TAG(ged) at a $100mn valuation on merit? Not really 27

Pakistan’s fintech startup TAG has claimed to have raised $12 million in a seed round at a valuation of $100 million, international news media outlets announced recently. This is not some strange news for people following business and the startup space in Pakistan. These companies often get astronomical valuations in massive rounds raised. What is also not new news is that these valuations are often not very realistic, and even when they are, they are never exactly what they seem. The case of TAG is somewhere in the middle. Armed with a young and hungry founder who carries the reputation of being cutthroat when it comes to business and someone who knows how to get things done in Pakistan, TAG is a fintech startup gunning to become the first digital bank of Pakistan. For now, the startup is in the process of launching a mobile wallet through which users will be able to transfer funds, pay bills, receive payments, withdraw funds through ATMs and conduct POS transactions through debit cards. The startup also claims to have arrangements with corporations that will disburse salaries digitally into their employees’

TAG wallets. Just three months after its launch in 2020,

TAG secured an in-principle approval for the Electronic Money Institution (EMI) license to operate as a digital wallet from the State Bank of Pakistan (SBP) in November last year and was granted the approval for pilot this year in August. Similar to TAG are fintechs NayaPay and

SadaPay, also mobile wallets, and therefore competitors to TAG, also plan to provide funds transfers, bill payments and card transactions.

The unique proposition of all these wallets is that compared to banks, these wallets will have an enhanced digital experience for customers with considerably less fees. While SadaPay is also in the pilot phase, NayaPay has received a license for its commercial launch this month. Another fintech company, Finja, has also received the approval for commercial launch, making it one of the only two fintech startups which have the regulator’s approval for commercial launch. Finja is more focused on providing payroll management and credit services for professionals and MSMEs. While various media outlets have announced and the founders and investors have endorsed that TAG is valued at $100 million, the company’s valuation really is still undecided.

TAG’s recent seed funding round was led by New-

York-based Liberty City Ventures, while Canaan

Partners, Addition, Mantis and Banana Capital also participated in the round. Previous investors in the pre-seed round were Quiet Capital and

Fatima Gobi Ventures. As quoted in a media report, Polymath Digital doubled down in this round while Khwarizmi Ventures and the co-founder of Plaid William Hockey also participated.

The valuation confusion

According to investor communication published on AngelList, a revered online platform which connects investors with startups, the startup TAG had raised $10 million on SAFEs (simple agreement for future equity) at a valuation cap of $100 million, and was raising more at the same cap, but is construing the same as actual valuation. Before we move on to explain details about TAG’s seed round, we’ll try to explain what a valuation is and how it is not the same as a valuation

cap.

Valuation is simply the actual worth of the business quantified, which is why some startups not only in Pakistan but across the world have exhibited tendencies to exaggerate their valuations, that is the actual worth of their business. Because these startups, mostly early stage, do not have a certain net income, of course then, exaggerating the worth helps them appear stronger, gain traction, attract talent, evoke investor and media interest (not necessarily positive), secure partnerships and scare off competition. Startups which have not launched their products yet in the market have a lot to gain from such announcements, and that seems to be the case with TAG, which like SadaPay and NayaPay has yet to launch its wallet. Here’s where the problem is: the announcement means that the actual worth (valuation) of the company is $100 million, but in reality, for the seed round, TAG had raised $10 million on SAFEs at valuation caps of $60, $75, and $100 million. Startup founders can raise new funds as equity or non-equity. In the rounds which are equity-raised, investors get shareholding based on the actual value of the company. So if a company was valued at $10 million and an investor invested $1 million, the investor owns 10% of the company. Equity rounds in which shares are traded at actual value are also called priced rounds. In contrast, a non-equity funding round does not give an investor any shareholding in the company. Non-equity based rounds are raised by early stage startups which do not have sufficient internal cash, but need it to grow the business. It is also difficult to value a startup in its early stages because the startup has not grown enough to be valued accurately. So startup founders raise such non-equity based rounds at early stages which helps them raise funding all the while keeping them from losing any shareholding at that point. Moreover, investors participating in non-equity based rounds, because of not not getting any shareholding yet, do not get much governance rights. Non-equity rounds can be raised as con-

Most of the banks do not offer mobile banking. The ones that do have poor products, limited applicability, complex designs, and unreliable operations. These Banks still employ outdated systems and have failed to evolve. They have not graduated into the 21st century tech-wise. Therefore, incumbents are in a vulnerable position to lose to an innovative, challenger bank

Talib Rizvi, executive director, TAG

vertible notes or SAFEs (simple agreement for future equity). Both convertible notes and SAFEs guarantee funding but are converted into equity during a later stage (priced round) when the startup has grown, institutional investors come in, do more detailed due diligence and there are data points available to value the company and give investors shareholding based on actual valuation.

Early stage investors, because they are taking a risk with their investment especially when the company can not be valued, want to be rewarded for their investments. So non-equity based financing rounds come with investors or founders setting a valuation cap which provides an incentive to the investor that if the company is valued above the cap, his shares would fetch a better price than the later investor in the priced round.

For example, if an investor puts $500,000 in a startup as SAFEs and sets a valuation cap of $5 million, if the startup is valued at $10 million in the priced round, his shares would convert as if the valuation was $5 million (the cap) and not $10 million, giving him a lower price per share as incentive. If there was no valuation cap and the priced round valued the startup at $10 million, both the early investor and the new investors in the priced rounds are buying shares at the same price, while the risk for the early investor was higher because he invested early. A valuation cap, therefore, is simply the highest price at which shares of the early stage investors would convert at, in the next round, which increases willingness to participate in a funding round. This does not mean that the company is actually valued at that amount.

So coming back to TAG: according to our information from AngelList, there were investors in the fintech startup’s seed round which invested at valuation caps of $60, $75, and $100 million as SAFEs.

There would be investors who would have invested, let’s say $100,000 at a valuation cap of $60 million in TAG’s recent round. There would be others who would have invested at a valuation cap of $100 million. So when TAG raises the equity or priced round next and the actual value of the company is revealed, the early investors would convert at the valuation cap at which they invested earlier. So let’s say if TAG is valued at $110 million in the next funding round which happens in let’s say a year’s time, the investors who invested at a valuation cap of $100 million would convert their earlier investment into shares at the $100 million valuation (the cap) instead of $110 million (the actual valuation), giving them a better price per share.

The ones that invested at a valuation cap of $60 million would get an even better price per share. Omn the downside, if the actual valuation goes below $100 million, a pre-agreed discount rate (usually 20%) kicks in for these investors. So if the actual valuation of the company falls below the valuation cap and is let’s say $50 million in the next round, early investors get a discount; these investors get to convert their investment into shares at share price which is discounted by a fixed percentage.

As already mentioned, it is normal for investors in SAFE rounds to not conduct as thorough a due diligence as in a priced round. This also seems to be the case here as TAG founder Talal Gondal’s in interviews with foreign media outlets said that this round was closed in two weeks, clearly not sufficient time to carry out a detailed due diligence which would be essential if it were a priced round. Profit reached out to TAG to see any document to confirm that the funding amount was $12 million and to confirm if and how the valuation, as claimed in media reports and endorsed by the founders, was $100 million, but no response was received from TAG.

Essentially, valuation caps depend on how well a startup is able to negotiate, and according to some, how well the startup could capitalise on investors’ fear-of-missing-out. In the early stages where there is no revenue, such negotiations matter.

The market value of a business is driven by how much an investor is willing to pay to get involved in a funding round. And investors are willing to pay a high price to invest in Y-Combinator startups.

Y-Combinator is the most prestigious startup incubator in the world and has produced globally successful startups such as Stripe and Airbnb. Because the incubator is prestigious and has produced success stories, other investors assume (probably rightly so) that if a startup went through Y-Combinator, it is a good startup and the bet then is that because the startup went into the Y-Combinator, it has a high chance of succeeding in the future; it’s an opportunity that should not be missed. TAG is among the very few startups from Pakistan that went into YCombinator this year in June. So if an investor gave TAG let’s say an investment of $1 million in the seed round at a $60 million valuation cap, that investor made a bet that TAG’s chances of success are high because it went to Y-Combinator, but would still want a valuation cap and/or discount to protect the upside and downside. Now there is a different level of tolerance of how much higher an investor can expect the next round to be. Some investors would expect it to be three times higher, others would expect it to be only 20% higher, and so investors could naturally fix different valuation caps.

Then there is this interesting dynamic with startups, that if it got a known investor to participate first, and that investor participated at a valuation cap of $60 million, the next investor would want to invest knowing that the startup went into the Y-Combinator and a known investor participated in the round. The new investor is betting not just on the startup and its team, but also on the Y-Combinator and the existing known investor.

The startup this time can negotiate by allowing the second investor to participate at a higher valuation cap. So the second investor would come at a higher valuation cap of let’s say $75 million. The price for the second investor is higher because if the startup gets a valuation of $80 million in the priced round, the investor that participated at $75 million valuation cap gets his shares converted at a price which would be higher than the investor

who invested at $60 million cap. The first investor is converting at a better rate than the second investor. When the third investor comes in, the startup can again negotiate even a higher price of let’s say a valuation cap of $100 million. So the investors that are the last cheque in, are willing to pay a higher price by agreeing to a higher valuation cap so that they can participate and invest in an early stage company that they perceive is good because of the Y-Combinator factor and the few known investors. Because such deals are rare, investors would not want to miss out. The valuation cap goes up, and the market value of the startup in terms of the price it was able to fetch from an investor also goes up, but in reality, the actual valuation of the company still remains undiscovered.

The basis for valuation and possible misrepresentation

It’s really the founder and the core team which really forms the basis for an investor to gauge what trajectory an early stage startup is going to go and as people who have interacted with Talal tell us, he is someone who is at the top of his game. It was the founder, Talal, who ideated TAG and got it the in-principle approval from the central bank within a matter of three months when it took some of the others a year or more. In an earlier interview, Talal told Profit that he knew how to work his way around bureaucracies. It was Talal who got TAG into the Y-Combinator, a feat many others in Pakistan would fail at, and after getting his startup into the most prestigious incubator in the world, made it, as we have learned, one of the most popular startups from being very unpopular in the beginning, and led the negotiations with investors. Hailing from a political family in Punjab, Talal has the right political connections and built the right team which has people who have served at influential positions in the government. For instance, TAG has on its board a former general of the Pakistan army and a former finance secretary who also served as the governor of the State Bank of Pakistan. These are the sort of people that you would not be surprised to see on the boards of big businesses in Pakistan, and it looks like an anomaly to see these people on the board of the startup. But it makes sense once we realise who the competitors to TAG are. Yes, other wallets are competitors to TAG, but all these wallets have one competitor in common: the banks. The financial services industry in Pakistan is dominated by big banks which lend to the government primarily, and corporations, ignoring retail consumers most of the time. As a consequence, Pakistan has a large unbanked population which fintech startups like TAG, SadaPay and NayaPay are trying to bank on. “Pakistan lags behind in tech adoption. One of the key segments happens to be fintech, which is currently a greenfield. Incumbents (Banks and telcos) have been complacent. They employ complex revenue models and have moved away from innovation. Most of the banks do not offer mobile banking. The ones that do have poor products, limited applicability, complex designs, and unreliable operations. These Banks still employ outdated systems and have failed to evolve. They have not graduated into the 21st century tech-wise. Therefore, incumbents are in a vulnerable position to lose to an innovative, challenger bank,” wrote Talib Rizvi, executive director TAG, in his commentary on the financial services sector and the rise of fintech companies. The problem, however, is that banks also have well entrenched lobbies in the financial system and banks look at fintech companies as competitors, which makes things difficult for fintech startups. This is perhaps why TAG’s other competitors also have former government officials on their boards. For instance, SadaPay has Waqar Masood, former federal finance secretary and former special assistant to prime minister, on its board. On the other hand, Nayapay is helmed by scion of an old and prominent business family in Pakistan with all the right connections. From a business perspective, the mobile wallet space has not yet been cracked by any player. Previously, Inov8 tried to do it through FonePay, Finja tried to do it through SimSim in partnership with Finca Bank, but both of them failed to create a dent. Traditional banks which already dominate, have been creating hurdles for fintechs by refusing partnerships, all the while improving their own digital muscle. Profit in on the politics in the financial services industry and opportunities for fintech startups in Pakistan ). With the right political connections and a team to go around bureaucracies, sources that have interacted with Talal tell us that the founder has a no-nonsense attitude, always on the top of his game, and ready to beat the competition. “If someone can crack wallets, it’s Talal,” a source told us. Cutthroat and hungry, Talal has been able to create a perception around TAG in front of investors too that his startup is the only one which can dominate the market. From the investor communication available to us, one of the investors in TAG said about SadaPay, one of TAG’s competitors, that it was led by an “American who is completely out of his depth” in Pakistan. Documents shared around on Whatsapp groups and the Pakistani startup community also claim that the founder of SadaPay was not completely clean with his records. But perception could be exaggerated and this is where we would bring some instances of misrepresentation by the TAG founder, to portray a better image and the opportunity thereof for TAG to become a successful business. While there is no solid data to project the future valuation of the company, startups can give an idea about the future growth to investors by stating factors that would make their growth possible. For instance, TAG positions itself as a ‘neobank’ in a country of over 220 million people, most of whom are unbanked. Pakistan’s 3G/4G users are increasing which means that the number of phone users that will potentially use TAG mobile wallet is also increasing. All these indicators help get a sense of direction the startup is going to go. Then some updates from the startup have helped investors make investment decisions. For instance, TAG said that it had gotten approval from the State Bank of Pakistan to launch operations, but without specifying if TAG “has gotten approval” means they have secured the complete license or TAG is only referring to the “in-principle approval’ or approval for pilot. The EMI license from the State Bank of Pakistan under which a fintech company can operate a mobile wallet has three stages: in-principle approval, approval for pilot and approval for commercial launch. All three stages have different requirements and the final decision to grant the license rests with the State Bank of Pakistan. If by approval, TAG means complete license, that has not happened yet. And if it means in-principal approval or pilot approval, it is not a guarantee that the license will be granted. The central bank’s own disclaimer in this regard states: “In-Principle approval letters are granted to EMIs based on the information submitted by them and a review of their application for In-Principle approval under Regulations for EMIs (Electronic Money Institutions). It must not be construed as an endorsement of the EMIs proposed business model, financial viability, etc. by State Bank of Pakistan. State Bank of Pakistan will not be responsible for any financial, legal and reputational loss to any entity or individual who has established a business relationship with the respective EMI based on the In-Principle approval letter.” TAG received an in-principle approval from the State Bank of Pakistan (SBP) last year, and received pilot approval this year in August which qualifies it to test its products and services with limited customers. The commercial launch is only going to come after the SBP is satisfied with the pilot phase of TAG. The startup has yet not disclosed how far away they are from the commercial launch,

in a question sent by Profit.

Another update cited as the basis for valuation was that the fintech TAG had “secured a major public sector contract that would allow us [TAG] to eventually onboard 1.2 million active users over the course of next year and bring us [TAG] ARR of $8.4 million.” According to TAG’s pitch deck available with Profit, the only public sector contract that TAG claims to have is with the Frontier Works Organisation (FWO). Frontier Works Organisation is Pakistan’s military-run organisation which undertakes construction projects. TAG would be digitising salary disbursements for FWO, according to TAG’s pitch deck. While TAG has claimed to investors that it had secured a major contract with FWO, sources close to TAG confirmed to Profit that no final contract with FWO is in place and as of now, there are only negotiations which FWO is continuously engaged in for many of its contracts; no contract with TAG is final yet. It also remains unclear if the FWO contract alone will bring 1.2 million users to the TAG wallet as claimed because FWO has between 7,000-8,000 employees as Profit has learned, and most of them are blue collar workers which have feature phones and cannot really have TAG mobile wallets on these phones. The number of mobile wallet users that FWO can bring TAG would, therefore, be significantly less. Our sources tell us that while the FWO contract is not final, other contracts are also being negotiated but none of these contracts have materialised yet. The claim, therefore, simply exaggerates the strength of the startup. TAG has another contract in place with Fatima Group, Pakistan’s leading conglomerate, which is also an investor in TAG through its venture capital arm Fatima Gobi Ventures. Moreover, earlier in June this year, TAG announced raising $5.5 million in the pre-seed round. However, according to TAG’s deck, the startup told investors that it raised $2.5 million in the pre-seed round. Profit reached out to TAG to understand how the $5.5 million adds up, but no response was received. In another investor presentation, the startup claimed that it had earlier deposited $2 million with the State Bank of Pakistan as a precondition to launch the pilot. While the startup has claimed in its deck that it deposited $2 million with the central bank to launch the pilot, as per the EMI license requirements from the central bank, a fintech company seeking such license is only required to show Rs200 million (~$1-1.3 million depending on fluctuating dollar rates during the last few months) as paid up capital, of which only 10% is required to be deposited as security with the State Bank.

Can wallets really make it big?

While the TAG investment is indicative of how fintech funding is picking up, the thinking behind such investments is the belief that tech startups are going to transform the financial services industry. The indicators with respect to financial transactions going digital are encouraging but while digital payments volumes are picking up, the increase in volumes does not necessarily mean that wallets created by fintech companies would be able to get a major share from this volume because, as elaborated in an earlier cover of Profit and we recreate briefly the arguments below, the financial services sector is dominated by big banks, which can control the future of EMIs like TAG and others. If an EMI threatens banks and their deposits in any way, which wallets like TAG plan to do, they will meet stiff resistance from the banks. The underlying fact is that the EMI license allows creating an app-based wallet to facilitate money transfers between two parties primarily, and does not allow much scale of earning interest on deposits. So these wallets are really looking at the opportunity of creating a big business out of app-based wallets only on facilitating payments between two parties. The scope of such transactions is limited, however, if you consider that EMI regulations place transaction limits - wallet users cannot transfer more than Rs50,000 into their digital wallet in a single day, unless they complete biometric verification, in which case they will be allowed to move up to Rs200,000 per month into their digital wallet. In contrast, the limits of transfers at banks are controlled by banks themselves, rather than regulations. TAG and SadaPay are issuing debit cards that customers can use to withdraw money from ATMs, and the ATM network is controlled by banks which can further create withdrawal limits for EMIs when they use bank ATMs. Currently, cash withdrawals are limited to Rs10,000 per day and banks charge an ATM withdrawal fee. Since the limit is low compared to banks’ ATM cards, the cost per transaction is high if you have a wallet card. Effectively, wallets become expensive for users. These users are unbanked because banking is expensive, and form the market for these fintechs to capture. On the other hand, putting money into a wallet is also going to happen through a bank, which can again set limits on how much money can be deposited into a wallet account and in fact ask for a fee for such deposits. It can also happen through branchless banking agents the likes of EasyPaisa and JazzCash have but both these players are notorious for keeping their wallets closed loop. Essentially, EMIs like TAG are creating a product which competes with basic banking services without providing value for these services. Now an EMI can upgrade itself to a digital bank and TAG has publicly announced that it plans to become a digital bank but the law in this regard is not final yet and it is anybody’s guess what its final shape would look like. The functions of the State Bank require it to be mindful of the depositors interest first, followed by conventional banks that take these deposits. Naturally, the financial services system is dominated by conventional banks with better lobbyists for regulations that claim to be in the interest of keeping the depositors’ money safe. In turn, the State Bank is likely to find itself persuaded by such arguments more than that of the EMIs. The State Bank also has its limitations: if it allows EMis to deliver the same services as conventional banks which have a higher requirement for paid up capital, it would be unfair to these banks and their investors. Then the Prudential Regulations do not allow specialisations which means EMIs would have to create general products, which means they would be competing with banks head on. Some niches have been created, for instance Finja is into lending primarily, for most others, it is an uphill battle in a market that is heavily tilted in favour of the incumbents, even with a regulator that has moved significantly in the direction of allowing innovative companies room to operate. So understanding that the power rests with the incumbents for now who are not likely to let it go anytime soon, the only play fintech companies are left with is to not threaten banks where they dominate. So if TAG wants to disburse salaries for corporations, it essentially threatens banks’s business with that corporation and if that happens, do not expect cooperation from the banks, and do not expect the State Bank to be particularly friendly to your lobbying, because the big banks have better lobbyists than you and can rely on with very reasonable-sounding arguments that all purport to be in the interest of protecting the depositor. So fintech companies really have a chance in the financial services industry if they do let’s say salary advances, like Abhi does. Banks are currently not interested in this space. Then microlending for small businesses is lackluster which banks have left unserved. With increasing VC interest in Pakistan’s startup space, EMIs might succeed in securing high valuations in future priced rounds, however, with banks’ dominance, getting a good return on these investments might not have the same likelyhood. n