In part one of a string of articles examining Africa's evolving Fintech landscape, Novan Maharahaje, Director of the Corporate Finance Advisory division of Ocorian AMEA, analyses the pros and cons of the approaches most commonly used when valuing an early-stage FinTech company and how there is no "one-size-fits-all" solution.
Africa is increasingly recognised as a land of opportunity for Fintech; EY's 2019 FinTechs in Sub-Saharan Africa report identified that there were more than 250 active companies in 2018 according to research1. The sector has capitalised on the digitalisation trend, favourable demographics and a talented and innovative entrepreneur base to bring banking, insurance and other financial services to an otherwise unserved and underserved population.
African Fintechs are having a direct impact on financial inclusion and positive spillover effects on other sectors such as agriculture, renewable energy and infrastructure – thereby attracting interest from a wider investor base including venture capitalists, private equity firms and development finance institutions, amongst others.
According to a report from the International Finance Corporation, more than US$50 bil-lion has been invested since 2010 in almost 2,500 Fintech companies worldwide. A somewhat similar trend was observed in Sub-Saharan Africa, where investments in this segment are on the rise in spite of a general slowdown in merger and acquisition activity in the region.
The valuation expectation gap is a key challenge during the investment process
Amidst all the global investor interest and recent launches of accelerator programs by the likes of Google, Visa and Microsoft, both entrepreneurs and investors still face some key challenges during the investment process. Amongst these, access to finance (from the perspective of entrepreneurs), access to credible targets (from the perspective of investors) and the valuation expectation gap are the most pervasive.
In this article, the first of a series delving into Africa Fintech's opportunity, we focus on the valuation challenge of early-stage Fintech companies.
How to value an early-stage Fintech company?
Early-stage Fintech companies often exhibit the following patterns, which create some practical valuation challenges:
- Rapid growth, high uncertainty and hefty current losses;
- Investments often expensed rather than capitalised;
- High customer acquisition costs;
- History of little or no revenues;
- Economic earning potential resting on key-man and/or intangible assets;
- Scalability at near-zero marginal cost; and
- Low survival rate and its impact on discount rates.
Consequently, traditional valuation techniques based on forecasted cash flows, projected growth rates and discount rates may not be relevant or realistic. In practice, the commonly used valuation techniques include the venture capitalist method and the top-down and bottom-up approaches2.
No satisfactory "one-size-fits-all" approach
Simply put, the venture capitalist method involves projecting estimated revenues or earnings in a future year (usually when operations are normalised), applying a relevant multiple based on peer analysis and discounting back to present value using a targeted rate of return. However, the lack of market comparable data and industry benchmarks in Africa makes this approach arbitrary at best or unrealistic at worse, hence widening the valuation expectation gap.
The top-down valuation approach derives future cash flows by projecting revenues based on estimated market share in a future year (when the company is in a steady state), applying expected margins, deducting taxes and accounting for reinvestment needs. In the context of African Fintech, the lack of credible studies about market size and the fragmentation of product offering are practical limitations of the top-down approach. In contrast, the bottom-up approach derives the expected cash flows based on income generating capacity from investments made.
At Ocorian AMEA, the valuation approach we use depends on the age, the stage of lifecycle of the subject company and the investment cycle. For early-stage Fintech companies facing limited capital means and involving significant key-man risks, one of our favoured approaches is the bottom-up approach, backed by secured contractual commitments.
As the Fintech company builds a track record and starts earning profits, we have added visibility over its product offering and expansion strategy, hence what will drive projections. Risks are clearly identified and mitigated, influencing discount rates. In this case, we prefer to use discounted cash flows derived from contractual agreements and secured pipelines, stressed by industry and sectorial analysis, and probability weighted scenarios.
In our view, there is no "one-size-fits-all" approach when it comes to valuation. We would recommend using a primary approach crosschecked by a second one.
Ocorian AMEA offers a complete range of corporate finance advisory services, including business valuations, assistance in fund raising, M&A advisory and capital market transactions. We help our clients become investment-ready and grow their footprint by providing governance, financial and transaction advisory services. Our clients, across the Fintech spectrum, cover a wide range of solutions including money transfer, e-wallets, micro-finance, digital banking, micro-insurance, prepaid energy, energy micro-loans and digital banking platforms. Learn more about our AMEA offering here.
1. FinTechs in Sub-Saharan Africa: An overview of market developments and investment opportunities by EY
2. These valuation techniques are extensively covered by academia and valuation professionals, including Aswath Damoradan (a Professor of Finance at the Stern School of Business at New York University and widely recognised as an authority on valuation matters).
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