This is part 2 of our piece on early stage funding.Part 1explained how and why early stage funding has been changing over the last decade. We now move on to what these trends mean for Pakistani tech founders and then give our take on what will happen as we enter a new economic cycle.

How should Pakistani startups interpret all this? For pre-revenue Pakistani startups, the old 2010 Seed is still more relevant, because Seed investors investing large amounts these days expect the startup to have a solid working product and customer validation through revenue from the product. It is important to differentiate this from non-product revenue, such as from consulting, which can be useful for keeping the startup afloat but is more or less useless from an investor’s perspective. So early stage Pakistani startups looking to raise from the Valley will be better off initially raising a few hundred thousand dollars from angel investors. Another great path to penetrating the Valley’s investor and mentor network is through accelerators.

It is also important to understand that Pakistani startups should not realistically expect the same kinds of large valuations as Silicon Valley based startups. Valuations in the Valley are generally much higher than in other ecosystems, because investors have a higher risk tolerance and, linked with that, because it’s the world’s pre-eminent tech ecosystem where startups can benefit immensely from the closely knit network of investors, domain experts, advisors and early adopters. Moreover, if the founders are graduates of well-known local universities such as Stanford, investors are more comfortable investing in the startups and that also adds a few hundred thousand to the valuation. The idea is similar to the Berkus Method of startup valuation, where a value is assigned to each major element of risk faced by the startup, such as $300k if the idea is sound, plus another $500k if the prototype is ready, and so on.

What about the impact of the coronavirus?

After a prolonged period of unprecedented growth, trends are now expected to reverse as the VC market enters what Wing VC calls a freefall phase. In the short run, investor sentiment will fall and valuations will decrease significantly, as will the number of deals. We also believe, in contrast to the Wing VC study, that those VCs who have raised funding will invest in larger, later stage rounds to reduce risk, so median investment size will go up instead of down. In the medium term, VCs will find it harder to raise from LPs, so overall funding will decrease, but, we believe this bear market will not last as long as it has been suggested and the picture won’t be as gloomy for startups as the one being painted. Here is why.

The success (or failure) of tech startups in general depends a lot on the qualities of the founders and less so on market conditions. Resourceful and gritty founders will find a way to succeed in a bad economy, and bad founders will fail even in the best of times. Consider that Microsoft, Apple and Airbnb were all founded during recessions. Business is surely more difficult during downturns, but that also means that there is less competition as only the most tenacious startups make it through. Furthermore, startups may also capture customers away from large corporations during recessions, because a) they can afford to offer cheaper products that are attractive during tougher times, and b) they are leaner and can respond to changing customer needs more swiftly.

W. Chan Kim and Renee Mauborgne, authors of the iconic Blue Ocean Strategy, talk about achieving growth through downturns in anHBR article. “…when the economy is in a downturn, there is a natural flight to value for money…People become far more selective about the products and services they choose to buy and those they stop purchasing. Those forgone products and services tend to offer incremental value, while the chosen ones offer a leap in value, or the largest consumer surplus, that makes people’s lives better. Under these conditions, market-creating moves — which break away from existing offerings and offer buyers a leap in consumer surplus — fast become the products and services of choice.”

It is usually startups that come up with these “market-creating moves” that offer a leap in value, as they are closest to the pulse of the customers. We have seen this already during covid-19, where startups have been responding to a surge in demand for solutions in various verticals, such as WFH and workplace management, video conferencing, productivity, social media, remote learning and edtech, video streaming etc.

Finally, what’s different from past market cycles this time is that tech demand is in secular growth and startup formation is a reaction to this secular demand, whereas during previous downturns tech demand was experiencing cyclical growth. Tech has now taken a quantum leap and is more than just a competitive tool. Global technology adoption is reaching an inflection point. Enterprises are at a turning point where technology is no longer being adopted in silos, but is becoming a prereq for entering the arena. It is used by enterprises in every stage of their value chains to serve their customers better. In short, all businesses are becoming tech businesses. So early stage funding will experience a downturn in the short run, but strong, secular tech demand pulled by the ubiquity of tech will help it rebound sooner than expected by most.

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