The question of startup valuations has been making its way into everyone’s mind since the early start of the pandemic and its subsequent economic ramifications.
For the past three years, interest and investment in the venture capital asset class has grown significantly from a host of different parties ranging from family offices to Corporate VCs through to traditional VC funds, leading to a considerable expansion in the amount of capital available to be deployed. Many of these newly formed companies had little to limited experience in the asset class.
This newly available capital led to a decrease in the cost of capital for startups and therefore the velocity and number of funding rounds have both increased, leading in turn to a number of knock-on effects on the industry as a whole.
The first effect being that companies started having more than just the handful of investors to fundraise from which, as a result, pushed more founders to take the leap of faith into entrepreneurship.
The other, more problematic effect was that valuations started soaring beyond what they had been only a few years back, reflecting an increase in supply of capital relative to the availability of companies to receive it.
In private markets, the highest bidder usually sets the price, and that price has been sky high for some companies in the region as new sources capital rushed to deploy in the tech sector.
The New Normal
Suffice it to say, the days of the 20x revenue multiples are over. The pandemic hit both investors and founders in places where it hurt as sources of capital contract and the rate of deployment slows. The remaining active investors will now have even higher expectations on underlying performance of prospective investments.
Investors are shifting their focus away from cash-hungry or subsidy-driven businesses and to companies that are efficient, sustainable, and have clear paths to profitability and positive unit economics. Companies that used to be rewarded for high growth and high burn rates are in a very different situation now and are being compared to companies that are able to reach profitability fast. There is no question as to who will be able to secure venture financing.
Companies that are still set on high valuations are facing a harsh new reality. If they were struggling to raise capital in the past year and/or needed deep pockets to fund their business models, then unfortunately they will soon be out of business. Businesses have to focus on becoming more efficient and have more aggressive financial targets with tighter capital allocations.
It is too early to get conclusive or substantial data on the drop in valuations globally. However, from research by CB insights, early data suggests seed and early stage companies already show a drop in valuations of between 10-30% across North America, Asia, and Europe with MENA undoubtedly set to follow.
As investors perform their valuation exercises today, comp sets will show lower averages as per global public data, and this should in turn drop regional valuation multiples to similar levels.
There are different consequences to what has already started happening, or what can still happen, in the region.
There will be a shift in business models and mindsets showing something interesting is emerging amidst all the chaos. Even though there might be more caution and possibly less appetite to invest today, good companies will always attract capital.
Companies that are countercyclical with good unit economics will always stay of high interest to investors during any crisis. These companies will remain to be the outliers that will attract the desired capital at favorable valuations even as average valuations across sectors drop. Investors will have knee-jerk reactions to invest in businesses that are perceived to be in a good position to thrive in this environment and allocations will remain competitive whatever the circumstances.
For seed companies, it can go either way. Some investors can be more skeptical when it comes to seed as they are more risk-averse, not wanting to place early bets in new companies while uncertain of what the future holds. Alternatively, other investors might have more appetite to invest in seed companies which, by default, have lower valuations and smaller ticket sizes. Most importantly these investors would look to place early bets on emerging winners that are countercyclical at an early stage and take a bigger piece of the pie.
Growth companies raising Series A/B on the other hand, face different issues. As their required funding and valuations are larger, they face different types of risk. Investors will try to push their valuations lower or invest smaller tickets forcing them to re-consider their cost base and burn rates. On the flipside, they do benefit from being part of a portfolio with an existing investor base that want to see them survive and therefore existing investors will extend them a lifeline if they are running out of cash.
In both cases, mature founders who are quick to grasp the realities of crises can choose to take a hit now by potentially raising money at less than ideal valuations to be able to sustain their business. This will make it easier to fundraise, survive during this period, and come out at the other end alive.
Founders who stick to sky high valuations will inevitably have a flat or down round at the next financing round. Investors are looking for value during this period, and unjustifiably high valuations will be definite deal-breakers.
The end game
As the investment period gets more challenged, companies should consider how to reposition themselves to be more efficient and seize opportunities with less resources.
During the past three months, Deliveroo created essentials on-demand on their platform, Kitopi started selling essentials and groceries within 60 minutes through integrations with Instashop and Chatfood, Mumzworld began selling disinfectants, hygienics, etc., and Abwaab accelerated the launch of its online education videos and released their product within days. The list goes on and on.
Companies should look at this period as a time to pivot into new opportunities, rethink their fundraising plans and reconsider their valuations. The end game is not to have a high valuation, but it is to have a sustainable business that can survive during the worst of times.
Sarah Abu Risheh is Partner at Nuwa Capital.