Daniel Iyanda, Staff Writer, Financial Nigeria
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Should African start-ups bootstrap or fundraise? 19 Jun 2019
The classical roadmap of a Silicon Valley start-up is this: come up with an idea, create a fanciful PowerPoint presentation pitch, raise funds, grow, raise more funds, go public or sell the company. This model certainly appeals to many Nigerian start-up entrepreneurs. Some of them have been quite successful in raising sizeable funds, using the fundraising stratagem.
The fundraising model tends to attract investors who overlook the profitability of the start-ups in the immediate- to medium-term, in the hope of cashing out bigger later. Instead of appraising profitability, the investors and founders emphasize path to profitability (P2P). But the P2P can be vague or a mirage.
Some founders have been bold enough to accept that their P2P is not clearly defined. At its initial public offering (IPO) in May, Uber explicitly stated that it does not know when it would turn a profit. Jumia, on the other hand, despite accumulating over $1 billion in losses since it was founded in 2012, highlighted high earning potentials in its prospectus.
Jumia’s claim has since been challenged in a class-action lawsuit. It is accused of issuing a prospectus that “contained materially false and misleading statements and omissions about the Company’s orders, order cancellations, undelivered orders, returned orders, active consumers, active merchants and related party transactions.”
The penchant for metrics that downplay the cashflow and profitability of start-ups has been around for decades. In the United States tech industry bubble of the 1990s, investors fell head over heels for prospective high valuation of internet companies based on metrics such as website traffic. They hoped these companies would be worth millions. They did, on paper, until the bust.
But not everyone is convinced of a looming valuation disaster involving tech start-ups. Benedict Evans, Partner at venture capital firm, Andreessen Horowitz, believes we’re not in the middle of another technology bubble. “It is different this time compared to the dot-com bubble era,” he said.
The idea that fundraising is the holy grail of start-ups is problematic. The idea of fundraising has ensured that revenue and profit as the fundamental drivers of business growth are no longer appealing to many start-ups. According to a report by PitchBook Data, a financial data and software company, investors don’t care about these business fundamentals anymore. Investors are valuing unprofitable startups higher than profitable ones. Over the past nine years, the profitability of startups has barely made any difference in the performance of their stocks. As of March 2019, the unprofitable startups that went public in 2018 recorded a median stock-price growth of 120%, compared with 57% median decline of stocks that were profitable during their IPO.
According to PitchBook, 64 percent of more than 100 unicorn companies (privately-held start-up firms valued at $1 billion and above) that completed a venture capital-backed IPO since 2010 are unprofitable. On the stock exchanges in 2018, money-losing startups performed better than those that were making money, which shows that investors favour future growth above present profitability.
The preference for growth is predicated on the notion that growth guarantees high valuations, which allows early investors in a start-up to reap huge returns when more money is invested into the firm in later funding rounds. Therefore, startup founders are guided by the theme: “We should spend money to become large. We’ll obtain that money by raising equity at a high valuation, which is justified by how large and valuable we will become once we spend the money.”
However, Chamath Palihapitiya, CEO of Social Capital, a technology holding company, said this phenomenon is creating a dangerous, high-stakes Ponzi scheme in the startup and VC ecosystem. Africa, and particularly Nigeria, is very familiar with Ponzi schemes, notably MMM and Loom, more recently. The chickens usually come home to roost when fewer people are joining the scheme and old members are cashing out. But the growth-hunting start-ups have another leeway. When growth plateaus and the business is still unprofitable – which makes raising new funds difficult – investors and founders would cut their losses by issuing an IPO.
But there is another – but less cosy path – for founders, called bootstrapping. This model compels founders to rely on their ingenuity to nurture their business ideas to profit, rather than relying on investors’ funding. Although this route is difficult to travel as there are no cushions for a soft landing, it ensures entrepreneurs focus on what really matters: cash flow and profit.
Bootstrapping a start-up ensures the customers remain the focus of the business, unlike fundraising where the founders focus on the investors, valuations and the next round of funding. Bootstrapping, also, ensures the founding team retain 100 per cent ownership of the start-up and dictate the trajectory of the business.
At the recent Disrupt 2019 conference, the Chairman of Zinox Group, Leo Stan Ekeh, advised entrepreneurs to generate revenue to grow their business and not be taken in by the illusion of ‘free money’. The idea of free money has seen many founders indulge in extravagant lifestyles just after raising funds, sometimes with serious consequences. Marek Zmyslowski, the founding CEO of Jovago (later rebranded to Jumia Travels) and Co-founder of HotelOga, was placed on Interpol’s Most Wanted list for allegedly embezzling investors’ funds.
With an unscrupulous entrepreneur, “free money” meant for “blitzscaling” the start-up would be squandered, either through misappropriation or mismanagement. But when bootstrapping, because all the resources needed will not come at once but in bits and pieces through revenue and personal finance, entrepreneurs are forced to make the most of the available resources.
Many startups have been successfully bootstrapped. Mailchimp is closing in on $700 million in revenues for 2019. Founded by Ben Chestnut and Dan Kurzius in 2001, Mailchimp was profitable from day one. That’s what bootstrapping does: it forces entrepreneurs to generate revenue from the beginning and not to depend on investor’s money.
Moreover, bootstrapping forces entrepreneurs to imbue cost-saving systems into their business. Usually, startups that are bootstrapped use the lean startup methodology, which avoids wasteful practices and increases value-producing practices, to give the startup a better chance of success. According to the CEO of My Growth Fund, Vusi Thembekwayo, loans, grants or equity funding will be efficiently used only when there are no leakages in the business.
The proponents of fundraising and blitzscaling, such as Reid Hoffman, Co-founder of LinkedIn (now Partner at a VC firm, Greylock Partners), are quick to submit that Mailchimp would have been bigger if it had raised funds. This is true to an extent because startups that are bootstrapped don’t have the luxury of resources to “move fast and break things.” But not all start-ups attract the investment they need, and some of those that attracted funding have failed – they failed en masse in the US tech stock crash in the 1990s as already noted.
But the matter is quite complicated in Nigeria. Although it is cultural for Nigerian entrepreneurs to own their businesses in entirety, many are not able to raise the funds to execute their ideas and generate a decent cashflow. They have to look for grants and equity funding, while they are also not able to access or afford bank loans.
African entrepreneurs must carefully choose from whom they will receive funds because the misalignment of entrepreneurs and investors has been the undoing of many businesses.
Fundraising or bootstrapping requires guile and gut. According to Mr. Ekeh, “You must have 40 per cent common sense, 40 per cent understanding of the business you want to do and, because it is Nigeria, you should have 20 per cent spirituality.” Be that as it may, it is important that both investors and founders don’t lose focus on what really matters: revenue, profit and long-term growth.