Advice to startups and investors operating in frontier emerging markets
Thoughts On The Market (Long Read)
Many people have asked us how the current global economic environment has affected our markets (as a reminder, our focus areas are Pakistan, Bangladesh, Central Asia, Egypt, and adjacent markets), and we wanted to share our high-level thoughts here. Rising inflation, particularly the price of fuel and basic foodstuffs, has a significant impact on these markets which rely heavily on imports and where a large part of the population lives close to the poverty line. The government and central banks have responded by raising interest rates to combat rising prices while trying to balance this with targeted support for the most at-risk sections of the population. These measures are a necessary short-term pain in order to protect the long-term health of the society and economy, and we believe that although the next 6-12 months will be more volatile than the last, none of our markets will go the way of Sri Lanka.
In the VC space, our markets are not immune to the changes in the global ecosystem. After 13 years of low-interest rates and less disciplined capital allocation, global VC investors are 1) increasing focus on existing portfolio companies as opposed to new opportunities, and 2) for new opportunities, significantly raising the bar in terms of quality and efficiency of a company’s growth as opposed to growth at any cost. As public markets broadly determine ‘end state’ valuations for private companies, the retrenchment in markets has also trickled down to earlier-stage companies.
To put this another way, it is possible to think of a business as a system built on assumptions, with each assumption having a confidence level attached to it. In recent years, the confidence level needed to invest has been at all-time lows. If a company grew, a larger margin of error was implicitly provided as to the efficiency with which that growth was achieved. Less focus was placed on unit economics and profitability.
Early-stage valuation expectations in our markets have always been lower than their developed market peers, although we had seen them become increasingly frothy in the 12 months prior to the global correction. These expectations have returned closer to their historical norm, with seed stage deals in the region of $5-10m. At these levels, there is ample opportunity to generate significant returns for investors who can take a long-term view on the size and potential of the opportunity in these markets.
The role of liquidity in our markets
There has never been an abundance of venture capital in our markets, so start-ups have always had to grow more efficiently with what they have available. In recent years, we have seen a growing number of local VCs raising capital and deploying into early-stage (Pre-Seed up to Series A) companies. This liquidity is like the oxygen that the ecosystems needed to really start developing, and the last two years have seen record funding amounts in each market. The size of the opportunity, combined with the relatively lower valuations and lower price of venture capital, attracted more international investors into the markets, providing further oxygen for the ecosystems to develop. Unfortunately, this international capital was not always accompanied by the sort of rigorous due diligence one would expect and played a part in the frothy valuation expectations mentioned above. As the global VC market has corrected, the cost of capital globally has increased, and its supply to these markets has reduced. Fortunately, the local and regional VCs and thus, the supply of capital, have grown to the point where there is no shortage of funding for companies at Pre-Seed, Seed and up to Series A stage with an appropriate valuation.
The liquidity gap in our markets is at the growth stage. Local VCs do not have the funds to meaningfully underwrite Series B and beyond, while the number and capacity of regional growth investors (mainly based out of the GCC) is still limited. Larger international growth investors had begun to look at these markets, for the same reasons as their early-stage peers, but this interest has cooled somewhat in the current environment. This can be terminal for high cash burn businesses, as we have already seen for quick commerce start-up Airlift in Pakistan. However, it is important to reiterate that there has never been a large amount of capital available in these markets. The businesses that have succeeded up to now have done so by being incredibly efficient with what capital they have and focusing on building sustainable, profitable models. The best companies are Camels – as Alex Lazarow defines them – in that they are structurally built for the volatility inherent in emerging markets. These companies have the option to “turn on” profitability when funding is not available, much like they can accelerate growth when they have the capital to do so. In this environment of reduced liquidity across the global venture ecosystem, the profitability option is even more important, as companies look to extend their runway and plan for the worst.
Linked to this is another important distinction between our markets and more developed economies. In markets such as the US where the supply of venture capital is plentiful, there is intense competition in every vertical between the incumbent organisations attempting to digitalise, established technology companies with deep pockets, and start-ups that can raise tens or hundreds of millions of dollars to fuel growth. This means that the cost of customer acquisition and growing market share is high, and the path to profitability is long. So long as there is plentiful capital available this is not a problem, however, if capital dries up, then these start-ups must take significant valuation haircuts or risk failure. In sharp contrast to this, our markets are characterised by sclerotic incumbents with limited capacity to digitalise, no established large technology companies, and limited funding – a blue ocean, if you like. This means that the opportunity's size is large and the cost of building a business is much lower. That should not be taken to imply that it is in any way “easier” in our markets, in fact, there are many idiosyncrasies that make it more difficult, but what it does mean is that high-quality start-ups solving fundamental problems can reach profitability and scale with far less capital than their developed market peers. Finally, because competition is typically less intense, growth can be calibrated more effectively to enable the business to be built sustainably.
It is often mentioned that some of the most iconic technology companies that are household names today, such as Stripe or Airbnb, were founded during previous downturns. While this statement is so overused it has become clichéd, what is important to draw out is why these companies were able to succeed. One key reason, out of many, is that their target users, whether businesses or consumers, were more willing and open to trying new products and services that could either help them reduce costs or increase income. This is exactly the reality that exists in the markets where we invest today. There are huge inefficiencies across the economy and society affecting the day-to-day lives of businesses and consumers, which neither the government nor the incumbents can fix. The current inflationary environment only increases the need for technology-driven solutions that can solve these inefficiencies in a sustainable way that delivers a significant positive impact for the end user and profits for the start-ups doing so. The option of “blitz scaling”, using large amounts of investor capital is not available for these start-ups, however, the structural dynamics of the market mean that it is still possible to build meaningful businesses at scale with the capital that is available. These camels will be the long-term winners in these markets, and these are the companies Sturgeon looks to invest in.
The realities of company building
Building a company is the story of persistent grit. A long slog through difficulty and adversity to create something of value. During the journey of building a company, founders will experience various cycles. There will be times when founders find raising capital easier and at higher multiples. There will also be times that the reverse will be true. There will be times – particularly in frontier markets – when the underlying economies will experience extreme volatility. The point here is that if a given product or service truly serves the needs of the market then building enduring value in the face of the reality of these cycles is always possible. The job of a founder is that of a system builder who also needs to re-calibrate for an ever-growing and more complex system. Knowing when to be aggressive, knowing when to focus on efficiency of growth etc. and re-calibrating respectively is very important.
In the current economic and fundraising reality, history can serve as a good example and guide for responding to such an environment. To summarise what the Meritech article covers in much greater depth, the experiences of Salesforce and NetSuite during the 2008 crash are salient again today. Both were high-growth businesses at the time, trading at high multiples on public markets. As a result of the financial crisis, these multiples contracted 80-90%, and both businesses responded by reducing growth (for which full-time employee numbers can be a good proxy). Revenue and employee numbers remained steady as the market stabilised over the next two-three years. Subsequently, as the markets recovered, both companies could resume investment in growth and saw valuations rise in line with growing revenues and multiples. Looking back in time, both Salesforce and NetSuite probably shouldn’t have cut investments in growth so dramatically – they were emerging leaders in massive markets and were still profitable on a non-GAAP basis during the worst recession in decades, but hindsight is 20/20. Planning for the worst and optimising the company-building machine to reflect economic realities greatly increases the probability of achieving the long-term potential of a business, no matter how painful the short-term decisions that need to be taken.
A framework for emerging/frontier markets investors to process today’s market
Considering all the above, what should all this imply about company building in the current market?
·Founders need to re-underwrite their assumptions: Building a fast-growing business comes with a steep learning curve. When founders start their companies, they do so with a set of assumptions with varying confidence. Depending on how long a founder has been running their business, they will have learnt a lot since that start date, and it’s vitally important to re-underwrite all those starting assumptions. For example, if you were operating on 60% confidence on certain key assumptions, what information or data would you need to move them to 90-95% confidence levels? To what extent are you confident you have product-market fit? If you are past that point, to what extent are you confident that you can scale growth and the infrastructure necessary to support that growth efficiently – i.e., with a clear positive or path to positive unit economics? To what extent do you know whether your investors can and are willing to fund you going forward? Seek truth in all elements of your business and work from there.
Over-communicate – Founders should overcommunicate internally to their teams to explain the path and focus the company should have. Importantly, over-communicate to your investors (existing and potential). Understand their capability to fund you going forward and under what conditions. If you are a founder with a cap table of investors that will have difficulty funding you, adjust your plans accordingly. Again, assume future fundraises will be more difficult than your last and you don’t have a cap table to support you – aim to focus on efficiency of growth and prove how and why you can accelerate it when feasible to do so. Think and mentally prepare for all scenarios good or bad, and what that should imply about your focus and execution. Also, think of your investors as extensions of your team – they should be there to provide whatever resources are necessary as you build your businesses.
How Frontier Founders should plan their runway
Startups with two years of runway ahead of you: Consider yourself in a good position. Focus on growth but make sure you know your unit economics inside-out. If you operate in a segment with little to no competition, there is an argument for increasing aggression to capture more of the market. Agree on a game plan with your investors and team, then execute ruthlessly.
Startups with closer to one year of runway: Take a close look at what you think your business will look like towards the end of your runway. Is it high growth with unclear unit economics? If so, focus on achieving a reasonable growth rate but with an understanding of how to get to a state of positive unit economics. Communicate early with your investors to understand whether they will fund your business in the state that you present it in. If yes, then great. If not, then assume a new round with new investors will take two-three months. Plan accordingly and reach out to your VCs so they can work with you on finding the appropriate investors.
Startups with sub-six months’ runway: The next six months will be critical to the survival and ultimate success of your business. If you are post-product-market fit, to what extent do you have a good understanding of your unit economics? If you don’t, do the work to understand it very well. Set up a regular cadence of communication with your key investors (we suggest bi-weekly) so you can set an appropriate game plan, with them constantly in the loop helping you out. Understand very quickly if they can fund you now to increase runway, and if not, work with them to find appropriate investors to fill your cap table.
Last word
In closing, survival is a necessary condition for growth. Sturgeon (and any investors) in frontier markets should be steadfast in their belief that investments in category-defining companies across respective verticals, countries, and regions will generate significant long-term returns. The road to success is not linear nor easy. It’s important for investors and founders to adjust relative to reality, chart the necessary course, and re-calibrate accordingly.
Our promise to companies is that we will do whatever it takes alongside our founders to make success a reality.
For more information please reach out to the team or visit STURGEONCAPITAL.COM.