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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