Middle East startup funding is overheating: It’s time to slow down

The economic response to the pandemic that caused shocks to supply chains and saw huge sums spent by governments to shore up their economies was always going to cause inflation changes in asset valuations. Unsurprisingly, this global reckoning has hit MENA’s comparatively young ecosystem of startups and founders hard. Quenched demand due to consumers spooked by rising living costs only increased the pressure.

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The data resembles a rollercoaster, reflecting market uncertainty and the ability of a few huge deals to create wide variations in investment totals. September 2022 had MENA startups raising $174 million, marking a 50 percent drop year-on-year. While August had seen a notable uptick in investment activity, July recorded the year’s lowest amount to date, with only $105 million raised by startups region-wide.

Just a year ago, the region’s startup sector was showing signs of overheating. While some young and unexperienced founders are now suffering the consequences of running unsustainable businesses – it cannot be ignored they had investors and venture capitalists who enabled all that growth (on paper, anyway).

While funding headlines abounded, successful exits were less widespread. Instead, there were cases of startups that – after reaching several hundred million dollars of valuation without any semblance of profit – would start their exercises in financial gymnastics – to legitimise the next financing round. Questionable VC funding decisions contributed to a founder culture too little concerned about long-term value creation. And that’s a big problem.

This is not simply, or primarily, a notion about morals or business culture or bringing value to consumers. An underappreciated downside of the current founder culture is – it does not financially reward founders, at least not permanently. Stellar valuations during the hype cycle are what might be seen as a sugar high.

We also must stop using the flawed comparison with everyone’s favourite growth stocks like Google, Amazon, or SpaceX. These companies – all of them trailblazing and amazing businesses – are not profitable because they choose not to be.

‘Planting’ potential profits into further growth to stay at the frontier of tech business, the value and viability of their business models has been proven beyond doubt. Once these companies decide it is time to leave the growth path and give money back to their shareholders, their incredible valuations will reliably convert into massive dividends. The MENA tech company which convincingly could make a similar case using this business model has yet to be founded.

Region’s startup ecosystem

MENA’s tech and startup ecosystem today is more sober, compared to the feverish market environment as recent as the start of 2022 when the world was coming out of the pandemic. Throw in the cold shower of the Russian/Ukraine war starting late February – and the sanctions that followed it – and the blast of uncertainty has resulted in public and private markets being nowhere near record valuations. Persistently elevated inflation has raised cost of capital around the globe and fears of recession are looming large.

Contrary to becoming alarmed by what we are seeing I’d like to advance a daring but optimistic prognosis: what we are witnessing is the regeneration of the region’s startup ecosystem.

Sure, there will be many down rounds, with disappointed founders, desperate VCs, and disenchanted investors. Certainly, MENA entrepreneurs will go through their fair share of bankruptcy filings, painful lay-offs, and ambitious business dreams vaporised – like so many in other global markets.

But – the one big learning investors, VCs, and founders will share is – profit must be front and centre.

MENA’s startup culture

A healthy founding culture for the MENA region would be a prize well worth the current pain. A sustainable approach could look like this:

• Founders should present a clear path towards profitability, or at least self-sustainability, to investors early on. VCs need to be vigilant to make sure this requirement is met for all their investments.
• Revenue goals must be reached with a reasonable amount of funding, instead of relying on the next round when the last one has been burned through. Commercially viable products should be outlined clearly at this point, and break-even become visible at the horizon.
• If entrepreneurs and VCs can identify excess growth potential after having hit these milestones, additional or increased funding can be justified.

This sounds arduous and less exciting, and indeed it is.

Voices arguing for a less profit-focused approach by championing innovation are, however, deceptive. In fact the opposite is true – MENA’s startup culture over recent years has skewed incentives by elevating compelling narratives over practical application, and hype around buzzwords over genuine progress. Such a culture stifles innovation, and will fail to adequately reward its innovators. Hence the correction at a time when markets are nervous.

The current collapse, at least in the Middle East, is more a re-evaluation than a recession caused by fundamental problems within the economy. If it changes the Middle East’s startup culture, it might just be the wakeup call we needed.