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There is a scenario that plays out time and time again whenever there is a startup and a larger company across the table and they do see enough synergies with what they do to consider an acquisition or investment into the company. The indicator by when one has to launch the desperate salvage attempt is when the bigger company asks for details regarding how many people are employed, for how long and the salaries of each one of them.

As innocent as this question is, it usually means you are going to get an offer on the table which is not more than 10-30 percent more than what it took for you to build the entire team and product. It would be an understatement to say that the notion and mindset of buying a company at a premium is nascent, underdeveloped and, in some cases, seen as outright obnoxious. Is that a good thing? Why did Youtube get valued in the range above $4 billion? Why did Skype command such a valuation? Why did hotmail get the value that it did? It all did because there is a salient code in work in the Silicon Valley.

As a startup, you are always strapped for resources—cash, manpower, marketing muscle, the scarcity of focus to put into anything else. Yet you have set your eyes on industries that are well-established and with players 10 times your size eyeing to take them down.

Compete economics can work in the favor of both scenarios. Netflicks is a company based out of the U.S. which rents movies and provides a subscription service through which they provide on-demand video services—more like the Seventymm counterpart in the U.S. The asset that they are most known for is their recommendation algorithm. The user experience is so great that no Netflicks subscriber would ever dream of switching over to another service—definitely not for the advantage of paying a few bucks less. And that’s a rather lucrative stickiness factor when you are playing in a market where competitors are born every other day. How does Netflicks stay on top of this? They announce an annual challenge where they provide a subset of their user data-set to the public and put a prize tag of a million dollars for anyone who can make the algorithm better by a sizeable margin. The end result, they keep getting better at what they are better at, every year.

This is the reason why the Silicon Valley and matured markets pay high amounts of money for up and coming companies—way more than what it would cost for someone to put together a team and build it. You are not really buying a team; you are buying a winning team. And that’s a huge difference. In the landscape of compete economics, when a need arises there are many entrepreneurs who build solutions to it, but only one stands the test of time and of proving itself, and as such it is not worth just for the value of what it takes to build it, but the value of the entire space where the breakthrough happened—that’s why companies command such high prices, deservingly so.

SMEs should keep this in mind when negotiating valuations—if you are a pioneer in your space and have survived— you are worth more than the cost of building the product. If you are a young startup, learn from the practice of Netflicks—leverage researchers, students and a smarter audience outside of your small organization to give you the breakthrough—at a fixed cost—and in a manner where you are handed a thousand different solutions to tackle the problem but you only have to pay the winner.

VIJAY ANAND is the Founder of Proto.in and Vice President (Incubation) at IITM’s RTBI.

©Entrepreneur July 2010

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IITM, Proto.in, RTBI, Vijay Anand