Valuations and the Future of Startup Investing

There are many business models that an entrepreneur may choose to adopt when running a business of any kind. For most businesses, the end goal is profitability. While profitability typically indicates the ability of a business to bring in revenue, it is not always the case that a business that is deemed profitable is actually revenue-making in the near term. This was (and is) the case for many tech startups which were deemed profitable but were not revenue-making.

Earlier this week, WeWork, a provider of eco-friendly co-working spaces announced that it had filed for Chapter 11 bankruptcy, indicating that the company could no longer sufficiently meet its debts and obligations. This announcement adds to the recent wave of tech startups going bust due to bankruptcy, fraud, or a myriad of other issues. Given that tech was touted as the new oil and the frenzied VC investing we have witnessed over the past couple of years, announcement after announcement coming out of the tech ecosystem across various countries seems to indicate a shift in the tide. In today's newsletter, we shall be talking about the sustainability of startup valuation models and the future of investing.

Valuations are an important metric in measuring the value of a business. Valuations are also a critical step in raising capital for a business. A company’s valuation tends to determine how much external funding/capital the business can access. Businesses with a higher value attract more investment and can raise more capital. A high valuation indicates optimism about a company’s worth and its potential for success. Valuation is the process of assessing the economic value of a business. This process involves evaluating all aspects of a business from its earnings to assets, to determine the value of the business. There are many reasons why valuations are carried out: it could be for tax purposes, to raise additional capital, or to determine the company's sale value in the process of an acquisition. For startups, valuations help to provide critical information about the company to investors. Every investor investing capital does so because of an expected return, thus investors need to obtain the information that is typically uncovered during a valuation to make an informed decision. Valuation helps to determine the potential return on investment and is a useful standard for determining the viability and profitability of a business.

Valuing a business is not an easy task; there are different approaches to valuing a business. For companies that have been in existence for a period of time, valuation is often carried out by making reference to certain multiples such as the Enterprise Value or Earnings Before Interest, Tax, Amortization and Depreciation (EBITDA). Valuation can be done using the company’s book value, i.e., simply subtracting the company's liabilities from its assets to determine the owner's equity. Another approach to valuation is using the discounted cash flow method. This is done by calculating the present value of the company's expected future cash flows using a discount rate. Valuation may also be done using the enterprise value which determines value by subtracting the cash not used to fund the business from the company's debt and equity. The comparables method is also useful in carrying out valuation. This method examines companies similar in size and within the same industry to come up with a fair value for the company being valued.

One key thing that runs across a lot of these valuation approaches is the presence of earnings or cash flows of the company. However, these are elements that are often not present in early-stage businesses. For a lot of tech-based startups, the early stages of the business are very centered around research and development, and fine-tuning the product before launch. Tech startups are notorious for burning through money at very alarming rates as they innovate and attempt to scale into profitable businesses, and this typically means little to no revenue and negative EBITDA. As with any idea that is innovation-based, a lot of these startups sell a futuristic idea of what their products/services have to offer, thus, making it even more difficult to value the worth of the business with any degree of accuracy.  

Valuations can be tricky, more so for startups that have little to no revenue or profit. A lot of startups are heavily dependent on external sources to raise the capital needed to scale the business. This funding is usually in exchange for an equity stake in the business, thus making it necessary for the potential investors to know or at least establish a metric for determining the company's value before investing. For many startups, the goal is to scale, achieve expansion, and possibly launch a successful IPO (Initial Public Offer), thus valuation is a crucial step and is used by investors as a starting point during negotiations.

As earlier mentioned, startups tend to have very little historical financial information. Unlike established businesses which have revenue levels, EBITDA, cashflows, and other historical data that can be used to make projections, most startups are in the early stage of the business life cycle and so do not have a lot of historical information. They also tend to propose groundbreaking and innovative ideas which make it difficult to use comparables from other businesses to determine value. Another problem is the uncertainty of the future performance of startups. Although the Google and Facebooks of the world collectively blew everyone away, it is safe to say that many startups will never attain that level of success. Thus, there was a need to come up with alternative methods for determining the value of a startup.

One such method is the Scorecard Valuation Method (also known as the Bill Payne Method). This method is named after Bill Payne, a popular angel investor. It is used for pre-revenue startups and involves comparing the company receiving funding to other comparable companies that have received funding. Another method used in startup valuations is the Berkus Method. This method approaches valuations from a risk-based perspective. Using this method takes into consideration the quality of the company's management team, viability and attractiveness of the startup idea, potential customers in the pipeline, and whether the company is generating revenue already.

Perhaps the most common approach used in valuing an early-stage startup is the Venture Capital Method. The VC Method approaches valuation by focusing on the expected return on investment at the projected time of the investor's exit from the company. This method also focuses heavily on the post-money valuation of the company. The peculiarities of the tech industry meant that analysts and investors often applied the post-money valuation in determining the business value. A post-money valuation is done after an external funding round. Essentially, it combines the intrinsic value of the business with the value gotten from investments by VC investors and Angel investors. The VC Method is somewhat similar to the discounted cash flows method in that they both make use of a discount rate to determine the present value. The startup's expected revenue is estimated and the future earnings (accounting for money to be raised by the startup in a funding round) are multiplied by the price-to-earnings ratio of comparable companies in order to set a terminal value (proposed end value) of the company. A discount rate is then calculated taking into account the risks associated with the business. This discount rate is then used to discount the terminal value to a present value.

It must be mentioned that the reliance on the post-money valuation led to the overvaluation of many startups. Post-pandemic, there was a significant boom in the tech industry. The market was awash with VC funds and it seemed a tech product was born every minute. Several factors contributed to this boom: from the rise in the use of technology products due to the restrictions on movements imposed by governments across the world in response to the pandemic to the transitions to work-from-home structures by many companies. The post-pandemic era witnessed a sharp rise in the volume of VC investments with VC Investment nearly doubling in 2021 from 2020's figures. A lot of startups are valued post-funding rounds and this means these companies would become more valuable (at least on paper) after each funding round. Without a doubt, an overreliance on a valuation model that takes into account these VC funds cannot accurately depict value The post-money valuation model simply approximates value but does not take into account the strength of the company's product/services and revenue. While capital is important, it is revenue that keeps a business alive.

Many persons pointed out that these valuations did not seem realistic, and hindsight being 20-20, they were not wrong. A lot of the value ascribed to tech-based startups seemed far-fetched and very futuristic, particularly for businesses that had no significant cashflows or revenue.

As the world started to move away from pandemic restrictions, the cracks started to show. Q4 2022 witnessed a decline in the market value of many tech startups with market values declining by as much as 85% for some startups. For example, in March 2021, Stripe was valued at $95 billion post-funding, the company’s value has however declined by about 73% from this initial figure as of July 2023. The startup space has also become inundated with market saturation. Take Nigeria, for example, it would seem that every minute, a new product or platform is birthed, promising a more seamless payment system. There is a new tech startup every day and it is becoming increasingly harder for these companies to stand out and secure a competitive advantage. Investors are starting to realize that a lot of these companies will not be the next Facebook or Apple, and expectations are starting to get a lot more realistic.

Beyond this, rising inflation rates across various economies in the world have had a significant effect on startup investing. For a lot of investors, investing in startups seemed a very profitable venture. It presented an opportunity to invest in a young business and potentially own equity in a multi-million dollar enterprise. The key word here is “potential”; a lot of these predictions were based on future projections and also came with attendant risks (after all, about 7.5 out of 10 VC-backed startups fail). As governments try to combat inflation, interest rates have steadily been on the rise. Governments often increase interest rates as an anti-inflationary measure, which in turn increases the cost of borrowing and reduces spending. This often translates to an increase in the yield on debt instruments (such as treasury bills and government bonds). These instruments are considered risk-free and in the worst case, pose less risk than investing in a startup which may or may not succeed. As VC funding starts to dry up, a lot of startups have had to carry out massive layoffs and come up with new funding plans to conserve cash and stay afloat.

For a lot of African-based startups, the story is not any different. In Q3 2023, investors invested $300 million in African startups, compared to about $600 million invested in Q4 2022 and Q1 2023, marking a steady decline in funding and the ability to raise capital for African startups. This year alone, in Nigeria, there have been multiple scandals involving one tech founder or the other outrightly embezzling funds, less than desirable corporate governance practices, or asking investors to accept nontradeable or convertible tokens in exchange for their investment. This combined with the global downtrend has significantly slowed down growth, slashed valuations, and culminated in massive layoffs and liquidations of many startups.

What is clear from all of the above is that pumping money into new-age fancy ideas with no clear path to profitability was never a good idea. As with every new idea or new wave, there is a lot of optimism that it will be the next big thing, the thing to disrupt the world order. The attendant woes, fraud, failed IPOs, and struggle to meet investor expectations have soured optimism. The economic uncertainties and failure of high-profile IPOs have also considerably slowed down investor appetite. In Q3 2023, EY reported that fund formation in the United States experienced a continuing decline, with Q3 23 ranked as the lowest quarter for fund formation since Q3 2017. Interestingly, they also reported an increase in performance for generative AI and energy sectors in terms of VC funding. Thus, we can expect a diversification in the type of companies that receive VC funding. It can also be expected that a lot of investors will shift from investing simply to make returns to becoming more hands-on with managing their portfolios and possibly investing more in later-stage startups with a proven track record of success. Another interesting trend is the rise of investment groups raising funds to acquire/buy-out majority and ownership stakes in previously overvalued startups at a discount in order to turn the business around.

So what lies ahead? I do not believe that investors will completely stop investing in startups. However, it is clear that there is a need to adopt a more realistic valuation approach, particularly for tech-based startups. One thing is clear though, the era of unlimited VC funds is on its last legs. The decline in stock value of many tech startups and even well-established tech companies are all pointers to the end of an era of massive valuation figures built on lofty ideas of future expectations of profitability. Unlike in the early days when investors were willing to place a higher priority on growth over profitability, investors are starting to prioritize profitability. With rising interest rates and economic uncertainties, startups have to start offering alternative ideas, away from traditional tech, in order to attract funds. In addition to these, for African-based startups that already operate in an environment that is viewed as a risky investment destination, it is crucial to adopt more stringent corporate governance practices to boost investor confidence. Lastly, it is important to take a more realistic approach to valuing startups, particularly when they are non-revenue making, and come up with clear paths to profitability and revenue making.