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Technology Business Valuations – A Hurdle to VC Deals in the Developing Markets

This article is a follow-on installment of one of my previous posts: Venture Capital and Angel Investing in Developing Countries – Challenges and Opportunities. If you haven’t read that one yet, please do so for additional context and background.

technology business valuation

Image Source: walthall.com

Ask prospective local investors for a $200K investment at $800K pre-money valuation and see the jaws drop. Most investors will question whether you and ‘that thing’ on your laptop is worth that much money. That’s a legitimate objection by anyone not used to valuing tech ventures, especially seed stage ventures that are still pre-revenue or project insane numbers based on some ‘creative’ sources of revenue in the future.

Part of this is usually inexperience of the founders pitching to the investors who are just not able to sell the value proposition of the company effectively. There is usually too much focus on costs and very little on the value being provided. Thankfully, the pitching skills of founders are getting a good polish in several pitch competitions, launch pads, incubators and entrepreneurship courses at local universities across the region.

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 using discounted cashflows or asset based valuations don’t provide much confidence to investors because:

  • The cashflow projections of a currently pre-revenue company requires a big leap of faith on part of the investors in the absence of comparable success stories and trusted tech-savvy advisers who understand the business model;
  • Bulk of the asset based valuation of a tech start-up 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 price and not the accountants who usually aid the investors;
  • Some of the revenue models proposed by start-ups are not yet fully proven in mature markets, let alone in the developing region;
  • Intellectual property (IP) is perceived to be less protected by law and hence of lower value.

Another method of valuing tech companies is based on comparable deal value which is also hard to locate in the local markets.

A fourth model is based on strategic value of an acquisition post merger which is solely buyer driven and can sometimes result in insane pricing like that of Instagram, but which may be justified in the eyes of the sole acquirer, 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 value solely driven by the demand for that deal and totally devoid of any fundamentals. The developing world is still working on kicking off a VC ecosystem, and hence not supported by 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 will take to build the same product or service from scratch. That certainly doesn’t work for the founders and seals any prospects of raising venture capital for them unless the company is centered around a key piece of IP that took years of R&D to develop, something that might evolve out of a start-up bootstrapped in a university.

So how do we avoid these stalemate like scenarios and invigorate the start-up ecosystem with some capital injection? The following, in my opinion, can help the investors get closer to the deal table:

  • Successful exits in the local markets;
  • Proven revenue models that work in the constraints of the local environment and play to the strengths of the local markets;
  • Supplementing the accountants who advise them for the deals with experienced tech savvy advisers;
  • Test 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.

The founders on the other hand:

  • Need to refine their pitching skills so that they can solidly pitch the startups’ value proposition, not just to its investors but its customers and partners as well;
  • 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;
  • Sign up experienced advisers to help with strategic direction of the company;
  • Shoot for a broader market focus that spans at least the region and not just the country;
  • Approach investors after proving product-market fit and adequate revenue/eyeballs traction;
  • Try to collaborate with international companies and investors;

This also means that local entrepreneurs will need to bootstrap their start-ups for longer periods and iterate over their business models quickly enough so that product-market fit is established sooner. The Lean Startup model should therefore be preferred by the start-ups in the region.

The governments need to play their part as well. The VC industries in two of the most thriving entrepreneurial ecosystems in the world, United States and Israel, owe their success to government interventions. In the case of United States, the government backed Small Business Investment Company (SBIC) program provided a downside protection to the investors. In the case of Israel, the Yozma fund provided upside advantage to foreign funds to invest in local companies. The results have been compelling!

When everything is said and done though, the investors also need to realize that early stage investment deals in the developing region 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 start-up with broader markets and follow-on investors at the right time.

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6 Responses to “Technology Business Valuations – A Hurdle to VC Deals in the Developing Markets”

  1. Great articles, was very interesting to learn about the Yozma fund. If the right policies are implemented in Pakistan we really jump start this industry.

    Posted by ayd | June 19, 2013, 5:41 PM
  2. Thank you. Yozma is actually a great model for Pakistan. It provided an upside advantage to foreign investment managers to fund local companies with a sizable leverage by the Government. All the funds had an option to buy out the government share at pre-settled nominal price within 5-7 years. The plan was that the funds that do really well will be rewarded and guess what, almost all the funds bought out the government share. The rest is history 🙂

    Posted by Khurram Zafar | June 19, 2013, 5:51 PM
  3. Dear Khurram. What do you recommend for a start up valuation once idea is in revenue stage? We are 2y/o Fashion Tech company of German origin, set up in Shanghai / China. In the past two years our team did set up the working version of our idea. It went well; company did break even in the beginning of 2013.
    Furthermore you mention in your article that it is better to cover larger markets in the business plan then one country only. We had this discussion with our team. Our idea is scalable for the whole world generally. However worldwide business model results in numbers which sound exaggerated. To keep it real we put our focus to China market first, as China is already one of the biggest world markets. What would you recommend? How to stay real while presenting full capacity of the business idea? Thank you very much for your reply, Iris Germanica

    Posted by Iris Germanica | June 19, 2013, 6:02 PM
    • Dear Iris: It’s hard to pin a number like this without propoer due diligence, but once a company has established product-market fit and there is a decent growth trajectory in terms of revenues and customers, the more traditional methods of business valuation become more reliable. So your future cashflows discounted to the present a good value assuming you can defend your growth thesis with investors.

      Regarding larger markets, my point was that the businesses in the developing world inherently need to support larger markets as opposed to just local. There are plenty of businesses that are based on replicating global, proven business models in local markets also. The advantage is that when the business model is inherently global, it’s easier to find comparable businesses elsewhere and that aids in valuations.

      Having said that, it doesn’t mean that a startup should focus on the global or the larger market from day one. That can be saved as a growth strategy. It makes perfect sense, in fact is preferable, to re-factor the business model in a small market until product-market fit is established and then scale operations else where.

      In your case, China is a huge market already, so this may be a moot consideration.

      As far as projections are concerned, that’s where your established traction and scale metrics come into play. Your business needs to identify, track and optimize the right metrics so you can defend your projections. For example, how much does it cost to acquire a new customer in an existing market through referrals versus in a new market (acquisition and activation) is just one of them. Numbers have a lot of power and if you can show investors you really understand your business and the metrics that determines its growth and use them as a basis for your projections, all reasonable investors will buy it. Problem occurs when startups track their growth using vanity metrics like revenue for example. Spend a day with your team to identify the real performance metrics of your business, it’s the most important exercise you can do at this stage.

      Posted by Khurram Zafar | June 19, 2013, 6:24 PM
  4. I do think that there’s also lack of savvy tech investors in Pakistan and the idea of sweat equity is non-existent. It is common sense yet I have met a lot of people who very conveniently choose to ignore it.

    On Policy level; doing things the right way in Pakistan takes time. From simple incorporation to getting the share structure of your company approved by SECP. Anything fancy is likely to be rejected the first time around unless it’s changed.

    Posted by Rami | June 22, 2013, 1:05 AM


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