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What's worth more in Startup Land? Popularity or cash?

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Open...and Shut Do new startups need to choose between making money or making friends? The obvious answer is that startups should focus on revenue, that they should be "hungry for profit", as Harvard Business School professor Clayton Christensen writes. That is, after all, what companies are valued on, right? Their ability to generate cash?

Maybe, maybe not.

I've argued that VMware, Google, Salesforce.com, and other technology giants are now paying top dollar for developers. And outside open source, many of the world's most valuable startups are valued more for their explosive user counts than for their impressive revenue numbers.

Consider why a big company acquires a smaller one. In some cases, they might be buying revenue, but it's hard to imagine many startups with revenue that would move the needle at Google, Salesforce, etc.

Instead, these big companies acquire smaller ones to add to their product lines or to build out their developer and user communities, for the most part. In the case of this second reason, the big companies assume they are better placed to monetize a startup's community than the startup is. They may be right.

Or wrong. Some are now speculating that digital music, for example, has failed, shrinking the overall music market by eight or nine percent. Some new technology or business models consume value but have yet to demonstrate a real propensity to give back.

Still, as Steve Blank notes: "A startup is an organization formed to search for a repeatable and scalable business model." The startup doesn't need to demonstrate it has arrived at its ultimate destination. It simply needs to show that it is well on the way, and aggregation of users or developers or momentum of revenue is a clear way to signal that you're onto something, whether you're JBoss or Twitter or Facebook.

One oft-overlooked point, however, is that a novel web business model may have the power to generate profit at anemic revenue levels, as venture capitalist Fred Wilson posits:

The web can create incredibly high operating margin businesses. Craigslist has an operating margin of 90%. Google's keyword business has an operating margin north of 60% (based on net revenues) and possibly higher. Could Facebook and Digg copy those models and create a lot of value on revenue numbers that many think are pitifully small? I think so.

…[T]heir business models will be built on operating margins that are very high and can create a lot of value without a lot of revenue.

I think that's an important part of the economics of the web that are left out of most discussions of Internet business models. Yes, we are turning analog dollars into digital pennies in many cases. But we are also doing the same thing on the cost side, maybe even more so. And I think that "operating leverage" is going to create a lot of value.

Which brings me back to my original question: should a new startup focus on making friends or making sales?

Both, of course, but if you have to choose, which should you focus on?

Users/developers, I'd argue, as they are the basis for revenue. It's hard to sell anything if no one cares about your product or knows that you exist. Still, at some point you must start to amplify your focus on revenue, or you end up as a never-ending popularity contest.

The trick, then, is to sell at the opportune moment, because the more money you make, the more your valuation shifts out of the la-la land of promising momentum or cool technology and into the hard metrics of earnings. Most startups won't want to wait until they're making gobs of money. And at the point they start to generate serious cash, they have no need to be bought by a larger company, anyway.

So when should you sell? VC Ben Horowitz offers some great advice for determining whether to go it alone or sell:

So, the judgment that you have to make is a) is this market really much bigger (more than an order of magnitude) than has been exploited to date? b) Are we going to be number 1? If the answer to either a) or b) is no, then you should consider selling. If the answers to both are yes, then selling would literally mean selling yourself and your employees short.

As Horowitz argues throughout the post, it can be difficult to apply such principles in practice, because of emotions and imperfect information, among other things. But one thing is clear: if you don't build a community worth buying, you won't have to worry about making the decision, anyway. So focus on building a great community of users and customers, first, and then the M&A opportunities should follow. ®

Matt Asay is senior vice president of business development at Strobe, a startup that offers an open source framework for building mobile apps. He was formerly chief operating officer of Ubuntu commercial operation Canonical. With more than a decade spent in open source, Asay served as Alfreso's general manager for the Americas and vice president of business development, and he helped put Novell on its open-source track. Asay is an emeritus board member of the Open Source Initiative (OSI). His column, Open...and Shut, appears twice a week on The Register.

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