STARTUP FUNDING 101: THE INVESTORS' GUIDE

Startup funding is an integral force driving the growth of startups in Africa’s growing tech ecosystem. Thus, understanding how investors assess opportunities and allocate funding is essential for every purposeful founder, looking to build out their startup into a viable business.?

To demystify this process, our very own Victoria Akingbemila teams up with Oluwatobiloba Onigbogi, a seasoned business analyst with deep experience in fintech and venture capital. Oluwatobiloba shares his expertise on evaluating startups, key considerations in investment decisions, the importance of strategic partnerships, and much more. Let’s dive in as they provide a detailed overview of how venture capitalists think and what startups need to know when seeking funding.

QUESTIONS AND ANSWERS?

A. What are the key factors you consider when evaluating a startup for investment?

Experienced founders are likely familiar with terms like “investment thesis” and “investment criteria” from venture capital investors, either through conversations or on their websites. An investment thesis outlines a firm’s vision, investment focus, and rationale for targeting specific sectors, markets, or growth stages. For instance, Accion Venture Lab focuses on for-profit enterprises offering innovative financial services to underserved populations. They look for companies that are post-R&D, have a full-time team, and ideally possess a pilot or prototype.

Investment criteria, on the other hand, are the specific metrics investors use to assess opportunities — Think of it like a spec. Equity investment is like a marriage: you approach it carefully, ensuring the person you’re committing to is a good fit. Different Venture Capital firms (VCs) have different metrics and their investment thesis plays a huge role in influencing them. One thing to keep in mind is that VCs will invest in you if they have a reason to believe that you will be a successful investment.?

For example, unlike other venture capitalists that concentrate on the quality of the founder, Sequoia Capital is more interested in the size of the market, preferring to gain a foothold in large markets before other players arrive. Techstars, on the other hand, is more concerned with the founders and the team when selecting startups for acceleration. The core question for them is: why are you and your founders the best people in the world to solve this problem??

Successful startups, whether they enter with zero revenue or millions, share a common trait: exceptional founders who are uniquely suited to address their market's needs. I would share a comprehensive set of metrics that founders can keep in mind during their fundraising process.?

1. Team: The question on an investor’s mind is - Why are these founders the best team to solve this problem and build this company? Proven individual and combined expertise and experience of the founders are relevant in answering this. Two extra points if you are a two time founder whether your previous startup failed or succeeded. Other important factors will be the team dynamics, how the co-ownership of the company is evenly distributed among the founders, significant history of the founders and gender equity.?
2. TAM: Yes! The Total Addressable Market is an important factor to Investors especially VCs. They think of it like this —? a? larger market size means more potential returns. Knowing your market size helps you determine your total market volume and revenue potential while projecting your growth at different stages of building. To get it right, you need to identify your target market within the larger opportunity, perform a competitive analysis, and use data to estimate your potential market share. It's also crucial to understand the market demand, your product’s Unique Value Proposition, and how your startup aligns with both current and emerging trends.
3. Business Model: A startup should be able demonstrate a clear path to making profit. Picking a company to invest in based on its financial health varies by the stage. It’s critical to see a well balanced revenue composition which comprises efficient cost structures, steady cash flow and good profit margins. To understand a startup’s business model, VCs analyze unit economics, breaking down revenue and costs into small, measurable parts to check the startup’s financial stability. They also review the balance sheet (assets vs. liabilities), income statement (profitability), and cash flow statement (cash generation for growth). Financial forecasts are examined to see if they are realistic and if it aligns with market trends.?
4. Traction: I would invest in a company if I saw evidence of consistent progress over a period of time. This is a form of validation. Revenue growth, User acquisition and retention, strategic partnership, product engagement, and market share are metrics that can be used to measure progress and determine a startup gaining traction.?
5. Timing: Nothing is greater than an idea whose time has come. There are certain products that are a mismatch for the market due to a number of reasons. It could either be because of poor infrastructure, lack of regulatory structure, cultural misfit or economic reasons. It’s important to be able to assess whether the startup is entering the market at the right time.
6. Market Defensibility (Trenches): A competitive advantage and sustainable edge are two elements of this metric. Investors need the confidence that a company can safeguard its market share. Intellectual property, a strong brand, unique technology, exclusive deals and with key partners, high switching costs for customers and a high entry barrier for new competitors are ways to prove that a company has market defensibility.
7. Tech (Product): You must have wondered why VCs invest in tech enabled companies. The plain reason is because it has high growth potential. Unlike traditional businesses, tech startups can quickly scale to serve a large audience with low costs and high returns. When assessing a startup’s tech, factors like implementation cost, scalability, viability, and compatibility with existing platforms are key considerations.

B. How do you determine the appropriate valuation for a startup?

In truth, determining the appropriate valuation for a startup is both an art and science.? Initially, it might feel like pulling a number "out of thin air" (POOTA), as I discovered during a VC fellowship. However, the process is much more complex. Angel investors and VCs often use a mix of formulas blending quantitative metrics with qualitative judgments to determine pre-money valuation. For startups with revenue, the valuation is more straightforward using actual figures. Without revenue, projections and the prevailing market conditions, drive the valuation.?

Startups have to be assessed on the basis of many factors like the team, product, assets, business model, size of the total addressable market, competitors’ performance & market opportunity. Goodwill and intangible assets are also in the picture.

Investors have, in practice, used different methods in valuing a startup varying from Discounted Cash Flow (DCF) Analysis, Comparable Company Analysis (Comps), Precedent Transactions, Venture Capital Method, Book to Value Method, Berkus Method, Cost to Duplicate Method, Risk Factor Summation Method etc.?

One of the most common is the Comparative Company Analysis (Comps) Method. This method compares the startup with similar companies that have attracted funding or been acquired recently. Investors use these comparable companies to estimate the target startup’s value based on metrics like user base or revenue multiples. For instance, if a similar startup was valued at $500 million when it had 10,000 active users, this would assist to set the valuation standards of the given startup.

Once the comparables are determined, VCs gather key financial metrics such as revenue, EBITDA (earnings before interest, taxes, depreciation, and amortization), and market capitalization. They then proceed to calculate valuation multiples, including Price-to-Earnings (P/E) ratios and Enterprise Value-to-Revenue (EV/Revenue) ratios.

These multiples are then applied to the startup’s financial metrics to estimate its value. Analysts may adjust for differences between the startup and its comparables, such as growth potential or current market conditions. Ultimately, the comparables method offers a market-driven perspective on valuation, often used alongside other methods for a more comprehensive assessment of a startup’s worth.

C. What are the common stages of startup funding, and how do they differ?

The stages that startups go through in funding include, pre-seed funding, seed funding, series A,B,C, and eventually, an Initial Public Offering (IPO). Below is a step by step discussion of each? stage:?

1. Pre-seed funding stage: This is the earliest stage of investment for startups. It involves raising capital to kick-start operations and transform an idea into a viable business. At this stage, investors are betting on the founders, their idea, and the potential of that idea to grow into a profitable business. Pre-seed funding typically comes from personal savings, family and friends, crowdfunding, grants and hackathons, or angel investors. This capital is generally used for refining the business idea and developing a prototype or minimum viable product (MVP), hiring initial team members, and covering operational cost of running the business.?
2. Seed Funding: At this stage, the startup has gained some traction and can demonstrate a market need for its product. Investors at this stage are interested in the product’s viability and the business strategy for generating revenue. To attract investors, startups typically prepare a pitch deck communicating the startup’s goals, traction, milestones and financial projections. Usual investors at this stage include angel investors, venture capital firms, and accelerators or incubators.?
3. Series A,B,C funding : Each round serves a specific business need and involves different capital and expectations.?

Series A funding is focused on scaling the business model that was validated during the seed stage, refining the product or service based on customer feedback gathered using the MVP and expanding the team to include more skilled areas like sales, marketing, and product management.?

Series B funding is used to scale the business into new markets, increase brand recognition, optimize business processes and procure improved technological infrastructure to improve operations. Investors at this stage expect consistent revenue growth, a clear path to profitability, and evidence of competitive advantage.

Series C funding is typically aimed at expanding into global markets and broadening the customer base. The startup might develop new products and consider strategic acquisitions. Investors expect from the startup, substantial revenue and profitability, along with established market dominance.

4. Initial Public Offering (IPO): An IPO is a significant milestone as the startup transitions from a privately held company, to a publicly traded one. This involves offering shares to the public by listing on a stock exchange. At this stage, the investing public becomes the primary investor, choosing to invest based on the company's financial growth, strength, and future prospects. The purpose of an IPO is to raise capital to fund business expansion, invest in new projects and technologies, make acquisitions, enhance visibility, amongst others.?

Each funding stage represents a critical step in the growth and development of a startup, with its own unique challenges and opportunities.

D. What advice do you have for startups seeking their first round of funding?

Securing the first round of funding is crucial in every building process. Thus, it requires careful preparation, strategic planning and leveraging strategic partnerships. Here is invaluable advice for startups seeking their first round of funding:?

1. Understand your business model: It is important to clearly define what distinguishes your product from competitors and why customers would choose it over others. Define your unique selling point always. You must also have a clear understanding of your startup’s target customers, their pain points, and how your product addresses those pain points.?
2. Create a compelling pitch deck: Use your pitch deck to tell a compelling story about your startup’s journey, vision, and the problem you aim to solve. Ensure the pitch deck is concise, visually appealing, and contains key information to convince potential investors. Additionally, highlight key milestones you have achieved and plan to achieve and show traction through metrics that show early customer adoption.
3. Build a strong team: At the early stage, investor’s are primarily betting on the team's potential to build a successful product. Thus, invest in the expertise and depth of your team, ensuring that they have synergy and are committed to the startup’s success.?
4. Research Potential Investors: This helps you identify potential investors who are interested or have an expansive portfolio in your industry. Assess how these investors choose startups, their investment temperament, and the criteria they look for, so you can align your pitch with their interests.
5. Leverage Networks: Networking makes the process of building a business easier. Attend industry events and workshops to connect with potential investors. On the other hand, build relationships with mentors, advisors and other entrepreneurs who can make investor introductions, or provide insights on building a business.?
6. Breathe: Fundraising is a lot of work. You will have conversations with tons of investors who will have several stages. Don’t be under pressure if you don’t get immediate results. Fundraising takes time, and rejection is part of the process. Stay persistent and learn from each conversation. Take care of yourself during this period, and celebrate small wins along the way.

E. How do you assess the risks associated with investing in a startup?

Venture capital is famously high-risk, primarily because many startups fail. Investors face challenges such as high failure rates, limited transparency, restricted liquidity, market volatility, heavy reliance on a few key personnel, ownership dilution, tricky valuations, and regulatory hurdles. To manage these risks, they diversify their portfolios, conduct thorough due diligence, spread investments across different stages, set clear exit strategies, and actively engage with startups.?

Due diligence is a crucial part of the investment process. It involves scrutinizing all important aspects of an investment opportunity, which in this case is the startup, evaluating it against certain criteria and risk threshold and making informed decisions. The stages are traditionally divided into operations and business, financial, and legal due diligence.

Operational and Business Due Diligence: This phase assesses the startup's viability, by examining the startup’s team, market potential, business model, and service offering. This stage identifies risks such as market risk (where the TAM is not large enough or profitable), competitive risk (if competitors are likely to out-compete the startup or provide entry barriers), technology risk (if the technology fails), management risk (competence of the management team in effectively leading the startup to achieve its goals), and operational risks (the efficiency of the company).

Financial Due Diligence: Investors review the startup’s financial health by reviewing its financial statements, cash flow reports, and profitability metrics to gauge liquidity and sustainability. They also assess debt levels to detect potential financial instability. High debt relative to equity can be a red flag, signaling potential cash flow issues and financial instability.

Legal Due Diligence: This involves verifying compliance with regulations, examining contractual obligations, ownership structures, intellectual property rights, and potential litigation to ensure the company's investment viability.

F. What role do strategic partnerships play in your investment decisions?

Strategic partnership plays an important role in investment decisions for both the startups and the investors. They offer significant advantages to the startup’s growth, technological advancement, and even access to new markets.

By leveraging partnerships, a startup can access new geographical markets in other countries, engage in technology and expertise sharing, allowing the startup to leverage the technology of another company, and reduce the time to market entry, thereby saving cost. Partnerships also help distribute the risks associated with new ventures, increasing the likelihood of success.?

Strategic partnerships serve as a positive indicator of a startup’s potential, suggesting a level of validation. They can also pave the way for successful exit strategies, such as mergers and acquisitions, which can be attractive to investors.?

H. How important is the management team in your investment decision-making process?

The management team is as important as the startup’s financials. The competence of the management team influences to a considerable extent, whether or not the startup will succeed. This is because they set the strategic direction of the startup, defining its goals and how to achieve them, and make the core decisions. This is why, especially in early-stage funding, investors are critical of the management team.?

Against this backdrop, the management team must possess the expertise to build a product in the designated industry, as this expertise is invaluable in identifying market dynamics, providing product insight and tackling challenges. The relationship within the management teams is also important, as investors value teams that work well together; effective collaboration can lead to better problem-solving and innovation. The diversity of the team’s skill set is also crucial, as building out a product requires different levels of competence.?

The track record of the management team could also be a key determinant. It provides confidence to investors that the team has succeeded or tried before, suggesting a likelihood of replicating that success in the new venture. The presence of these key factors — expertise, collaboration, diversity, and a strong track record — enhances the startup's potential for success and attractiveness to investors.

I. What trends are currently shaping the startup funding landscape and how do you foresee the future of startup funding evolving in the next few years?

Due to the recent cycle of startup failure based on basic, fundamental factors that could have been avoided, investors have become more thorough with their due diligence process. They have also decided to make the process continuous rather than happening only at the initial stage. This means that investors are getting much more involved in the startup than before. There has also been a shift towards investing in startups that have a clear path to profitability as well as a sustainable business model.?

There has also been an increased focus on sustainability with investors prioritizing startups who address (ESG) Environmental, Social, and Governance issues and how it is ingrained in their overall business model and value creation. Green tech, sustainable products, and companies with strong social impact missions are receiving more attention and funding with sustainable efforts getting extended support worth approximately $13.9B from worldwide investors according to reports.?

AI and Machine Learning (ML) have been major disruptors in recent times with their emergence leading to the creation of specialized venture capital funds targeting AI and ML startups. According to a 2023 PwC report, global AI startups attracted $57 billion in investment across various sectors. Leading the way is OpenAI, a tech and AI company in research and development, that has attracted substantial investment, including a $1 billion investment from Microsoft in 2019 and an additional $10 billion commitment in early 2023. These startups using AI & ML to offer solutions have gotten attention because of its scalability, market potential and disruptive nature.?

As the global startup ecosystem continues to grow, investors may increasingly look beyond traditional markets to identify high-potential opportunities in emerging economies. For example, investment in African startups has surged, with significant funding rounds in sectors like fintech, health tech, and e-commerce, with African tech startups raising over $3 billion in funding, in 2023, reflecting growing interest from both local and international investors.?

J. What are some red flags that might deter you from investing in a startup?

I personally would not invest in a founder with questionable character as well as fraudulent history. It’s a relatively small ecosystem and so I believe it’s important to guard your reputation especially because investment is based on trust and I have seen a number of deals that have been made based solely on trust. Quite frankly, the redflags have subtly been highlighted in the first answer while addressing startup evaluation. During the screening stage, startups usually that don’t meet up with the criteria mentioned honestly will give investors concern.?

Just to add, I would mention that other redflags are businesses with no market validation and no proof of concept. Reckless behaviour like having little knowledge or regard for industry regulations as well as no clear path to sustainability or profitability are also redflags. Other concerns are high burn rate, little appreciation for following due process, no clear business vision and funding or budget allocation.?

Like I earlier mentioned, paying attention to the startup investment metrics and sticking to them will further inform startups about the redflags that investors look out for.??

CONCLUSION

The path to securing funding can be daunting, especially for early-stage startups. However, understanding the key factors that drive investment decisions can make a significant difference. From evaluating the right metrics and building a strong team to aligning with market trends and fostering strategic partnerships, these considerations are crucial for success.

Ultimately, investors are looking for businesses that show potential for substantial growth and returns. As the tech ecosystem in Africa continues to evolve, mastering these principles will be vital for startups aiming to attract investment and scale globally.?

We are rooting for you to build big things!