This article first appeared in Digital Edge, The Edge Malaysia Weekly on February 12, 2024 – February 18, 2024
Welcome to 2024. The last few years, since Covid-19 emerged, have been challenging in many ways, especially for start-ups and the venture capital industry.
The funding winter for start-ups, as venture capitalists (VCs) held back from investing due to the many uncertainties in the market, led to a significant drop in start-up funding and valuations, causing many companies to cut costs as fundraising became a lot harder.
Some even suffered from down rounds, where they raised funding at much lower valuations than earlier rounds, which means they had to give up more equity interest to investors. Others were forced to close as they couldn’t raise funding or did not have a strong business proposition. The failure rate for start-ups in Malaysia was about 16.7%, according to TechInAsia in November last year.
This downturn has changed investor perspectives. Hence, start-up founders need a mindset change to succeed over the next few years.
Start-up growth and funding narrative
I have been involved in the technology ecosystem for 25 years and have made 16 personal investments as an angel investor and another 36 via ScaleUp Accelerator. After 52 investments, I have learnt a lot about start-up investing and its challenges. But equally important, I have come to realise that the start-up growth, funding and exit narrative needs a major overhaul.
In the 30 years or so since Malaysia created the Multimedia Super Corridor and jump-started the start-up ecosystem here, we have adopted the Silicon Valley start-up narrative as the de facto model, not just in Malaysia but also in Asia. This narrative expounds that founders need to raise a lot of money, for as long as they can over multiple rounds, to keep growing revenue even if it means running up high losses until the revenue and the company are large enough to be sold in a trade sale.
By the time this happens, the investors would own the majority stake and the founders would have a small equity interest. But this is because the valuation is super high and the small stake is still worth a lot more than if they had built the business slowly.
This is not necessarily true, but this forces the CEO to be the chief fundraising officer as he or she is continually engaging with investors for the next round of funding, and the next, and is not really focused on building the business. As the funds raised are used for revenue growth and almost always results in losses, the funds run out within 12 to 24 months. So, the CEO is constantly in fundraising mode.
As the model is based on revenue growth — often two to three times annual growth — very few start-ups get to a profitable stage, hence the main viable exit is through a trade sale to a larger entity.
While this model works in the US, where there are many large multibillion- or even trillion-dollar companies that become acquirers, this is not the case in Asia. It is even less so in Malaysia. None of the large companies, whether public-listed or government-linked, ever acquires start-ups. And the number of those that do is quite dismal — I can’t even name 10. But even when they do, the prices they pay are also dismal, not even amounting to US$10 million (RM47.3 million). While there are exceptions to the rule, they are few and far between.
A valuation of US$10 million or less means investors can’t make money. Poor exits and low valuations make the Silicon Valley start-up narrative a non-starter in Malaysia and Southeast Asia, yet many investors still blindly follow this narrative, pumping cash into start-ups and forcing them to grow revenue rapidly in the hope that they can find a buyer for their investee. Start-up founders follow along, but the moment the cash stops flowing in, everything grinds to a halt and the start-up suffers, leading to retrenchments, slower growth and sometimes closure if it runs out of money.
Another aspect of this formula is that founders don’t have a long-term plan for the start-up. They buy into the idea that they need to raise money, push revenue growth and finally sell the entire business to a third party and exit with a big pay cheque. This is essentially a build and flip model, which means founders are not building a meaningful, long-term, multigenerational business that can sustain itself and be highly profitable for generations. They are only focused on building a business for an exit in a trade sale.
If they are lucky enough to get a trade sale, then they make some money. But if they don’t sell for a high price, they won’t make a lot of money and they may have spent 10 years building a business that has no future over the long term. This is 10 years of their life lost. We can’t really blame founders or even VCs as this is the Silicon Valley start-up narrative that has been conditioned into our psyche.
This narrative works in Silicon Valley as start-ups get acquired for tens or hundreds of millions or get listed for a billion dollars, but it doesn’t work in Malaysia and Southeast Asia. We need a new narrative for this region.
A new narrative for Malaysian start-ups
Since the current narrative does not work in the region, we need a new one that is based on a longer-term perspective, both from the founders’ and investors’ mindsets as well as a change in attitudes about start-up growth and fundraising.
Here are five proposals that we should consider in crafting a new start-up narrative for Malaysia and Southeast Asia.
1. Build an enduring business
The build and flip model has to change. Founders need to start thinking about building an enduring, multigenerational business. This is how conventional Malaysian businesses have been built over the last 50 years and even the most successful tech companies in the world, like Microsoft, Google, Meta and Amazon, are built as enduring businesses. This requires a change from the build and flip mindset to a “build to last a lifetime”. Founders who do this are more purposeful, have a strong mission based outlook and will build successful businesses.
2. Change the growth model
Change the financial model from being purely revenue-driven to being profit-driven. Yes, founders still need to grow revenue, but they need a better financial model that will provide strong gross margins over a three- to five-year period and solid net profit margins as well. They need to focus on fulfilling customer needs, and as long as they build something customers are willing to pay for, they can build a solid financial foundation to drive profits. The “high revenue growth, with huge losses in the hope of finding a buyer” model needs to be discarded in favour of building a profitable, cash generative model.
3. Limit the amount raised
Too much money is bad for business and for the psyche of founders. Some companies have raised more than US$200 million and to me, this is a ridiculous amount to raise in this part of the world. This is equivalent to almost RM1 billion and other than building large manufacturing plants, I don’t think start-ups can really use RM1 billion, unless they spend it indiscriminately, hire too many people they don’t need and pay too much for them, or that founders take huge salaries that spoil them and make them lose their hunger for building a successful business.
There are so many cases of founders raising large chunks of money and hiring too many expensive people, only to sack them when fundraising dries up. I even know of start-ups that have delivered even more revenue and become more productive after sacking 30% of their staff. This clearly shows that too much money is bad for founders.
Another thing about raising too much money is that the ownership of both founders and earlier investors get diluted too much. It is therefore common that founders will only own a minority stake in their business by the time they get to the Series B or C funding round and early investors get diluted to a single-digit percentage in shareholding.
A high dilution rate means everyone makes less in an exit. With low dilution, even a small exit can give founders and investors a big return, whereas if a start-up raises up to, say Series D or E, even a big exit can provide a small return. As an example, if founders own 50% of a business, to get a US$50 million return, they will need a US$100 million exit. If they own only 5% of the business, they will need a US$1 billion exit to make the same amount. A US$100 million exit is already tough, a billion dollar exit is a very slim prospect.
4. Spend time on the business, not fundraising
The current multiple rounds of fundraising model forces the CEO to be constantly talking to investors, pitching for funds and worrying about whether they can raise enough money to keep the start-up afloat and be able to pay salaries. Is this what the CEO should be doing or should the CEO actually be running the operation to grow a successful and profitable business?
I have engaged, trained and coached almost 3,000 founders in 25 years and I can say without a doubt that they prefer to build their business rather than raise funds, but they are caught in this vicious cycle that they can’t break out of. If we change the narrative, they will be happier founders and we will see more successful start-ups.
5. For enduring businesses, an IPO is a better ‘exit’
Almost all investors will tell you that their preferred exit is a trade sale or merger and acquisition (M&A). This is because of the current Silicon Valley start-up narrative, but such exits are a rarity in Southeast Asia. Despite this, every investor is focused on M&A as an exit. Having invested in 52 deals over almost 15 years, I am highly sceptical of this model. Being in Malaysia makes this 10 times as hard.
Also, if we change the narrative to build an enduring company, then an M&A is not the ideal exit, an initial public offering (IPO) is. With an IPO, investors will get a good exit and founders can cash out some of their equity interest, but they still control the company and can continue to build an enduring business that lasts a lifetime.
An IPO is not an “exit” for founders as they are not selling all their shares and exiting the business. An IPO is merely the next part of their journey in building an enduring business. Investors, however, can sell their shares and exit the business with a very good return.
Many investors think that an IPO is very difficult but I believe an M&A is actually harder. The big question is not whether the start-up can IPO, the big question is whether it can become profitable enough for an IPO. The old narrative of revenue growth at all costs is the reason why most cannot exit via an IPO. The new narrative of building an enduring and profitable start-up lends itself easily to an IPO. So this is not difficult, but it will require a mindset change among founders and investors.
Having worked with and invested in many companies, I believe it is time for Malaysia to create a new start-up narrative. I will shamelessly call this “Doc Siva’s New Start-up Narrative” to build a purposeful, enduring and profitable start-up. As we start a new year, I hope this resonates with you and I am hopeful that we will see many more successful and enduring Malaysian start-ups in the years to come.
Dr Sivapalan Vivekarajah is co-founder and senior partner at Scaleup Malaysia Accelerator (scaleup.my) and adjunct professor at Sunway University’s School of Science and Technology. He is also the author of Supercharge Your Startup Valuation.
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