Op-Pieces, Startups, Ventures

You paid $20,000 for that?! The shared startup valuation nightmare

Here Come The Vikings

By all indications, these should be good times for the startup ecosystem in Nigeria and for Lagos in particular. 2014 is still in its infancy and we have already seen the ranks of ecosystem enablers swell considerably, witnessing several announcements and quite a few launches. Now we have 440LTDPassion Incubator, and LeadPath. According to one technology blogSavannah Fund is also on its way here. So why are some sounding the alarm and warning of imminent mayhem? Startup founders do not want to be sold into indentured servitude and investors, for all their smarts, lack the informational edge the founders possess. Founders and investors approach negotiations with a(n) [un]healthy dose of scepticism. Who will come out on top? If you were rooting for the unlikely underdog victory here, let me burst that bubble real quick. For the foreseeable future, investment terms will continue to be investor-friendly to the exclusion of all else. Here’s an attempt at explaining why.

Are We living in The Matrix?

Can a system be exploitative, yet helpful? Neo clearly had his doubts.
Can a system be exploitative, yet helpful? Neo clearly had his doubts.

In the movie The Matrix, Keanu Reeves’ character, Neo, learns that he has been living a lie. The life he thought he had was nothing but an elaborate and never-ending dream called the Matrix. In the war between sentient machines and man, humans had blocked out the sun’s rays to deprive machines of their only energy source, solar. The machines in turn adapted and learnt to draw energy from humans whom they kept sedated in cocoons. These cocoons are liquid-filled vessels interconnected by cables through an elaborate electrical system, pretty much like futuristic incubators. Initially they gave the humans utopian-quality dreams of everlasting life, untold riches, joy on tap, and other good stuff but humans rejected these realities and many died. To protect their new energy source, the machines made the Matrix more realistic, introducing sorrow and pain. Humans were more amenable to this version and average life expectancy shot up. The machines did not alter the matrix to punish, rather they did it to preserve. They were not responsible for shielding the sun’s rays but they adapted iteratively to a bad situation. You might even argue they put a human face on cold, hard self preservation. Is that what our local investors have done?

What Do Accelerators Do?

Strictly speaking, programmes that provide workspace are incubators and those that do not are accelerators but these terms are used interchangeably. Seed accelerators are fixed-term, cohort-based programs, that include mentorship and educational components and culminate in a public pitch event or demo day. So they take you in off the street (aka your dingy room in Iyana-Someplace, the backside of Lagos’ backside), teach you manners (Lean Startup, Agile, and Design Thinking, etc.) and improve your diction (presentation skills), dress you and pretty up your face (Minimum Lovable Product), and stage a debutante ball (Demo Day) for you. This is all very My Fair Lady-ish, no? In exchange they retain some equity in your business. Paul Graham’s (PG) Y Combinator runs probably the best-recognised accelerator programme yet they rarely invest more than $20,000 for up to 10% equity. Interestingly, only around 3% of candidates succeed in getting in the keenly contested programme. The Y Combinator brand commands real respect and it has even been suggested that some startups would gladly give up the required equity for no monetary consideration just to enjoy the cachet of being a part of a Y Combinator cohort. Perhaps this is where Passion Incubator sees themselves with their contrarian accelerator model.

As a startup founder, you and your co-founders will have to research and decide if an accelerator/incubator represents value for your startup. Here are three things which make Y Combinator peerless in my book:

  1. Early adopters: The large family of Y Combinator alums who will try most products coming out of the accelerator at least once. This is a remarkably pliant and responsive market, an invaluable asset for B2B startups especially.
  2. Guaranteed Investment: Yuri Milner’s Start Fund’s $100,000 and Ron Conway’s SVAngel’s $50,000 is a package deal which is available to ALL Y Combinator startups, no questions asked, no presentation required.
  3. THE MOST FOUNDER FRIENDLY TERMS ON EARTH: Y Combinator developed the SAFE (simple agreement for future equity) to replace convertible notes and it is some scary s#!t . . . if you are an investor! Have a look for yourself.

 “Yuri and Ron’s approach to investing in all of you, I’m sorry to say, 62 of you, they invested in by accident. Statistically, there’s an Airbnb or Dropbox in here somewhere and they don’t know, especially at the very beginning of the batch, they don’t know which one it is. So they’ve got to offer you all terms that 62 out of 63 of you don’t deserve to make sure that they get the Dropbox, whoever it is.  If they had made their terms just a little bit harsh in any way, there is a disproportionate chance that the first startup that would turn them down would be the best one. “

Paul Graham, co-founder Y Combinator,  to Summer  batch

Any accelerator in Nigeria that can guarantee just one of these three sweeteners is definitely worth a look in. My passing grade for Nigeria is deliberately set low because the market dynamics are in reverse here and the burden of proof rests with founders.

Why Not Give Everyone The Same Deal?

Last week, Eghosa Omoigui admitted that local investors can be predatory. This is hardly news but it speaks to the heart and soul of the matter. Are investors exploiting startup founders? My good friend, Iyin, seems to believe some foul play is afoot and wrote a blistering comment to a blog post on accelerators which was so heartfelt, so eloquent that it ended up being reincarnated verbatim as a blog post in its own right, generating much furore in the process. Reproduced below is another comment he made, this time in response to a reader’s comment, which in turn was in response to his blog post, which actually began life as a comment. Confused yet?

“In product focused startups, success is binary. A startup is either a success (or on its way to being one) or a complete failure. There is no midpoint. If you can look into a startup you want to funds’ future for the next three months and see how far it could go (with you [sic] help and funding) do you seriously believe that startup will be worth just $100,000? Then why even bother with investing $25,000? Why not invest $10,000 or $15,000?

I believe in fair value – especially for accelerators. At the early stages most of the value of the startup is in the future. Otherwise, you might just as well call the valuation what it is $0.

I recommend standard terms for accelerators. Just give everyone the same damn deal. It is 15% for 15k or it is 10% for 10k or as I want to understand, it is 20% for 20k. Of course, exceptions can be made as is always the case but they shouldn’t be exceptions that have you lowering the startups valuation.

Otherwise what you are just doing is preying on young founders who may not have the same negotiating strength as you and will end up taking crappy deals.”   

Iyin Aboyeji, Fora founder

While I support his position on standard terms somewhat, we disagree on implementation. Primarily, there are no “standard terms” for this environment. Term sheets are negotiated in a context of their own. If you are an Ivy League alum, you get a better deal. Even at that, Ivy League schools are not created equal with Stanford, MIT and Harvard in a class of their own with respect to startup cred. If your startup is in Silicon Valley or New York, you get optimal terms too. If you are an ex-Facebook or ex-Google employee, you earn automatic street cred. If you are working on this season’s sexy idea, you are in luck as well.

 Startups Are Not Created Equal . . . I Think!

Standardisation saves time but we discount outliers by converging to the mean
Standardisation saves time but we discount outliers by converging to the mean

Bringing it home, how would the Nigerian proxy for the successful startup founder look? A late-twenties-to-early-thirties Lagos-based, University of Ibadan educated, two-time founder who cut his (they’re typically male, right?) teeth in financial services and is working on an ecommerce startup? That could be me sans the ecommerce business. However, we do not have enough supporting data to establish or repudiate the thesis that any so-called pedigree bestows an advantage when it comes to building a successful startup. All things being equal, Iyin’s suggestion of cookie-cutter terms could have been useful here. Unfortunately, all things are seldom equal. Quite frankly, there are too many unknowns. Also with so many successful-founders-turned-authors sharing secrets on how to hack growth, how do investors know when they are witnessing true traction or when it is smoke and mirrors? In any situation with that many uncertainties, a negotiated outcome is better for all parties. If as an investor I was forced to offer standard terms to all startup teams, I would naturally push for the most investor-friendly terms I could dream up, especially as the fundamentals of microeconomics (demand and supply) are firmly in my favour. This way my downside risk will be mitigated while leaving me poised to reap significant upside potential. Never ask the Cookie Monster to watch over the cookies. Knowing you might doubt me, I caught up with him for a comment. Feel free to substitute “Cookie Monster” with “New Incubators”, “cookie” with “startup control”, “Two-Headed Monster” with “banks” and “Herry Monster” with “VCs/Angels”. 

When me get back to apartment, after cookie binge, me can’t stand looking in mirror—fur matted with chocolate-chip smears and infested with crumbs. Me try but me never able to wash all of them out. Me don’t think me is monster. Me just furry blue person who love cookies too much. Me no ask for it. Me just born that way.

Me was thinking and me just don’t get it. Why is me a monster? No one else called monster on Sesame Street. Well, no one who isn’t really monster. Two-Headed Monster have two heads, so he real monster. Herry Monster strong and look angry, so he probably real monster, too. But is me really monster?

Me least like monster. Me maybe have unhealthy obsession, but me no monster.

No. Me wrong. Me too hard on self. Me no have unhealthy obsession. Me love cookies, but it no hurt anyone. Me just enthusiast. Everyone has something they like most, something they get excited about. Why not me? Me perfectly normal. Me like cookies. So what? Cookies delicious. Cookies do not make one monster. Everyone loves cookies.

Me no monster. Me OK guy. Me OK guy who eat cookies.

Cookie Monster, Sesame Street

Startup founders are not created equal and it would be a disservice to rank them the same and damn them all to one uniform deal. Similar terms, maybe. Same deal, not so much. I am also struggling with the whole binary state thesis for product-based startups.

Our [Lack of] Market Messes With Investors’ Models

We often overlook the simple fact that “a rising tide lifts all boats”. Developed countries have developed markets. Exit options abound from IPOs (Facebook, Twitter) to straight-up acquisitions (Instagram, Oculus VR) and even acqui-hires (Nokia!). Every participant benefits from such deep markets. Granted, there is still a fair bit of unpredictability in the process but the expectation of a liquidity event in a developed market is not anywhere near as remote as it is in Nigeria. This significantly de-risks the process for investors because it allows them model outcomes to a greater degree of accuracy. Without that outlet, investors will model a scenario which discounts the likelihood of an exit and this significantly depresses valuations.

Naturally, investors begin with the end in mind. Shallow markets make this challenging.
Naturally, investors begin with the end in mind. Shallow markets make this challenging.

One question you may ask is where Nigerian tech startups go to get listed. While AseM has started our promisingly, we do not yet have a true Nasdaq Stock Market surrogate for local technology companies. The New York Stock Exchange (NYSE) is different from Nasdaq in a number of ways. The Nasdaq is typically known as a high-tech market, attracting many of the firms dealing with the internet or electronics. Accordingly, the stocks on this exchange are considered to be more volatile and growth oriented. The companies on NYSE are perceived to be more well established. A company’s decision to list on a particular exchange is affected by the listing costs and requirements set by each individual exchange. Entry fees on the NYSE are $250,000 compared to $70,000 for Nasdaq. Annual listing fees can go as high as $500,000 on NYSE but hover around $28,000 for Nasdaq. This might explain why growth-type stocks (startups with less initial capital) opt to be listed on the Nasdaq exchange especially considering that both markets are comparable in terms of liquidity.

Baldfaced Plug

At PushandStart, we plan to become a market-maker for shares in private companies funded though our platform. Out thesis is that this should help alleviate the Illiquidity Discount and price private company shares commensurate with those of similar-sized public entities.

Equity Analysts Won’t Give Us The Time of Day

Further compounding the issue, the technology sector in Nigeria is not even a keenly monitored one. There is practically zero analyst coverage of and no research into technology companies. Our FSDHsBGLsVetivas and Meristems prefer to focus on Financial ServicesOil and GasConglomerates, and perhaps Industrial Goods. The role of research is to provide information to the market because a lack of information creates inefficiencies that result in stocks being misrepresented (over- or under-valued). Analysts use their expertise and spend a lot of time analysing a stock, its industry and its peer group to provide earnings and valuation estimates. Research is valuable because it fills information gaps so that each individual investor does not need to analyse every stock. Analyst coverage for your firm’s stock/industry makes the market for your shares more liquid and the pricing more efficient and it is regarded as a badge of honour. Remember, “what gets measured gets done” and though this was not what management gurus had in mind when coining the phrase, it applies. Investors can be notoriously work-shy and expecting them to do their own analyses may be a bridge too far. And no, bloggers are not analysts!

Startup Valuations Are Determined By . . .

The big determinants of a startup’s value are the market forces of the industry and sector in which it plays, which include the balance (or imbalance) between demand and supply of money, the recency and size of recent exits, the willingness for an investor to pay a premium to get into a deal, and the level of desperation of the entrepreneur looking for money.

The biggest determinant of a startup’s value are the market forces of the industry and sector in which it plays . . . and the level of desperation of the entrepreneur looking for money.

A drowining man will clutch at a straw
A drowning man will clutch at a straw
Dude, You Turned Down $3Bn?

I always point to poverty as being one of our biggest challenges as Nigerians and not economic poverty alone but also a mental poverty which is far less straightforward to diagnose. However, I am not referring to either when I speak of the “level of desperation of the entrepreneur”. It is about having viable options. In rejecting Facebook’s $3bn all-cash offer, Snapchat founder Evan Spiegel said “there are very few people in the world who get to build a business like this, I think trading that for some short-term gain isn’t very interesting.” This all sounds kosher but we must not forget that before the $19bn WhatsApp acquisition, Snapchat was the most talked about thing in tech startup circles. He literally had VCs stalking him with term sheets. Does your startup have that sort of pull? If not, you need to stay pragmatic.

How’d You Get So Rich?

There was also the time when Mark Zuckerberg and another partner showed up deliberately late at Sequoia Capital for an 8 am meeting, in their pajamas no less. They were there to pitch an idea for a peer-to-peer file-sharing program called Wirehog. Zuckerberg showed a PowerPoint presentation titled The Top Ten Reasons You Should Not Invest in Wirehog. The reasons ranged from a lack of revenue to the likelihood of a lawsuit being brought against them. They even mentioned their tardiness as one reason. Zuckerberg never really intended to take any money from Sequoia but his friend and Facebook president, Sean Parker, had an axe to grind with them so Zuckerberg went along with the prank. To pull a stunt like that, you need to have the whip hand. When describing Zuckerberg, people often talk of his lack of desperation and belief in a higher purpose than money making. Here’s a quote from one answer to a question about Zuckerberg on Quora

He doesn’t care about money that much. He’s not that desperate. When Facebook went out and sought venture capital, they never had to give up 30% like a regular company. The most Facebook had to give in a single round is 12.7%.

 – Kevin Gao. on to “How did Mark Zuckerberg retain 26% of equity after so many rounds of financing?”

L-R: Mark Zuckerberg, Daniel EK (Founder, Spotify), Snoop Lion (the artist formerly known as Snoop Dogg), and Sean Parker
L-R: Mark Zuckerberg, Daniel EK (founder, Spotify), Snoop Lion (the artist formerly known as Snoop Dogg), and Sean Parker

This is beyond incredible when you consider the various rounds of funding Facebook raised beginning with $500k from Peter Thiel in September 2004 at a valuation of a cool $5m. Facebook would go on to raise approximately $2.4bn before their eventual $104bn IPO. Here is a breakdown.

  • $12.7m from Accel in May 2005 for 12.7% of the company ($100mm valuation)
  • $27.5m from Greylock, Meritech and Founders Fund in April 2006 for 5% of the company ($550mm valuation)
  • $240m from Microsoft in October 2007 for 1.6% of the company ($15b valuation)
  • $135m from Li Ka-shing and European Founders Fund in a protracted round spanning November 2007 to April 2008 for 0.9% of the company ($15b valuation)
  • $100m from Triple Point Capital in May 2008 structured as venture debt and resulting in no dilution
  • $200m from Digital Sky Technologies in May 2009 for 1.3% of the company ($15b valuation)
  • $120m from Elevation Partners in June 2010 for 0.8% of the company (a blended $14b valuation)
  • $1.5b from Goldman Sachs in Jan 2011 for 3% of the company ($50b valuation)
  • $38m from Kleiner Perkins in February 2011 for 0.1% of the company ($52b valuation)

I will not insult your intelligence by claiming to know how Mark Zuckerberg and Facebook managed to pull this off. If I knew how he did it, I would be doing it myself rather than sitting here writing about it, no? However, here are a few outward signs of stuff they did right.

  1. Traction: The unprecedented momentum of product’s core metrics (users and usage).
  2. Mentors and Advisors: The excellent advice and guidance from the beginning, first from Stephen Venuto and Sean Parker, then Peter Thiel and Reid Garrett Hoffman, then Matt Cohler and Jim Breyer, and at some point Marc Andreessen.
  3. Cash: Enough revenues (mostly ads) to never have to raise a round with unfriendly terms.
  4. People: Zuckerberg made masterful additions to his team. There was Sean Parker as president, Matt Cohler as Facebook’s first business executive and Stephen Venuto as Corporate Counsel. An A-list team if there ever was one.

Takeaways For Investors and Startup Founders

For investors all I have to say is. “temper justice with mercy”. Today’s inexperienced and gullible founder may fail at a few things but she could go on to become tomorrow’s super-savvy serial entrepreneur and like elephants, “startup founders never forget”.

And if you’re a startup founder in Nigeria, take heart. There is so much dysfunction that is simply out of your control. Thin investor markets, online payments hurdles for customers (think OTP), infrastructure, dearth of reliable high-quality data, regulations and more. However, there are factors within your control too. Stuff you can do to make yourself a little less desperate. Get off your butt, galvanise talent around your your ideasolve a big enough problem, educate yourself on the lingo of finance, study entrepreneurship, stay lean. I want to leave us all with a closing thought from Eghosa Omoigui.

One thing I cannot condone is people sending me emails to say “I have an idea”. That is useless to me because I get them too. Hundreds of them.

– Eghosa Omoigui, Echo VC Managing Partner

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Finance guy, volunteer teacher, unsigned blogger, and high functioning recluse. Interested in business strategy, new ideas and capital formation.

8 Comments

  1. Wow..I think about 15 minutes of my time to read this and I duff my cap to you Mr Onyeaso, the quality of the writing, depth of research and all round "snaziness" go a long way to show how important this topic is to you. I will now go back to work while thinking about some of the points you raised and come back with a proper comment. In the mean time, I am sharing it with all and sundry.

  2. I'm trying hard not start with 'Wow'. Well guess I pulled it off but man is this very timely. The topic of funding, startup, valuation, investment, is a big one that we only see from a key hole. I really do hope people read this, get informed and hope you are open to helping. That's what you are doing at pushandstart.com yes?

    1. Indeed it is. I think if those who have the time and inclination begin to engage more actively with the problems, improvements will start to become visible. I listened to Obi Asika today talking of how they gave the Nigerian music industry much-needed CPR. It's not necessarily the same thing but in both cases, selfless people are needed to kickstart the movement.

  3. "If as an investor I was forced to offer standard terms to all startup teams, I would naturally push for the most investor-friendly terms I could dream up, especially as the fundamentals of microeconomics (demand and supply) are firmly in my favour. This way my downside risk will be mitigated while leaving me poised to reap significant upside potential."

    I actually think this is a HUGE mistake a lot of Nigerian investors make and it betrays their lack of understanding about the nature of internet startups.

    You see in internet startups it is difficult if not impossible to mitigate the downside risk because things move so quickly. This is why success is so binary in startups. You rarely get an ok company. It is either a fast growing company on its way to $100m or a complete failure. So for the investor since getting more shares in the company doesn't increase startup success (and it infact at a certain % begins to reduce it), getting 90% equity in a failed company means nothing. On the other hand, getting even 5% in a good company with smart founders could make you a billionaire. The tragic thing is that most smart founders that will be successful will see your terms and run away. It is only on the rare occasion you get smart founders who take bad deals.

    I also think especially for angel investors, taking a small stake (under 10%) in an early stage company is not just the right thing to do but the smart thing to do because this way can sell off your stake quickly : If an investor owns 20% of a company, seed stage investors will find it difficult to get out when bigger investors come in. It is easy to have a conversation about a growth stage investor buying your 5% stake off as part of a round that will see them own 30.%. On the other hand, a conversation about buying your 20% stake will be difficult since most investors believe money they invest should go to the company and not to private hands. You end up limiting your startups ability to give you liquidity and raise capital for their operations at the same time when you make your terms founder unfriendly.

    1. Thanks for clearing up the binary nature of startup success from your perspective. Unfortunately, there are too many startups that never got that memo are are muddling along.

      A lot of what you say is reasonable but I wonder if they are based on your no doubt vast overseas exposure or on a true appreciation of the realities faced by Nigerian founders. Take this for example:

      "The tragic thing is that most smart founders that will be successful will see your terms and run away"

      It is simply not the case. Or perhaps we disagree on what a smart founder is. Are you referring to a brilliant engineer or a savvy businessperson? Either way, pragmatism wins out most times and when it doesn't, the founder is left holding the bag. Alone.

      Your reasoning on the wisdom of taking a small stake is just as puzzling, especially when you consider that there are recorded instances of Nigerian angels taking money off the table when new investment – which they typically help arrange – is injected. Also, why would I as an investor wish to "get out when bigger investors come in"? It sounds counter-intuitive to me. If the business is doing well enough to attract follow-on funding, that means they're doing something right and I definitely want to hang on for that ride. I will accept dilution if I must and may try to sequester some of the cash if I am really predatory and the founders are sufficiently naive. Naturally, I will also have my tag-along provision to fall back on, ensuring some of my shares are in the pot if anyone is trying to get an early payday. My main point is that a lower stake does not confer any unique advantage.

      The real solution is multiple alternatives. Competition. Investors bidding up startups. Incubators offering ever-juicier deals to attract the best of the best. As I said a while back, the first few artistes who sold their album distribution rights to Alaba traders must have gotten scalped. However, once more traders saw the massive returns and flooded the market, tables were turned.

  4. I read it half way and got tired. Maybe Nwachukwu Onyeaso should learn something from Upper Iweka moguls on splitting the story into several parts "To God Be The Glory"

    From
    the much I have read so far, I will comment on standard terms because
    it is interesting that Iyin proposed it as I had written an entire post
    based on this for Bankole Oluwafemi before he jumped the gun.

    The future value of any startup or enterprise
    is based on the amount investors are willing to pay for a stake. That
    amount is based largely on availability of disposable investments and
    risk appetite. In other words, it is ALWAYS a supply side equation for
    funds at the seed stage.. No matter how you cut or dice it, standard
    terms are the norm even for YC and others to a large extent. There are a
    few exceptions but nobody has the time to do lengthy analysis and
    prognostications at seed stage. The proof is in the execution.

    Pedigree
    and all others only get you to open the right doors and maybe those
    right doors are those of investors who may have had some experience in
    your area. Yes there is bias. It will be foolish not to admit it. The
    ultimate bias is for success and all startups should do is strive for
    that and not voodoo valuations.

    Two
    sides of the equation met at an event organized by GrowthAcclerator in
    London last year. Two guys running the some of the largest UK SuperAngel
    funds (#1seed and Avonmore Developments) made it clear that it took them only 90 seconds to reach an investment decision on a seed investment and less than 10 minutes to negotiate terms.

    To
    give more than their standard terms, the idea must usually be of great
    novelty and utility and in most cases they get other investors involved.
    Greed plays a very little role at the seed stage, there is much more
    downside protection than upside appetite.

    If
    we don't have investors with this mindset yet in Nigeria then we are
    still grasping at straws. The superAngel fund is an investor aggregator.
    We may need more of those institutional aggregators to make progress.

    1. Point taken on the length.

      Looking forward to reading your views on standard terms.

      Mind you, I have no squabbles with standard terms (language, structure, covenants, etc) per se. My issue is standard deals – size-wise – a la http://www.kima15.com/.

      Theoretically, startups that apply to Kima Ventures and other such investors self-select, and of course these investors also vigorously scrutinise startups. However, without the flexibility of calibrating (within a [narrow or broad] band, of course) deals to suit particular cases, startups may be shoehorned into suboptimal arrangements.

      Whatever the case, things are getting more exciting with all the new entrants. Will they all ape each others terms and mirror themselves going forward or are there some renegades who want to try new things? Time will tell.

      Founders too need to try harder. Haba! Everywhere I go these days, I hear of the poor quality of ideas and the unprofessional attitude of founders. Or has this always been the case and I only started hearing of this because I am now engaged in finding a solution to the problem?

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