In the second part of our series examining Africa's Fintech landscape, Novan Maharahaje, Director of the Corporate Finance Advisory division of Ocorian AMEA explains how entrepreneurs and investors can overcome the valuation challenge of early deals to bring the fundraising stage to a successful completion.
In our first article, we covered the challenges faced by promoters and investors in valuing fintechs during the investment process. This article will examine the practical side of fundraising and what could make or break a deal. In particular, we focus on the often underrated importance of non-financial factors, especially in early stage valuations, before weighing the advantages of adequate transaction structuring.
Despite the growing number of early stage investors and venture capitalists prospecting the sub-Saharan region for deals, it is a known fact that fintechs with little or no revenue face dim prospects to raise finance successfully. Divergence about valuation is often cited as one of the reasons why deals fail at this stage. Nonetheless, we believe that valuation should not be a hurdle to the fundraising process.
We have witnessed many funds overcome this first hurdle mainly by: (i) considering several non-financial factors, including potential impact, and (ii) by way of flexible transaction structuring.
Non-financial aspects are gaining in importance
Given their increasing commitment towards responsible investments, many investors are now looking beyond financial returns to consider the positive environmental and social outcomes of their investments. A survey by United Nations-supported Principles for Responsible Investment (2018 Private Equity Snapshot) demonstrates the impact of Environmental, Social, Governance (ESG) factors on the investment selection process. Namely, this is in terms of identifying risks, selecting opportunities for value creation or ruling out potential investments. The snapshot also reports that ESG considerations have a bearing on current pricing offered or paid, as well as being covered in the post-investment action plan and in the shareholders' agreement.
The ESG impact potential of the investees is thus a key consideration for early stage investors. Many fintechs have multi-faceted impact potential, with some addressing as much as half of the 17 Sustainable Development Goals (SDGs). We have seen that those fintechs that prioritise impact and approach it holistically stand a better chance of attracting interest from potential investors.
Other non-financial factors often considered by early stage investors include:
- Quality of management team and their track record
- Product market fit
- Scalability potential
- Early traction gained (e.g. number of sign-ups, volume of transactions)
- Market failure and opportunity, plus proof of concept
- Experience in capital raising (whether in-house or with external advisors)
It is worth mentioning that the above should not overshadow the paramount need for a sound business model. This needs to be fuelled by well-thought growth strategies, interesting total investor return (financial, non-financial) and exit strategies. In theory, these considerations would be reflected in the valuation method used, including the discounted cash flow approach.
Adequate transaction structuring will ease the deal
The other aspect that could ease investment flows is adequate transaction structuring. Given the valuation expectation gap, whereby founders would want a premium (to account for market disruptiveness) and investors would prefer a discount (to account for investment risk), the transaction structure can make or break an investment opportunity.
We are now seeing the increasing use of hybrid instruments in fintech transactions. These include convertible debt with equity kickers, convertible notes with valuation floors and caps, and use of discount on future fund raising rounds.
Transaction structuring allows a deal to go through, even if the parties do not agree on initial pricing on entrance. Whilst this may be seen as only delaying the problem, in our view there will probably be more financial information and visibility about future strategies in subsequent investment rounds to back the valuations.
It is comforting that two methods are available to help overcome the barrier of fundraising for start-ups, whether in Fintech or other industries. They are equally fit for the African market, especially with impact taking centre stage.
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