A heated debate is currently circulating in Egypt about startups following the concern caused by Capitr, and earlier Swvl (a mass transit solution which decided to reduce some of its operations in Egypt). This led some social media users to liken them to illegal investment firms or individuals who are labeled as “Al-Mestrayahin”, or hustlers. However, this is far from the truth of the startups market, startups being the number one reason for world innovation. So, how can we understand what is happening in the startups market? What is their working mechanism, from emergence to growth?
The Beginning of the Journey
The company goes through stages of growth, starting by an idea and conducting market survey studies, until the establishment of the legal form of the company. This is followed by obtaining an initial investment to produce the experimental product and have it tested before it is launched to customers for use, then the continuous development of the company’s business model in line with the customer needs. Most startups start in centers called business incubators or accelerators, providing knowledge on how to manage companies, the legal basics needed to establish companies, and the best legal form to help those companies expand. This stage usually takes 3 to 6 months, in which startups owners receive enough information. There are several business incubators in Egypt, some of which specialize in specific sectors, while others support most sectors.
By graduating from the business incubator/ accelerator, the company founder would have obtained the necessary administrative, financial and legal knowledge to manage their company. They receive financing that may range from $50,000 to $150,000 without specifying an ownership share in the company (customary in the Egyptian market), as a contribution from the business incubator/ accelerator to the growth of the company. The company then begins to work with this fund by introducing a product in the market, and improving it with the aim of attracting new customers and increasing sales. In most cases, the company is not able to make profit at this stage of its lifetime. The focus of the company’s founders, (who are themselves the owners and managers) would be on increasing customer base and introducing new products that contribute to creating added value for the customer.
Within a period of 6 months or a year depending on the company’s ability to grow, the company begins to look for funding. Funding can be divided into several types:
- Seed Financing, this includes the funding obtained through the business incubator
- Early stage or Early Financing, includes funds called Series A & B, a label related to the order of financing obtained by the company for the purpose of classifying the company’s life stage the seed, early or last
- Late-Stage Fund or Serious D, immediately before the public offering. By then, the company would be able to make profits or it may be still growing and accumulating losses.
A number of main features are connected with investments in startups. The first of these is the fact that globally 90 percent of startups fail, an inherent fact associated with this type of investment. Therefore, these are mostly investment fund for startups (called venture capital investment funds) or investors with high potential (called high net worth investors). In the investment market, they are called qualified investors based on the fact that investors need to be familiar with investment tools for these startups, and aware of the high risk their money is exposed to.
The business models of most companies focus on attracting the largest customer base. To this end, all methods are available, even if services and goods are sold at a below-cost-price called cash burning. Usually, the company’s marketing, administrative and operating costs are greater than the revenues generated. In this case, the company depends on its continuation on financing from investors who trust the company management and expect it can reach the break-even point soon. Break-even is the point where the company’s costs and revenues are equal (even) to reach zero profitability. In most cases it is pledged within 3 to 5 years. To this avail, companies continue to raise funds and significantly increase their market value which may reach $500 million or $1 billion without achieving any profit.
The Corona year has had a significant impact on increase in innovation in the field of technology, which led to the boom in startups market. As a part of the global market, Egypt has witnessed great activity in the startup market. The total venture capital pumped into startups in 2021 amounted to $491 million through 147 investment transactions (funding round), a 20 percent rise compared to the previous year. According to data, Egypt achieved a compound annual growth rate for the fourth consecutive year by 117 percent during the period 2017-2021.
This placed Egypt second among Middle East countries in terms of the most investments attractive in the startup industry, with Egypt attracting 147 deals. It is interesting that the Egypt’s annual growth rate reached 26 percent, which is higher than the annual growth rate in the UAE, coming in first.
There is a hypothesis that the more capital allocated to a particular industry, the greater the probability of an economic bubble and then a collapse. Some claim that what happened in the past two years was a bubble in the global startup industry, causing it to explode. However, this cannot be the picture in a country like Egypt where the startup industry is still crawling and at the beginning of its growth phase, in contrast to this globally booming industry for more than two decades. Comparing the prices of startups operating in Egypt to their global counterparts, Egyptian companies are of low value, so what happened?
This takes us to the second hypothesis, the self-fulfilling prophecy, based on the global economic crisis due to the Russo-Ukrainian conflict, the rise in global inflation levels followed by the global central banks raising interest rates. All these imposed a belief that business has become more difficult at the moment due to difficulty in obtaining funding. Despite the short period since the Russo-Ukrainian war and the US Federal Reserve’s raise of interest rate (in September 2022), it cannot be assumed that funds allocated to this industry have depleted or ended. Hence, funds allocated in Egypt are still available, but investors’ fear of the general state of investment globally or the high probability of failure, prevent them from investing in startups, resulting in the difficulty of obtaining funds in their funding rounds. Since these companies do not prefer to enter into funding rounds on valuations lower than values previously raised (down round valuation) for several reasons including the disagreement of the current company investors to decrease the values of their contribution (equity dilution), some of these companies have resorted to postponing their funding rounds or alternative financing through bank loans (also called venture debt), given that debt financing basically requires the ability of these companies to provide cash flows from productive processes. Within the current context and their vast spending on growth (cash burning), companies do not generate cash from their operations. Loans were based on the premise that the venture capital market will return, and the capital will be pumped into future financing rounds to repay debts.
Yet, some companies could not wait until the future financing round. Because of lenders’ demands to pay debts, part of which may have been obtained personally or at the company level, the company fails to pay. It starts to shut down and lay off employees to reduce costs, and eventually fails.
Globally, this is the scenario in most markets, and the most likely that happened in the Egyptian market: only miscalculations in the company’s business plan, mismanagement, and inaccuracies related to the company’s financing operations, ending in its failure. Therefore, it is not related to any fraud or theft of investors’ funds. It is worth noting that most startups operate in Egypt in accordance with Egyptian laws, where the company is registered at the General Authority of Investment and Free Zones (GAFI), legally established, draft its basic system, and form its various boards which meet governmental standards, such as the board of directors, the advisory committee, the audit committee, and the incentive committee. Companies’ owners are young well-educated entrepreneurs, with market experience whether in other emerging markets or large companies operating in the same field.
In summary, startups totally differ from illegal investment firms. Startups are legal legitimate entities with licenses to conduct their businesses legally, attracting domestic or foreign investments through legal channels, with the rules of good governance (concerned with defining responsibilities and separation of powers in the company) applied. Local and global market conditions and investors fear to inject more money in risky startups under the current situation which offers high interest on fixed investment tools (government bonds) pushes fund toward choosing the safest alternative, which entails the collapse and failure of some startups, due to the lack of flexibility and ability to survive in the market during such crisis.