The year 2023 has seen a further deepening of the venture capital (VC) funding crisis for African startups. While this downward trend started towards the end of 2022, fundraising in H1 2023 was 46% lower than the value during the same period in 2022. Given this troubling trend, startups across global tech ecosystems have felt the squeeze and have had to cease operations.
In Nigeria, for example, crypto and Web3 company, Lazerpay stopped operations earlier in the year when it failed to secure additional funding following a lead investor's withdrawal from an almost finalised seed round. Similarly, five-year-old Ghanaian-founded fintech startup, Dash also closed shop after struggling unsuccessfully to sustain its business, among other reasons.
These cases are particularly concerning as these startups had previously secured investor funding. This raises the need for a closer examination of the financial indicators that may predict a startup's impending failure.
Chioma Daniel, the Head of Finance at TalentQL, shares her expertise on the financial red flags for startups and offers guidance for those close to their fiscal breaking point. The conversation covers early signs of financial distress, strategies for achieving financial stability, and the role investors can play in survival.
Oluwanifemi Kolawole (OK): From your experience, what are the early signs that founders should be vigilant about when it comes to their startup's financial health?
Chioma Daniel (CD): Not having viable revenue streams with consistent income. When a huge part of your revenue is not actual cash collected but money tied up in receivables. Long receivable collection days. High cash burn on operating expenses. I have specifically mentioned operating expenses because if cash is spent on investments and expansion with returns on investments that are clear, then there wouldn’t be much to worry about; planning is key. Startups like to grow with speed but it is important to take only risks that are calculated. Count the costs and the returns before you move. Have working systems and processes in place. This is very significant and worth investing in.
OK: What financial metrics or KPIs should founders closely monitor to ensure they have a clear picture of their startup's financial sustainability?
CD: Important key metrics include:
- Revenue: Monthly Recurring Revenue (MRR) and Annual Run Rate (ARR). Founders should question whether revenue is steadily increasing and if there is regular income. They should also consider the impact of seasonality on their business model.
- Expenses and profit margins: It's crucial to understand the main areas of spending and the benefits derived from these expenses. Founders should explore ways to reduce costs to improve the bottom line.
- Net burn: The difference between revenue and expenses must be monitored to gauge financial health.
- Cash runway: How long can the company sustain itself with its current cash reserves?
- Customer Acquisition Costs (CAC): The customer acquisition cost should be weighed against the revenue they bring.
- Lifetime Value (LTV): The total value a customer brings during their relationship with the business.
- Assets: What assets do you have and what is the value? What are your plans to acquire more assets?
- Goodwill: In the event of an exit, what goodwill does a founder or the startup have? Goodwill is intangible assets that are not easily quantifiable but are very valuable. They include brand name, propriety technology, intellectual property, solid customer base, etc.
- Liabilities: The scale of liabilities compared to assets and plans for liability reduction. What are your liabilities and how huge are they? Can your assets cover them? Why do you have liabilities? How do you intend to reduce them?
- Time to break even: The duration until the business becomes profitable.
- Return on Investment (ROI): Monitoring the return on all investments is essential.
- Compliance: Early regulatory compliance can prevent costly mistakes and penalties. Many startups push this to a later date to their detriment. At the start, it may seem like an unnecessary cost considering that the focus is growth, but it is wise to begin the necessary regulatory compliance as early as possible to avoid mistakes, penalties, lawsuits, etc.
OK: Are there specific strategies or best practices that founders can employ to extend their startup's runway and increase their chances of success during financially challenging times?
Join over 3,000 founders and investors
CD: Having a viable revenue model that can bring in assured regular inflow is important. Subscription-based models are a popular one. It is important to draw up a budget such that recurring operating expenses do not significantly surpass the recurring revenue. Other spending should specifically be for investing in growth. While startups would typically burn cash on expansion and growth activities, it may be prudent to set aside a reserve fund that will only be used when there is no other source of cash.
There is also the option of going to the market to raise more cash, the success of which is dependent on other factors such as a viable business model, market conditions, important problems that the business seeks to solve, working technology, the right team, etc
OK: In your opinion, what role do investors and funding play in a startup's financial health, and when should founders consider seeking additional capital?
CD: Investors should act as trusted partners, not just funders. They should keep the founders accountable by requiring detailed financial reports from the early stages. Upon receiving such reports they should ask questions to get a better understanding of the business. To keep the founders in check and also prove that funders are genuinely interested in the business.
Funding helps businesses explore growth opportunities, but startups need to show track records and plans that are truly worth investing in to be eligible for additional capital.
With proper planning and regular business performance tracking, it will be clear when to seek additional capital. Preparations for fundraising can then start early. However, it is important to understand the market dynamics for fundraising at every stage or else, the startup could be frustrated and not raise the expected funds.
One of the main reasons a Startup can seek additional capital is when they have attained product-market fit, are in the growth stage and looking to scale. All funds raised should be invested in growth. Another reason is a short cash runway.
OK: Can you provide insights into the importance of a contingency plan for startups and how founders can prepare for potential financial setbacks?
CD: A contingency plan is useful in keeping the business running in the event of an interruption in the normal course of business. Some events are beyond human control so it makes business sense to be prepared to some extent. It is helpful for startups to be open about having a plan B.
- For every major activity or part of the business process, assess the risks and ask “What could go wrong?” If the risks are very likely to occur and have a high severity, then it may be helpful to reconsider the activities or create a response plan for the risks.
- Have different revenue streams and grow each of them.
- If your main product is B2C, find ways to expand to B2B and even B2G.
- With proper planning and by taking calculated risks, the likelihood of financial setbacks is reduced. Founders can prepare for potential financial setbacks by first of all acknowledging the truth about how they are performing financially. Founders need to take financial reports seriously and ask questions about areas that are unclear.