African Angel Navigating the Valuation Maze: Insights for Early-Stage Investors

By Stephen Gugu

Last week, I had the privilege of hosting Eghosa Omoigui for a Valuations Masterclass webinar at the African Angel Academy. We discussed various aspects related to valuation, including how to think about it in the context of early-stage investing, correlating valuation at entry to returns of your portfolio. We also explored how valuation is just one of the terms you need to consider; the devil is in the details. Additionally, we talked about the applicability of the blitzscaling model in the continent. We concluded by addressing what a slowdown in funding for the ecosystem means for founders and investors, and how, as an early-stage investor, you can support your founders through this funding winter, guiding them in generating returns and navigating the funding environment.

We began by examining the critical factors to consider in the valuation for early-stage investors. When investing at this stage, it’s crucial to remember that your returns will be determined by the probability of success of your portfolio companies divided by the risk associated with each. Factors such as the quality of deal sourcing, due diligence, follow-through value addition, and connections for raising subsequent funding can all impact the probability of success. However, you should always keep an eye on various forms of risk, both systemic and unsystemic. As an investor, you need to ask yourself if there are company-specific risks you need to address, including governance and competition, while also keeping an eye on systemic risks such as exchange rate movements, regulation, and political risks.

Next, we examined how to perform valuations for early-stage companies and the recommended methodologies. We concluded that while discounted cash flow (DCF) provides valuable insights, it doesn’t account well for failure rates or the time it takes for companies to succeed. DCF also relies on numerous assumptions, and it’s essential to remember that good assumptions stem from good judgment, which comes from experience—both positive and negative. For angel investors, it’s beneficial to make initial deals with experienced early-stage investors who can offer sound judgment and guidance.

We then delved into the concepts of pricing versus valuation. Eghosa emphasized the importance of not only considering intrinsic value but also assessing whether you’re paying a fair price compared to the pricing of other assets at the time. As an early-stage investor, you need to continually ask whether this valuation/price makes sense and what the probability is of generating a decent return.

We proceeded to explore the key drivers of valuation multiples, with unit economics (margins) and growth rates in revenue, specifically monthly recurring revenue, being the key factors. Companies with strong margins and rapid growth rates command higher multiples, whereas those with weaker margins and slower growth will have lower multiples. It’s essential to evaluate these metrics when considering comparable metrics for valuation.

We then delved into valuation and terms, noting that securing a favorable valuation doesn’t guarantee a good return if the deal terms are unfavorable. Eghosa shared examples of deals with flat valuations but significant liquidation preferences that ultimately left early investors empty-handed. It’s crucial to carefully assess the terms of a transaction in addition to its valuation.

Lastly, we discussed the “blitzscaling” model, which has seen several startups go for scale at all costs, even when it’s unsustainable. This model was fueled by cheap capital that is no longer readily available. As a result, founders may face the prospect of a down round, which entails significant dilution. However, if they believe that the opportunity is still there, they need to accept short-term pain for future growth. It’s essential to avoid pushing entrepreneurs into this decision, as some may have already decided to throw in the towel. In such cases, it might be wiser to find someone else to run the startup or shut it down altogether.

It goes without saying that founders must focus on building profitable businesses without relying solely on continuous fundraising. As an investor, it’s crucial to support founders during these difficult times, particularly if they haven’t experienced such challenges before. Recognize that you may need to serve as both an investor and a therapist, alleviating pain and motivating entrepreneurs to persevere.

In conclusion, understanding and navigating the complexities of valuation is vital for early-stage investors. By considering factors such as risk, judgment, appraisal, and deal terms, investors can make more informed decisions and maximize their potential returns. As investors, we also need to remember why we exist in the ecosystem. Returns are important, but we must also remember that at the core, we are supporting entrepreneurs in solving complex problems on the continent. With this key objective in mind, this is our time to demonstrate our true worth to the ecosystem!

Thanks for reading!