‘It’s destined for disaster’, expert warns, as startups dilute equity

LBS

• Startup valuations in MENA region see a downward correction
• Investment in MENA startups sunk by 54% month-on-month
• Some ‘death warrant’ valuations give investors up 80% of company

Investors who demand increasingly bigger stakes in startups amid plunging valuations could be signing their own “death warrants”.

Startup valuations in the Middle East and North Africa (MENA) region are already seeing a downward correction this year, in line with global trends as VC funding has tightened since interest rates were increased by central banks to control inflation.

But valuations in the region are still to hit rock bottom, Jane Khedair, executive director of the Institute of Entrepreneurship and Private Capital at London Business School, told AGBI while in Dubai for the latest round of the LBS MENA Startup Competition.

“In the UK and Europe the market is much more advanced, so the businesses experienced the overvaluation earlier, where it’s now being clawed back,” she said.

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“Regionally here in the MENA valuations crept up more recently and by that same token they’ll also come tumbling down. It’s yet to happen.”

Khedair, who founded Business Plan Services (BPS) in 1991, helping companies with business planning and proposals for bank finance, business angel funds, venture capital and grants for more than 20 years, said the falling valuations are a “reality check and rightly so”.

“I think early stage entrepreneurial businesses were being overvalued because of the egos of the entrepreneurs,” she said.

“Anything is worth what somebody is willing to pay for it. When the market was inflated, people were able to raise money at inflated valuations, not realising actually that potentially they’d be raising two years later in a down round.

“But there’s now going to be a tightening of the belt because of the economic situation. Money is getting harder to come by.”

Data compiled by Wamda, the largest early-stage investment fund in the Middle East, showed that investment in MENA startups in September sunk by 54 percent month-on-month.

This reflected global trends, where KPMG reported that VC funding fell to a six-quarter low in the second quarter of 2022.

Research company GlobalData also reported that in the US total funding dropped by 21.7 percent in the first half of 2022.

However, Khedair said capital is still available for the right businesses but warned that private equity firms and VCs trying to take too much stake for their financial contribution could lead to disaster.

“It will be the valuations that tighten up, not the amounts of money that go into businesses,” she said. 

“If a business is good and it’s got potential, traction, proof of concept and validation, the money will come.

“A lot of businesses are having ridiculous amounts of money thrown at them still, but at a valuation which then means they’re having to give up 80 percent of the company.

“Frankly, the investors just signed their own death warrant. No investor is actually going to be able to get the best out of an entrepreneur where they’ve taken 80 percent of the equity. There’s no skin in the game left for the entrepreneur.”

Khedair added that businesses boasting of big raises aren’t always transparent about how much equity they have parted with.

“Raising money is one thing,” she said. “The abundance of money is available. But is it going into the right businesses and how many of those businesses are we going to hear about in two, or three, or four years time?

“I think there’s too much money being thrown at these businesses, but we’re not being told the valuation [and terms]. They’re giving up too much equity, which leaves no room for future rounds and no room for the entrepreneur. It’s destined for disaster.”

The majority of MENA investors are still based locally, but Wamda found that 20 of the 51 deals in September secured funding from overseas.

American investors were the most active in the region, followed by those from the UK.

Dubai-based Lucy Chow, general partner at the World Business Angels Investment Forum (WBAF) Angel Investment Fund, said that GITEX Global brought in dealmakers from outside the region who showed optimism about the MENA region.

“For example, I met with one who is leaving the region feeling they will fund early-stage MENA-based startups and take them to Europe to scale,” Chow said. “Tickets would be between $1m and $1.5m.”

Anuj Srivastava, co-founder and CEO of Livspace and a former Google executive, said that entrepreneurs should “never bet on the market” and focus on building value not valuation.

“I still think good-quality companies that have excellent unit economics, a good brand that’s making good margins and a clear path to profitability are rare, so they will continue to attract capital, but multiples will get adjusted,” he said.

Livspace, one of Asia’s largest omni-channel home interior and renovation platforms, entered the unicorn club in February with a Series F fundraising of $180 million led by global investment firm KKR.

It has earmarked $100m for strategic assets acquisition in home interiors and renovation segment in India, the Middle East and South East Asia.

“The amount of capital you’ve raised has nothing to do with good company building,” Srivastava added. 

“Google must have raised $25 to $30 million and you could argue it was a good idea. I think sometimes those are vanity metrics. But the right metric is things that you’ve done to build value in your company – the right culture, leadership, and how many people are choosing to trust their money, time and careers with you.

“Long-term institution building is something I wish we could see more of in the startup culture.”

Khedair also cautioned early-stage founders against the dangers of accepting “any money that comes their way”.

“I cannot stress enough to take money from the right source,” she said. “For example, there’s a multitude of accelerators here and they’re not necessarily adding value to the businesses.

“They’re putting some money in, they’re taking a slice of the action but they’re not really giving value.”

Dubai-based Heather Henyon, founding partner of Mindshift Capital, which invests in women-led, early-stage tech companies in the Middle East and further afield, echoed Khedair’s sentiments that the MENA region would reflect VC funding global trends, but was just lagging behind by about four to six months.

“We have seen a slowdown in venture and funding since the interest rates were increased by the Fed in correlation with the rise of inflation,” Henyon said.

“Valuations and pricing came down in the US before the summer. MENA is feeling the impact now and is course correcting.”