Is the VC Model Working in Africa?

* This article is sourced from Nicole Dunn, Venture Scale Lead at Founders Factory Africa. [ Edits by Ighlaas Carlie ].

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Is the venture capital model working for Africa?

Spoiler: We don’t know, yet. But we can make it work better.

Last month, I was part of a panel discussion on the topic, ‘Is the venture capital model working for Africa?’, moderated by Ndubuisi Kejeh with Machela Sathekga, an African angel investor, and Josie Middleton, Disruptive Technologies and Private Equity Funds at the IFC. In this two-part series, I attempt to capture some key insights from the discussion and my subsequent reflection on the topic.

Is the venture capital model working for Africa? It’s a provocative question that requires some clarification – what is ‘the venture capital model’, what does ‘working’ mean, and for who?

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What is the venture capital model?

Venture capital is a form of private financing in high-risk, potentially high-growth companies in exchange for equity. The original model emerged in North America in 1946 and was brought into the mainstream by industry veterans such as Sequoia’s Don Valentine. The premise was that disruptive solutions often require significant upfront capital before reaching maturity, and this capital was not accessible from traditional sources due to the high risk involved.

At the time, entrepreneurs were typically technical experts, skilled in inventing new technologies but not commercialising their inventions. Venture capitalists both financed the product development and supported company building. There is a case to be made that the approach adopted in venture capital today looks different to this original model, but for simplicity, let’s assess the fundamentals.

The typical venture capital fund operates on a 2% management fee on assets under management (AUM) and 20% ‘carry’ (carried interest or share of profits paid out on an investment), meaning most of the return is realised on a successful exit (a ‘liquidity event’, usually a public listing or acquisition).

This model relies on a few core assumptions:

• The investor can achieve outsized exits. Venture capitalists need liquidity to make money, so look for startups that can achieve exits at a significantly higher valuation. This relies on established public markets, large pools of private capital, and a large enough market of potential acquirers.

• These outsized exits compensate for the high threshold of failure. Venture capital is a risky business. Most funds assume that at least 50% (if not more) of their portfolio companies will fail (i.e. return on investment will be zero). To compensate for this high failure rate, the returns on the top 10-20% of the portfolio must be significant (at least 10-20x).  

• Significant economies of scale exist. Investors ‘bet’ on companies where a big market exists, assuming that a venture can achieve exponential growth with low fixed inputs at scale. This leads investors to emphasise market share (aggressive 'growth-at-all-costs') over near-term profitability, which in turn delivers radical valuation uplift.

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Do these assumptions apply in Africa?

African markets are small and fragmented compared to the United States, with a small middle class and limited consumer purchasing power. Infrastructure is sub-par or absent, and there is a lack of ubiquitous ‘hardware’, which is often a prerequisite for SaaS and data-enabled business models. Customers are geographically dispersed and often offline, making them time-consuming and costly to acquire. Venture capital was not designed with these market constraints in mind.

The ecosystem is also at a radically different stage of maturity. Venture capital has only meaningfully emerged in Africa in the latter half of the 2010s. It is inappropriate to blindly import a model from a market where tech startups have been funded for more than 70 years. The impact on founders is that there isn’t an established ecosystem to leverage – tech stacks must often be built from scratch, startups must solve for the whole value chain rather than a niche, and there aren’t third-generation founders that can act as early angel investors and advisers.

Combined with a lack of deep capital pools, this backdrop makes it difficult to apply the ‘growth-at-all-costs’ approach to birthing unicorns, as building a tech startup is more expensive, and there is no guarantee of capital at the next milestone to continue to fuel growth. Difficult, but not impossible.

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Working – and for who?

It’s hard to say what ‘success’ looks like. Venture capital is only one step in the financing journey, designed for particular business models. We cannot judge the model by its ability to meet the financing needs of all businesses at all stages – especially in an ecosystem where adjacent support is limited.

That said, venture capital is best suited to businesses that can achieve exponential growth (variable growth without a corresponding increase in inputs). These are predominantly tech-first business models that are asset-light and can be distributed through digital channels. For these companies, limited partners (LPs or the people who put up the venture capital) typically expect a 3x multiple (i.e. three times the original capital is returned) over a 7-10 year time horizon).

There are therefore three primary stakeholder groups that the model must ‘work’ for – LPs (who want a return on their capital), General Partners or fund managers (who want exits at high multiples), and startups (who want capital to grow).

What are the results so far?

It’s premature to reach strong conclusions, as venture capital in Africa is still nascent. Many funds are in their first 10-year cycle, so we don’t have the data to determine what returns have been achieved. However, we can see some early signals of success.

Venture capital investment in Africa increased 15x in the last six years, reaching ~$5 billion in 2021. This momentum has continued into 2022, with a new record month in funding every month this year – surpassing $2 billion in the first four months of the year. There has been a steady normalisation of both very early-stage deals (422 deals between $100,000-$500,000 in 2021) and mega-deals (rounds greater than $100 million), signalling growing confidence in the asset class and a higher quality pipeline of assets. The continent has now produced 8+ unicorns, providing some validation that startups can achieve scale despite harsh operating conditions.

There have been several liquidity events – with Jumia and Fawry listing on the New York and Egyptian stock exchanges, respectively (with varied results). Perhaps more successfully, more than 100 startups have exited through strategic acquisitions – notably Paystack to Stripe for $200 million, Sendwave to WorldRemit for $500 million, and DPO Group to Network International for $288 million. Consolidation is also taking place (as expected in fragmented markets) with multiple Africa-Africa acquisitions in 2021.

Several funds have started releasing their performance data. Future Africa, invested in 75 portfolio companies with over $30 million under management at the time of publishing, reported an aggregate fund Internal Rate of Return (IRR) of 113% and investment multiple of 4x – outperforming typical LP expectations. Zachariah George, angel investor and GP at Launch Africa and Startup bootcamp AfriTech, announced that his portfolio of 153 investments (94% in Africa) had achieved an IRR of 88%, with 4% of the portfolio (~6 investments) achieving 10-20x and 4% earning more than 20x. This return is likely understated, with ~49% of the portfolio at par mainly because they are recent investments (in the last 18 months).

At the very least, venture capital in Africa is working for some.

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What are the gaps?

Business models

Venture capital favours businesses that can grow exponentially without corresponding growth in fixed costs. Most investors do not have the fund structure or mandate to invest in business models that require ongoing capital injections to scale. These include asset-heavy business models – such as IoT-enabled farming equipment – which are critical to enabling SaaS models through on-the-ground data collection. This creates a vicious cycle – businesses building hard infrastructure do not get financed, which hampers potential exponential businesses that would rely on this infrastructure to scale (imagine trying to sell financial software and realising you need to build the internet or generate power).

These ‘assets’ are also critical to increasing individual and business productivity, which creates the local purchasing power to make more ventures viable. The ‘low fixed input model’ means that venture capital companies typically create fewer jobs relative to revenue than steady-growth SMEs – jobs the continent desperately needs.

Markets and sectors

There is also significant geographic concentration. 83% of funding goes to the top four markets (Nigeria, Kenya, Egypt, and South Africa) – a consistent pattern for the past five years. More than half of Africa’s countries (with a combined population of 250+ million) do not have a single startup that has raised more than $1m since 2019. The majority are countries with smaller populations, and therefore smaller local addressable markets, compounded by a lack of regional integration. Similarly, there has been underinvestment in key sectors, including health, agriculture, climate, and education technologies. More than 60% of venture capital in Africa flows into FinTech and more than two-thirds of mega-deals are attributable to the sector. While financial services provide the foundation to enable transactions in other ecosystems, founders in those sectors often struggle to find funds investing in Africa without a strict FinTech-only mandate.

Local investors

Some of the most active investors on the continent are based outside Africa. Why? Some argue that fund economics are challenging for African investors under a certain threshold, due to higher search costs, constrained deal flow (which necessitates covering multiple markets), and the need for post-investment support. The relative lack of angel investors, incubators, and accelerators means venture capitalists often have to stretch earlier in the financing value chain – creating an unfair expectation of the model.

On the other hand, there is a case to be made that venture capital hasn’t really been tried in Africa. Many local investors, who claim to be venture capitalists, are operating a private equity model at the venture capital stage – taking a significant minority (30-40%) or even majority stake in startups and requiring predictable recurring revenues at what should be the pre-revenue stage. This often leads founders to optimise for quick and unsustainable revenue rather than building sticky products that people love. To build a better pipeline of startups (and exits), we need genuine local venture capitalists – the Don Valentine and Paul Graham kind – operators and builders obsessed with building products people actually want.

Founder profiles

Importantly, this has led to the uncomfortable reality where specific demographics – men, predominantly white expat men – have benefited disproportionately from venture capital inflows. Less than 1% of African venture capital investment goes to female-founded ventures and 20-50% goes to expat ventures (depending on the market). In Kenya, this picture is more dire – where local founders raised a paltry 6% of total funding.

This suggests that venture capital currently works for the very few on the continent – people more familiar to the largely international base of current investors – and therefore isn’t working for most Africans.

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So, is it working?

It’s too early to conclude whether the venture capital model works for Africa. However, there are clear gaps. We can safely assume that the model will not work for all businesses, particularly many types of companies the continent needs. We also should not rely disproportionately on global investors; else we risk replicating historical patterns and terms of trade.

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