Valuing — and overvaluing — startups

Published April 19, 2021
In this photograph taken on May 24, 2019, People work at their stations at the National Incubation Centre (NIC), a start-up incubator, in Lahore. — AFP/File
In this photograph taken on May 24, 2019, People work at their stations at the National Incubation Centre (NIC), a start-up incubator, in Lahore. — AFP/File

Though scepticism is one the most desirable traits in this line of work, one can’t help but notice the wave of new tech startups over the past couple of years. While traction and scale are still some of the puzzles that need figuring out, local upstarts have had a blast as far as fundraising is concerned.

Last quarter alone recorded 13 deals worth $19.26 million, according to i2i Insights, while Techshaw puts those figures at eight and $18.7m, respectively. Also, these amounts don’t include undisclosed rounds, of which there have been at least three, including Safepay’s seven-figure seed.

Not only is more money pouring into the ecosystem but rounds are also getting bigger. For example, when Airlift announced raising $2.2m in seed investment in August 2019, it was a record deal at the time for that stage, which was eventually broken by Medznmore’s $2.6m in October 2020. However, that was quite short-lived as Bazaar unveiled a massive $6.5m deal in January of 2021, only to be surpassed again in March by Sadapay, which bagged $7.2m.

There is almost always a foreign financier behind all large deals

At the same time, it’s also becoming increasingly common for local startups to secure funding just on the pitch deck or with very limited operations. Truck It In’s $1.5m at pre-seed last week is a testament to that. With growing round sizes, valuations are also naturally on the rise, though hardly any numbers are available on that. And behind those large deals, there is almost always a foreign financier.

Of the 23 deals that have raked in $1m or more since 2020, only three were funded solely by locals. The rest, which made up north of $70m of capital deployed, included international financiers who were also leading the round in 17 of those occasions.

This isn’t to suggest that the growing valuations are entirely driven by foreigners. “Compared to the previous years, the valuations would have gone up either way as the market itself has matured. That said, they wouldn’t have increased at the same pace without the presence of international backers,” says Misbah Naqvi, general partner and co-founder at i2i Ventures.

“We do come across term sheets from foreign VCs that value startups at a much higher level than our own investment theses would justify given the market dynamics,” says Kalsoom Lakhani, co-founder and general partner at i2i Ventures.

In that case, the question arises: what makes foreigners more optimistic about local startups? “It could be because they are less aware of the frictions of the Pakistani market and, hence, more aggressive in their approach. Or the fact that these are generally deep pockets for whom $500,000-1,000,000 is a small ticket size to bet with,” continues Ms Naqvi. Basically, they have usually higher risk appetites, which obviously is a function of the size of their funds.

But for foreigners and locals alike, valuing startups is quite difficult. The lack of predictable cash flows makes modelling a tricky exercise. That problem is further compounded in the case of Pakistan as there are absolutely no public stocks to use as benchmarks or exits to compare against.

“To try and overcome this, we often look at comparables in other markets, generally emerging ones like India or Indonesia. But they too are decades ahead in terms of venture activity so a discount factor is applied that can range anywhere between 20-30 per cent,” Ms Naqvi adds.

Valuing early-stage companies is in large part a bet on the founding team, with market size playing a major role. However, the latter can sometimes present far too beautiful a picture, especially in a populous country like Pakistan, and often doesn’t translate into reality.

Of course, all of this is part and parcel of the asset class and there is a reason VCs are the riskiest ones at that. Not only are they putting in money in very young companies, mostly devoid of any fundamentals at the time, but also the tech industry as a whole is extremely dynamic. Too often — especially in the United States — the idea and the business model have never even been tried before. Thus, any approach to pricing the unseen and unimagined naturally is based on a fair bit of subjectivity.

Therefore, one should take startup valuations and their internal growth numbers with a pinch of salt. Yes, it’s an amazing feat that the local ecosystem is growing rapidly and becoming more attractive to investors. But let’s also be mindful of the fact that fundraising is not an end in itself. The ultimate goal is scale and its sustainability, an area where much still needs to be proved.

Published in Dawn, The Business and Finance Weekly, April 19th, 2021

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