Whether venture capital is the right model for investing in Africa was the topic of a recent clubhouse chat which discussed funding models in Africa to support African innovation.
The conversation consisted of a number of seasoned entrepreneurs and investors with experience investing in the continent. Panelists included Geetha Tharmaratnam, a Partner at Aequalitas Capital and impact investor focused on Africa, Luni Libes, founder of Fledge Accelerator, and several other VCs, angels, and seasoned investors. The consensus agreed that while VC is possible, there are many challenges to tackle and that it must be tailored to Africa rather than exporting traditional funding models from abroad. Major hurdles include:
- Silicon Valley copy and paste doesn’t work
- Bringing Limited Partners (LPs) to the other side
- Need for new funding models that aren’t tied to IPO exits
Silicon Valley Copy and Paste
The traditional Silicon Valley VC model operates with 2% yearly management fee and 20% carry, meaning the bulk of the return is generated upon a successful IPO. This model works fairly well for the established Silicon Valley VC ecosystem where investments go mainly into asset-lite (software, mobile, etc) companies, and there are many high multiple opportunities. However, for Africa, this is only a small portion of the market, and most SMEs are not on a path to IPO.
The cost for a fund manager of operating in the African region is also quite high and with the exception of a few countries with solid wifi penetration, the length of time it takes to find investments and execute them means fund managers are forced to take on additional roles they are not used to and become more involved in the startup itself. Given the smaller size of funds, this makes working in that model challenging both operationally and financially.
According to Tharmaratnam, VC is just another quiver in the bow adding to the types of financing vehicles in the region but not the main one. She states we have to start with the fundamentals of the business and whether real value is being created, otherwise it is a game of musical chairs. In Africa “the value of early-stage business starts with what they are doing for the economy vs. if there is a sufficiently sexy story to tell” which is a common thread for US venture capital markets where valuations are many times “divorced from cash flow.”
Another opinion that was voiced was that if investors can adjust to the African reality, where income levels are lower and businesses need to scale across smaller markets, while additionally taking on a very hands-on approach, that the VC model can in fact work. However, for exits, it’s important to know who strategic investors and likely buyers are while keeping in mind that IPO is not an option, and keeping focused on EBITDA and cash generation.
Bringing LPs to the other side
The other challenge that remains difficult for VC in Africa is not only the need for different financial models but also the need to educate limited partners (LPs) providing the fund capital so that they understand the different structures and adjust return expectations accordingly. New financial models such as Smart Asset Financing, flexible capital, and other non-diluted structures are better for the smaller, asset-intensive needs of African startups, and payouts differ vastly. Often these models are a mix of debt plus revenue share or debt/equity mixes that are hard for traditional investors to wrap their minds around, it will take more market education through platforms such as The Nest to make these models more widely understood.
What are the Alternatives?
Untapped Global has developed a unique alternative financing vehicle, called Smart Asset Financing
that leverages technology to track the usage of assets purchased through a debt model. For small businesses in Africa and in frontier markets, access to capital for large equipment purchases is often hard, if not impossible for entrepreneurs to secure. Untapped fills that gap for asset-heavy companies and with the use of its IoT sensor technology, enables investors to know exactly how their investments are being used, and how well they are generating returns on CAPEX.
Another unique approach to financing African startups comes from Fledge Accelerator, where they have developed redeemable equity, also called royalty equity. This revenue-based equity model enables Fledge to provide a loan instrument that has upside built into it. The accelerator buys shares but doesn’t fret over valuation. The funded company is then contracted to buy back their shares with a price set at the time of purchase and equal to a certain percentage of revenue every quarter. The example below provides a potential scenario where $100,000 is invested for 10 percent ownership, the startup then agrees to re-purchase half of those shares, buying back five percent at a 2x return to the Fledge, still leaving the accelerator with five percent ownership and an opportunity to share in startup upside.
“The revenue-based equity model aligns our interests with the founders, avoids any pressure to “sell-out”, and lets us invest in just about any market segment and most any country in the world. Plus, we make introductions to impact investors and make follow-on investments from our family of seed funds.” Luni Libes, Fledge Accelerator
Africa holds much promise as the fastest-growing continent on the planet, and with rapidly digitizing economies that are poised to leapfrog developed economies through growth and adoption. The keys to making investments work in Africa are approaching the continent with a unique perspective and mindset quite different from the Silicon Valley investing mindset. It requires patience, more hands-on involvement, more ecosystem building, and more creativity when it comes to financing models such as what Untapped Global and Fledge have developed. Rewards await both in terms of impact and profit for those who can master these nuances.
You can find and listen to this fascinating conversation here.