(Ir)rational exuberance… MENA tech valuations

Round sizes and valuations in the MENA region and the wider emerging market ecosystem are soaring. A cursory glance at Wamda, Menabytes or Magnitt would clearly shows a massive increase in funding in the past 18 months. 

This is undoubtedly a net positive and massive boost for the MENA ecosystem, but as always, it’s worth pausing to consider how this growth is being channeled and if we can be judicious in our development. Particularly, it’s worth noting how these large rounds are coming together and what the underlying drivers are. Take the following hypothetical example:

Company X is looking to raise a seed round of $2M at a pre-money valuation of $10M giving the company a post-money valuation of $12M. Let’s assume this is a SaaS business with some early revenue with an ARR of $1M. Regional VC Y opts to lead the round investing $2M. The implied entry multiple of the company is 10x (10x ARR of $1m = $10m pre-money).

Fast forward six months, Company X has started leveraging capital from its earlier seed round and now has an ARR of $2M. The same VC firm, VC Y, steps in to lead a subsequent Series A round. The VC sets the valuation for the Series A round of $20M, at an $80M valuation, and commits $5M from its fund. VC Y rallies their LPs to commit a further $5M and raises another $10M from other VCs and investors. 

The price is set at a high watermark with 50% of the round committed and a prevailing sense of Fear Of Missing Out (FOMO) emerges helping to solidify the round. The founders are ecstatic, as they now get to raise $20M to supercharge their business with less dilution than originally anticipated.

Notice that the implied multiple for the Series A is now 40x (40x *$2M =$80M) whereas it was 10x in the previous round. This is a purely fictional example, and one where I am obviously embellishing the numbers for effect but directionally representative of many Series A and Series B rounds that are coming together in the region today.

The interesting thing here is that the entry multiple has increased fourfold from 10x to 40x. There are always good arguments for multiples to expand, such as the market valuation/comps changing, the company having been de-risked to some degree, further product development/product-market fit, growth in new geographies, a new team on board, and so on. However, I would argue that something else might be happening here under the hood that bears more examination.

In an environment with information asymmetry and limited competitive pressure compared to more developed markets like Silicon Valley, getting to the number 1 position in your respective industry/segment rather quickly increases the chance of a positive outcome in that portfolio company exponentially. 

VC firm Y has a vested interest in creating regional champions. It is also significantly marking up its original $2M valuation by 4x in less than six months. The VC can then show their limited partners a significant markup from their initial investment and can use that appreciation of value to justify further fundraising in subsequent funds.

There is some dubiousness as to the actual veracity of the valuation of a company set by the same VC across multiple rounds (even more so if it’s the same firm but across different funds where conflicts of interest are even more pronounced). The irony is that if challenged, the VC can always point to the fact that, of the $20M round they’ve only invested $5M with the rest of the $15M coming in from 3rd parties, thus providing a fig leaf validation on their valuation. On the other side, the other investors in the round cite the lead VC’s conviction in the valuation to justify joining the round at this size. This basically creates a perfect tautology. Add a good dose of urgency and FOMO and you build momentum for both the round and the company.

If I were to be uncharitable, the closest analogy in public markets is what the SEC would call a pump and dump scheme. I don’t, however, think that VCs here are being that nefarious or ill-intentioned. Instead, they are trying to build regional champions by driving the maximum amount of capital to their chosen portfolio with the added bonus of showing significant markups in holding valuations along the way.

Arguably, this can be a very successful approach, pioneered to much scrutiny and controversy by a select group of large scale global investors, especially pre-pandemic. Post covid, it seems like there has been some vindication of this strategy as some of the assets they’d invested in appear to have performed very well.

I can see how building this type of momentum behind the right founder and the right company can create regional champions that will dominate by sucking up all the oxygen in the room (and the capital for that company’s segment to the detriment of other competitors) and as mentioned earlier, create a highly defensible moat. I, however, worry about founders getting caught out on the wrong side of this equation where this funding strategy creates an artificially low margin of error.

As all founders will attest to, the journey to success is uneven, with many ups and downs along the way. Let’s say that 12 months after Series A, our Company X hits a small bump on the road.  Delayed rollout of a new product, internal staff issues, delayed geographic expansion, etc. All very typical issues that companies might face post series A. Instead of hitting a projected ARR number of $10M, our Company X doubles to $4M ARR, a highly respectable growth ratio but hardly one that validates a story built around exponential growth that was posited at Series A. 

Suppose the company is unable to show growth that is commensurate with its perceived momentum. Then the story around the valuation and the subsequent rounds begins to unravel at the same accelerated pace of the original sense of urgency and excitement. Furthermore, while a company may hit all its targets, valuations are not set in a vacuum. The abundance of capital may shift and so might market sentiment which might easily lead to valuation/multiple contraction especially at later funding stages.

Without exponential hyper-growth, investors in subsequent rounds become less willing to play that game of kicking the can down the road. Some might consider that there is always the possibility of a down-round to keep the company going. In reality, investors rarely ever want to go down that path and investors simply pass on the company altogether. Once momentum is gone, it’s very hard to bring that excitement back into the company’s funding dynamics. Easy come, easy go….

However, there are no investors regionally of size or scale capable of stepping in and single-handedly fund a reset or continue to drive subsequent rounds at higher and higher valuations north of Series B.  

Furthermore when investing in a company for the first time, VCs are looking at achieving a specific exit multiple on their invested capital. Let’s say for the sake of simplicity that the target multiple is 10x on capital invested. If the VC invests $1m then at exit they need to achieve $10M. 

At the earlier stages of investment, entry valuation is not as important. The difference here is the outcome is most likely binary: either the company succeeds or fails and whether you invested at a $15M or a $25M entry valuation isn’t going to move the needle significantly if we believe the exit value is c. $300M. However, at later stages, this becomes a real concern as VCs might simply pass on an investment if the entry valuation has been set too high from prior rounds and precludes them from attaining their required exit multiple. 

With a new abundance of risk capital permeating throughout our markets, many founders might be forgiven in thinking that raising the maximum amount of capital at the maximum valuation is the optimal outcome. What we are trying to demonstrate here is that in some scenarios there is some very real downside to pursuing that strategy and that founders should be mindful not just of the current round but what impact might be in future rounds of financing.

– Khaled Talhouni is managing partner at Nuwa Capital

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