Africa-focused investors cannot simply copy and paste Silicon Valley investing models to apply on the continent. This is because multiple mismatches exist between key characteristics of the model and African markets” – Kinyungu Ventures.
Africa’s entrepreneurs are often forced to seek support from western venture capitalists due to shallow capital pools in the region. In the five years to 2020, North America-headquartered investors accounted for 42% of all African VC deals, according to the African Private Equity and Venture Capital Association, while only 20% of venture cash came from Africa-based investors.
Foreign capital has helped propel a number of African startups to success but is the Silicon Valley funding model exactly right for Africa’s relatively nascent tech ecosystem? This is one of the issues industry stakeholders have debated for a long time, and it does not appear to be going away anytime soon. One thing is for sure though; The existing funding model being deployed in the African startup investment ecosystem seems to have been imported wholesale from the United States, despite very obvious and significant differences in both societies. The Silicon Valley-investment style also has a significant influence on the local tech industry, so great that even existing local investors operate by the rules and expectations adopted from their western-based counterparts.
A recent white paper, Chasing Outliers: Why Context Matters for Early Stage Investing in Africa by East African venture advisory firm, Kinyungu Ventures, weighs in on the debate. After exploring what it calls “mismatches” between the typical VC investing model and Africa’s realities, Kiyungu recommends investment structures and approaches tailored to African operating conditions. It urges that “market realities” and “startup characteristics” should dictate how Africa-focused startups and funds operate.
Silicon Valley investing
The report, put together after speaking with 100 pan-African founders, investors, and Limited Partners across 15 African countries, found that there continues to be a wide misalignment between traditional venture capital models and the African market.
It defines venture capital as a “strategic input that enables companies with unproven business models to scale rapidly and exponentially beyond the confines of organic growth so that they can achieve outsized returns with a comparably outsized risk of failure” and details the core assumptions of the Silicon Valley-style investing model.
Firstly, VC investors believe that a startup is a venture that can achieve high variable growth with low fixed inputs, which is achieved through the use of technology, readily accessible infrastructure, and low asset ownership. This capacity for exponential growth is what motivates investors’ risk tolerance and rapid growth signals the opportunity size – as a company grows, its margins increase and costs to deploy products and services decrease. An implication of this assumption is that investors and founders emphasise growing rapidly, rather than achieving profitability while venture capital stimulates this growth in the pursuit of the market-capturing conditions that yield massive returns.
The model also holds that consumer markets that VC–funded startups seek to capture are broad, deep, and composed of digitally literate consumers with high purchasing power. This is especially true in markets like the United States, where 331,000,000 people have a per-capita GDP of $24,342 and three-quarters of adults have home broadband internet access.
Also, venture capital investing is a high-risk, high-reward approach in which a small number of exponentially successful “winners” compensate for a larger number of “losers.” For example, in a portfolio of 10 companies, one or two are expected to become as or more valuable than the other nine that return value equal to the initial investment, or that lose money. In essense, investors must seek incredibly large returns to cover these losses – some companies produce these types of returns and any valued at $1 billion or more is called a “unicorn.”
Lastly, venture capital investing involves using increasingly large amounts of capital quickly to create the exponential increase in value that drives return expectations. Investors select companies with VC–level return potential and provide capital across multiple rounds of fundraising that correspond with startups’ life cycles until they can exit their investments within the previously described range of returns.
Investors typically fund startups across multiple rounds of fundraising over many years so that they can dominate the market, made possible by a robust pool of venture and private equity capital from pre-revenue and seed to series D in the U.S. Robust secondary markets are also crucial to this, as they give later-stage investors a chance to purchase share ownership from earlier-stage investors.
These assumptions represent an approximation of what drives Silicon Valley–style VC investing. But do these same conditions apply to African venture formation and investing?
Also Read: Silicon Valley Has Deep Pockets for African Startups – If You’re Not African
Multiple mismatches and chasing unicorns
Africa-focused investors cannot simply “copy and paste” the above-described Silicon Valley investing models and apply them to African contexts as “multiple mismatches” exist between key characteristics of the model and African markets, the report cautions.
Looking at the assumptions highlighted also shows that VC is appropriate for a very small number of companies, anywhere in the world. There are just under 500 unicorns globally according to CB Insights and less than 5 in Africa, which calls into question whether their pursuit should fuel an entire industry in Africa or elsewhere, Kiyungu said, citing the high-profile failures of companies such as WeWork, which have increased the level of skepticism surrounding hypergrowth companies.
Startups typically lose money as they develop products and seek customers but losses are deeper for unicorns as they tend to spend large amounts of capital to fuel growth and subsidise their cost of service. Ideally, revenue growth accelerates enough for the company to become profitable but if it doesn’t, it could be forced to raise more and more money to drive growth until eventually collapsing.
Venture capital also needs addressable markets that are massive, infrastructure-rich, prime for digital disruption, and have deep capital pools like the U.S.. By contrast, African markets are small and fragmented, contain limited infrastructure, are costly and time-consuming to digitally enable, and lack sufficiently broad and deep pools of investment capital. “It’s difficult to apply cash-burning, “blitz-scaling” models that pursue growth over profitability in this type of market,” the report argues.
Given VC’s relatively short tenure in Africa, there is still much to learn but Kiyungu notes that the incongruity is stark.
“I don’t think the venture model will work in Africa because we’re never going to grow big enough or fast enough,” an investor was quoted as saying. “We’re not like the U.S., where you can sell lip gloss to 300 million people every month and make a billion dollars. So, if a typical venture model is one out of 10 wins, that one covers the losses plus all your instrumental gains. If you’re never going to win that big, you might have to be a little less risk-tolerant and maybe aim for three or four.”
Also Read: Cities Like Lagos Need Global Designs, Adapted for Africa
Disconnect between ambitions and realities
A fundamental premise underlying the argument for venture-backed opportunities in Africa is the growth of its middle class, as a proxy for large consumer markets. But the 10 or 20-year-old African VC thesis predicated on a growing, young, tech-savvy, middle class has yet to be proven, the report says. “On the continent, this segment is smaller and holds less purchasing power than assumed.”
Typically, a large market of consumers with disposable income enables startup growth. As a founder explained, “Amazon is successful in America because Americans have money to buy things. Nigerians don’t have that type of money to buy things.” In Nigeria, GDP per capita was estimated at $2,229 as of 2019.
The Brookings Institute in a 2018 report projected that more than half of African households would have discretionary income by 2020 while BMI Research’s dependency index shows that having dependents reduces economic power for African middle-class consumers. For example, the average Nigerian consumer might be responsible for up to eight people.
Along with having limited purchasing power, African consumers are utility- and price-sensitive, and they primarily spend their limited incomes on products or services that add value (i.e. “painkillers”). Yet African consumers may still not pay for a service with a seemingly obvious value, such as a solar home system if the value proposition isn’t compelling, Kiyungu notes.
Consumers also make purchasing decisions based on prioritising cost over loyalty and ease of purchase (where making change isn’t required). As a result, startups’ products have to be affordable and accessible, despite limited access to consumer finance. Typically, African consumers are expensive to acquire (so there are high consumer acquisition costs) and difficult to retain, as indicated by the low lifetime value of the customer. These consumers are also difficult and costly to reach for several reasons, but access to far-reaching digitally enabled distribution networks figures prominently.
More so, what constitutes achievable returns represents another clear mismatch between the VC model and African market realities. Venture capital requires exponential returns that are hard to generate in Africa due to market dynamics that are expensive and difficult to navigate. Arguably, the VC model doesn’t fully account for these realities, given that it requires big returns in a short amount of time and is expensive to operate due to personnel and deal structuring costs. Also, the pool of available capital in Africa is too shallow to fund hyper-growth companies.
“Ideally, fund structures should fit the needs of the entrepreneurs, general partners (GPs), LPs, and the markets they are built to support. Even Silicon Valley VC was invented to enable investing in early-stage American companies,” the report states. Nonetheless, very few businesses are truly venture businesses – in Africa or anywhere else.
There are obvious mismatches, yet the sheer size of the African market also presents a real opportunity for profit once the environment is clearly understood by investors and funds, according to Kiyungu. African ventures can generate attractive returns, but they may take a long time to do so because of the challenging market characteristics. So these conditions require adaptation not only from startups but from the funds that finance them.
Also Read: Research: The Average Successful Start-Up Founder is Much Older Than You Think
Broadening VC approaches
Silicon Valley has defined how startups should be built and funded. But many of these stipulations don’t quite fit much of the rest of the world, and their utility is being questioned in Silicon Valley as well, the report says. It’s worth questioning whether an entire funding ecosystem should be built to serve unicorns, its rarest and most fragile members.
“Capital in Africa is scarce and pursuing a “growth at all costs” strategy where capital pools are shallow presents huge risks for companies,” Kinyungu’s Managing Director and co-publisher of the report Tony Chen said. “We’ve also found that many great businesses don’t fit the typical VC profile, but have tremendous unfulfilled potential.”
The consulting firm calls for a “broadening of approaches” to institutional investment on the continent, suggesting that investors should prioritise investing practices that reflect the realities of operating in Africa, including the adoption of more flexible structures with longer time horizons. Key recommendations for funds as contained in the white paper include adopting more focused investment strategies, such as investing in B2B companies or cross-subsidising a portfolio with less risky, steady return assets.
Venture funds focused on Africa can also consider non-unicorn investing models geared at more resilient companies, with returns distributed more widely across the portfolio as well as use flexible structures such as debt or permanent capital vehicles (PCVs) to accommodate market-level changes, where feasible. Lastly, they should allow a longer time horizon for returns, understanding that growth could be slow and difficult to achieve for many companies.
“While African markets aren’t always able to provide the outsized returns that Silicon Valley typically looks for, in high-growth companies, a more focused strategy here could unlock real gems, as has been proven by some of the startup successes the continent has seen over the years,” Lead Researcher Tayo Akinyemi said.
