Cross-posted and adapted from the original version published on Techies.pk on June 19, 2013.
If you ask prospective local investors for a $200,000 investment for a company at $800,000 pre-money valuation, you’re likely to see some jaws drop. Most investors will question whether you and ‘that thing’ on your laptop is actually worth that much money. But it’s a legitimate objection by anyone not used to valuing tech ventures, especially seed stage ventures that are still pre-revenue that may show some seemingly high projections based on some ‘creative’ or previously unseen sources of revenue in the future.
Part of this reluctance is often due to the inexperience of the founders pitching an idea to investors who are just not able to effectively sell the value proposition of the company. Usually they focus too much on costs and very little on the value being provided. Thankfully, many founders have new opportunities to polish their pitching skills at several new pitch competitions, launch pads, incubators and entrepreneurship courses through local universities or programs across emerging markets.
But an equal, if not bigger, part of the issue is the lack of expertise and adequate data to value local technology ventures. The usual approaches of using discounted cashflows or asset-based valuations don’t provide much confidence to investors. Here’s why:
- The cashflow projections of a currently pre-revenue company requires a big leap of faith on the part of investors in the absence of comparable success stories and trusted tech-savvy advisers who understand the business model.
- The bulk of the asset-based valuation of a tech startup would be based on the goodwill of the founders and the intellectual property of the company which again requires seasoned technology advisers to evaluate, and not the accountants who usually aid investors.
- Some of the revenue models proposed by startups are not yet fully proven in mature markets, let alone in emerging markets.
- Intellectual property is perceived to be less protected by law in developing countries and hence of lower value.
- Sometimes investors try to value tech companies based on comparable deal value, which can also be hard to pin down in local markets.
Another model, based on the strategic value of an acquisition post-merger, which is solely buyer driven, can sometimes result in insane pricing like that of Instagram, but which may be justified in the eyes of the sole acquirer, like Facebook in that case.
In mature VC markets, the law of supply and demand sometimes takes over deal pricing where the price of a deal might go up beyond a reasonable valuation solely driven by the demand for that deal and totally devoid of any quantifiable reasons. But emerging markets are still working on kicking off a VC ecosystem, and hence don’t support this model either.
In the absence of these valuation methods, the only choice typically left for valuating tech ventures is a ‘cost to build’ model where an investor might conduct due diligence to figure out what it would take to build the same product or service from scratch. This certainly doesn’t benefit the founders and hinders any prospects of raising significant venture capital unless the company is centered on a key piece of intellectual property that took years of R&D to develop, something that more often evolves out of a startup bootstrapped in a university.
So how do we avoid stalemate scenarios and invigorate the startup ecosystem with some capital injection? Here's what it may take for more investors to come to the table, (most are easier said than done):
- Proven revenue models that work within the constraints of the local environment and play to the strengths of local markets.
- Supplementing the accountants who advise them for the deals with experienced tech savvy advisers.
- Examples of successful exits in local markets.
- Testing the waters with more mature, growth stage ventures where the risk is slightly lower at the expense of a more expensive deal.
- Collaborate with other local investors to pool in money and form a broader focus fund that makes seed stage, early stage and growth stage investments.
- Collaboration with international VC funds or angel investors to provide their investments international exposure which a local founder might be hard pressed to achieve by him or herself.
Founders on the other hand could make a deal sweeter by making some tweaks as well:
- Refine pitching skills through practice to focus more heavily on the startup’s value proposition for investors as well as customers and partners.
- Rely on proven and classic business models like charging for a product or service instead of experimenting with newer revenue models still being proven in more mature markets.
- Recruit experienced advisers to help with the strategic direction and credibility of the company.
- Shoot for a broader market focus that spans at least the region and not just one country.
- Approach investors after proving product-market fit and adequate revenue and traction.
- Try to collaborate with international companies and investors to build you name and learn from other experiences.
This may mean that local entrepreneurs will need to bootstrap their startups for longer and iterate their business models quickly enough so that product-market fit is established sooner. For startups in the region, the Lean Startup model may be the best option.
When everything is said and done, investors also need to realize that early stage investment deals in emerging markets are extremely cheap compared to similar ventures in more mature markets. If they can find a great team with a great idea and proven product-market fit, the upside can be huge, especially if they can help connect the startup with broader markets and follow-on investors at the right time.