, too many people would be working on them.

The advantage of a small but rapidly growing market is that customers are usually pretty desperate for a solution and will put up with an imperfect but rapidly improving product. So it’s a great thing to work on something that not many other people are working on, and you should be happy because it means others won’t compete with you.

Avoid the Competition

I think there is a deep intellectual and psychological blind spot in human nature where we see competition as a form of validation. We all find it reassuring when others are doing the same things we are, and we often go for the things that others are going for. For some reason, we find ourselves very attracted to competition in one form or another. But there is always the question: does the intensity of the competition really make sense?

Sayre’s Law states that “in any dispute the intensity of feeling is inversely proportional to the value of the issues at stake.” When it’s really hard to differentiate yourself from others, and when the differences are really small, you have to compete very ferociously to stand out. This same logic can be applied to starting a company – does the competition really make sense in a crowded market where the stakes are so small?

Competition does make us better at whatever we’re competing at, but oftentimes so much of our identities get wrapped up in winning these competitions that we lose sight of what is truly valuable. It’s not that when lots of people are trying to do something, that’s proof of it being valuable. Instead, when lots of people are trying to do something, that’s often proof of insanity. So if you want to build a valuable company, don’t always go through the same door everyone’s rushing through; maybe open up a new door so unique that no one else can keep up.