A Challenge to Early Stage Investors: Fund Entrepreneurs that Solve REAL Problems
Exceptional. Inspiring. Thought-provoking. These are some of the words I heard others use to describe their experience during the 2016 Global Entrepreneurship Summit (GES) at Stanford University. We heard from senior level government officials (including President Barack Obama, Secretary of State John Kerry, and Secretary of Commerce Penny Pritzker) and leading entrepreneurs from around the world, some on the cutting edge of technological innovation and others leading their countries through economic transformation.
GES 2016 focused on creating the conditions that will allow entrepreneurs around the world to thrive. And rightfully so.
I regularly marvel at the groundbreaking work that entrepreneurs like Anne Wojcicki (23andMe), Elon Musk (Tesla and SpaceX), and others are doing. I equally admire the drive, vision, and creativity of entrepreneurs like Kwami Williams and Emily Cunningham (MoringaConnect), Bim Adisa (Beacon Power Services), Joel Jackson (Mobius Motors), Ivan Mbowa and Munyutu Waigi (Umati Capital), and Isaac Oboth (Media256).
From helping us understand our genetics so that we can make better decisions about our health and well-being (23andMe), bringing electric cars to the mass market (Tesla), and exploring the final frontier (SpaceX), to increasing the livelihoods of some of the poorest people in the world (MoringaConnect), providing businesses with reliable access to electricity (Beacon Power Services), making mobility more affordable (Mobius Motors), helping businesses unlock their cash flow (Umati Capital), and delivering authentic and high quality stories about people across Africa (Media 256), these entrepreneurs are each leaving their unique and positive mark on the world. They are examples of how you can do well and good at the same time.
We (investors) still have a long way to go in creating the right conditions that allow more entrepreneurs around the world to do well while doing good; to build businesses that not only thrive financially, but solve problems that continue to plague our society.
Based on my conversations with several investors over the last few years and at GES, I believe that we, early stage investors (angels and VCs), need to refine our thinking about a few things. In this post, I discuss:
- the role of entrepreneurship in society — it extends beyond simply building new products and services;
- the fact that although some early stage investors think otherwise, every new business is a “start-up;”
- all businesses are scalable, not just those in the software/technology sector;
- how we can allocate capital more effectively — the power law of investing (the assumption that the best investment in a portfolio returns more money than the rest of the investments in that portfolio combined) is used as a justification for taking undue risk on companies that should not be funded; and
- what are the implications of ineffective distribution of capital — they’re scary.
The Benefits of Entrepreneurship
There are several benefits of entrepreneurship. The obvious benefits include the introduction of innovative and creative new products and services, reduced dependency on old systems and technologies, and an increase in the types of businesses offering particular products and services — giving consumers more choices and power. But entrepreneurship can do, and does do, so much more for individuals and communities. Successful entrepreneurs create new jobs, open new markets, contribute towards generating new wealth which can help alleviate poverty, and generate new business and personal income leading to higher tax revenue for governments, which in turn provides for better infrastructure and social services. There is also a longer-term self-perpetuating benefit as new successful entrepreneurs inspire and support the next generation of entrepreneurs.
Lately, I’ve been thinking about President Obama’s remarks in the Rose Garden a few years ago when he nominated Dr. Jim Yong Kim to serve as the head of the World Bank (props to Freakonomics for drawing this to my attention).
Specifically, I’ve focused on the President’s words about the benefits of prosperity.
In the developing world, the creation of new wealth and the alleviation of poverty is without a doubt the most powerful aspect of entrepreneurship. Yes, innovative products and services have been incredibly useful in developing countries. They’ve reduced dependency on antiquated ways of doing things and increased efficiency; but the biggest impact of new businesses like MoringaConnect and Andela is that they allow people to earn more money which they can use to provide adequate food and shelter for their family, pay for healthcare expenses, send the children to school, and still have disposable income.
All successful and sustainable businesses in developing countries have the potential to contribute towards poverty alleviation and, as the President said, “that makes the world a stronger and more secure place for everybody.”
What is a “start-up”
In order to contribute toward building successful and sustainable businesses in developing countries, we need to refine the view that some investors (especially those in Silicon Valley) have of what it means to be a “start-up.”
According to Qasar Younis at Y-Combinator, a start-up is highly scalable technology company. This is what Qasar said at GES during the session entitled “Master Class 6 — Y Combinator Unlocked: How to Build a Successful Startup.”
Y-Combinator is great and all, but I’m going to go with good ol’ Merriam-Webster on this one.
This may seem like a trivial matter. Mere semantics. But to me, its fundamental to the debate on what types of companies early stage investors should be funding. Indeed, it goes to the heart of what the term “venture capital” means.
Entrepreneurs create the small- and medium-sized enterprises (SMEs) that are the lifeblood of every economy. SMEs account for 90 percent of businesses and more than 50 percent of employment worldwide. In Africa, SMEs account for 80 percent of all jobs, many in the agricultural sector. These companies provide not only jobs and income to their employees (which in turn contributes towards alleviating poverty), but also the goods and services people rely on to survive each day. And SMEs pay taxes that allow our governments to provide the public goods that we all utilize: roads, schools, water, security, courts, etc.
In Africa, SMEs account for 80 percent of all jobs
By myopically limiting our meaning of “start-up” to mean just highly scalable technology businesses, we prevent millions of businesses around the world from receiving venture funding. Some of these businesses provide agricultural inputs and machinery to smallholder farmers that help them increase their yields and earn more money, they help reduce post-harvest waste, and they address chronic food security challenges. They create real value for customers and deliver competitive returns to investors.
Now, I’m not a naive. I understand that various forms of technology impact almost every part of our lives. As my colleague Seyi Fabode constantly reminds me, every company is now a technology company. And as Marc Andreessen famously wrote in 2011, software is eating the world. It’s changing everything, from our ability to process information to the systems through which we do things.
The idea that every company is a “technology” company isn’t a new idea. People have been using the word “technology” to describe advances in the way we do things since the word was adopted into the English vocabulary in the early 1600s.
So I concede that all companies do, or should, employ various forms of technology, including software, to improve their efficiency, effectiveness, and ability to scale their operations. If we can all agree that every company is a “technology” company, then I would argue that all companies that have the ability to scale should be eligible for venture funding.
Less than 10 percent of the of the world’s 500 largest public companies are classified as technology companies. The list of the largest employers in the U.S. includes Walmart, McDonald’s, Target, Kroger, and Coca-Cola, but not Google, Facebook, or Apple. However, most of the funding going into early stage companies continues to go to technology companies.
Yes, I know, some will say “so what” if Google, Facebook, and Apple don’t employ the most people? Those companies haven’t been around for very long, they still employ a large number of people, and they provide astronomical returns for their initial investors. These are fair points.
However, we should not forget that every company begins its life as a start-up. Walmart, McDonald’s, Target, Kroger, and Coca-Cola were all start-ups at one point and they too were able to earn attractive returns for their initial investors. Most of those companies made their founders some of the wealthiest people in the world.
By starving start-ups in developing markets of capital, we inhibit their ability to scale and provide the goods and services that are so critically needed in those countries, and we delay the economic development the will create greater wealth and prosperity in those countries.
Let’s re-think the currently limited notion of what types of companies early stage investors should invest in. I’d hope if given the chance, Qasar would refine his views on the meaning of the term “start-up.” Hopefully other early stage investors would as well.
What Is a “Scalable” Business?
I used to be a lawyer, so let’s go back to the dictionary. Merriam-Webster’s simple definition of scalable is “easy to make larger, more powerful, etc.”
In order to be scalable, you simply need to be able to expand easily and grow.
A scalable business does not have to be a technology company. Examples of this include Lululemon, Chobani, Under Armour, The Honest Co., Shake Shack, Shinola, Blue Bottle Coffee, and countless others. These companies now sell their products around the world, earn millions (billions for some) in revenue, and their investors are of course thrilled with how their investments have performed.
In developing countries, almost every sector is ripe for growth. For example, even though African countries currently produce 75 percent of all the cocoa in the world, they only receive 2 percent of the value in the $100 billion chocolate industry. Talk about an industry that’s ripe for disruption. Another example is Nigeria’s film industry. Although Nollywood is the second largest film industry in the world (based on the number of films produced per year; Bollywood is first), and the third largest film industry in the world based on revenues (Hollywood and Bollywood earn more), the quality of films being produced is not good. There’s a huge potential to increase quality, provide jobs, and make money in an industry valued at over $5 billion annually and growing fast.
One may ask, if there are scalable, profitable investment opportunities, where are the exits to prove it? Multinationals and other investors are already seizing upon these opportunities. In recent years:
- Coca-Cola paid $240 million for a 40 percent stake in Chi, a Nigerian juice and dairy company.
- KKR paid $200 million for a stake in Afriflora, an Ethiopian flower export company.
- Danone and The Abraaj Group bought a 49 percent stake in Fan Milk International, west Africa’s largest maker of frozen dairy products, in a deal valuing the company at $360 million.
Many of the companies that we (VestedWorld) consider for investment operate with little domestic or regional competition and their margins typically exceed 50 percent.
I mentioned previously that Dangote Cement earns a profit margin of around 53 percent on cement, one of the world most basic products. That margin is remarkable in comparison to the 2 percent margin for the cement industry elsewhere in the world.
If early stage investors want to invest in real, high-growth, high-margin, highly defensible, highly impactful businesses, developing countries present as good an opportunity as any. Why do early stage investors repeatedly take risks on product/market fit, existence of a market, competition, timing, etc. just for a one in ten chance that they’ll be right. That sounds more like high risk gambling than skillful investing.
Instead of betting on dozens of companies that could be the next Facebook, why not invest in a couple of companies that could be Nigeria’s Tysons Foods, or Ethiopia’s Nike, or East Africa’s Ford Motor Company, or the African continent’s Gap or Disney?
Effective Allocation of Capital
The World Bank estimates that we will need to create 600 million jobs in the next 15 years to absorb the growing global workforce, mainly in Asia and sub-Saharan Africa. Filling that need will require SMEs. But without financing, these business will not be able to realize their full potential and provide the needed jobs.
We will need to create 600 million jobs in the next 15 years
The current financing gap for formal SMEs is estimated to be US$1.2 trillion; the total financing gap for both formal and informal SMEs is as high as US$2.6 trillion.
Talk about a massive market opportunity!
I applaud the investors, advisors, NGOs, and governmental entities that are trying to solve this problem, especially at the early stage. That includes firms like Novastar Ventures, Omidyar Network, Small Foundation, Accion, Blue Haven Initiative, Endeavor Catalyst, The Lundin Foundation, Schooner Africa Fund, CRE Venture Capital, 500 Startups, Village Capital, Open Capital Advisors, Africa Enterprise Challenge Fund, USAID, the IFC, and several others.
But we need way more capital flowing into these markets.
It’s time for us (early-stage investors) to be honest with ourselves: the technology start-ups that are getting the most attention (the press is complicit in this), the most support, and the lion’s share of venture funding (see my prior post) are NOT creating long term, sustainable value. In many, many instances, they aren’t even creating technologies that solve REAL problems. Case in point, the app Yo.
Research from organizations like the Kuaffman Foundation and individuals like Shikhar Ghosh at Harvard Business Schools estimate that 3 out of 4 venture backed companies do not return capital to their investors.
Of the venture backed companies that do return capital to their investors, most investments do not grow to become unicorns.
At the 500 Startups PreMoney Conference, David Cohen (TechStars) said that you need to invest in 200 to 250 companies in order to find a unicorn. And that’s not a guarantee. Even Fred Wilson (Union Square Ventures) made the observation a few years ago that most venture backed start-ups are not sold for more than $100 million.
Instead of investing in companies like Secret, Color Labs, and other technology companies with little to no hope of finding product market fit or sustainable revenue models, or using a spray and pray approach to investing (investing a small amount in a large number of companies, with little due diligence, hoping that a handful of them succeed), or shooting to find a unicorn every time they make an investment, in order to be better stewards of their limited partners’ capital, early stage investors should be investing in businesses that have more realistic chances of being successful.
Start-ups in developing countries offer ample opportunities for early stage investors to invest in businesses that take advantage of clear gaps in the market, are scalable, and that solve real world problems.
Those investments would help address the financing gap, build businesses that create new jobs that pay their employees decent wages, promote economic development in low-income countries, and contribute towards making the world a more secure place for everyone. Everyone wins.
Who can argue with that?
Well, some will argue that there are risks associated with investing in developing countries. However, most of those risks can be mitigated or, if not, the risk can be factored into the price you pay.
Others will say that we wouldn’t have some of the innovative companies we have in the U.S. today if early stage investors hadn’t taken a chance on them. We have enough photo editing apps. If a company is developing a technology that’s truly innovative and needed, it’ll get the funding it needs.
We pride ourselves on our ability to solve difficult problems. Let’s put the minds and talents of some of our smartest and hardest working people towards solving problems and scaling businesses that ACTUALLY make a difference in the world.
Insufficient investment and stagnant economic development in developing countries cause significant problems, such as:
- Food Insecurity — inadequate food production, soaring food prices, poor quality and nutritional value, and erratic weather patterns have all contributed towards creating a world in which close to 800 million people are undernourished. Most developing countries are net food importers and, as such, are extremely sensitive to increases in food prices.
- Youth Unemployment/Underemployment — the developing world is home to more than 75 percent of the world’s youth population. By 2035, the number of Africans joining the workforce will exceed the number people joining the workforce in all other countries combined. Inability to find gainful employment can have long-term consequences — erosion of skills, lower life-time earnings, little to no prospects to improve their lives, increasing appeal of extremist organizations such as Al Shabab, Boko Haram, ISIS, and Al Qaeda, and mass migration and refugee crisis.
- Slower Poverty Reduction — The richest one percent of the world’s population has more wealth than the rest of the world’s population combined. People living in the world’s richest countries are now 134x richer than those living in the poorest countries. This is a direct result of persistent lack of economic development in certain parts of the world. The rapid spread of information means that more people are now aware of their relative lack of wealth and opportunity. As with unemployment and underemployment, high levels of poverty create conditions that are ripe for political conflict, instability, and even terrorism.
This is simply the tip of the iceberg and we’ll continue to discuss the implications in additional posts going forward.
Challenge to Early Stage Investors: Invest to Solve Real Problems
The entrepreneurs from over 170 that I met at GES 2016, and the ones that we at VestedWorld meet with in our travels across sub-Saharan Africa, are doing their part to address poverty, food security, unemployment, and economic growth in their respective countries. It’s time for us, early stage investors, to do more.
In his remarks to all the GES 2016 delegates, President Obama said that “the world has shrunk. It is interconnected.” The entrepreneurs and investors in Silicon Valley and across the developed world have played an incredible role in creating this interconnected world — Mark Zuckerberg and Facebook, Larry Page and Sergey Brin and Google, Reid Hoffman and LinkedIn, and Niklas Zennström and Janus Friis and Skype, are just a few examples.
The President went on to say that:
In today’s world, where our economies have undergone dramatic shifts, where businesses don’t stop at borders, where technology and automation have transformed virtually every industry and changed how people organize and work, entrepreneurship remains the engine of growth. That ability to turn an idea into reality — a new venture, a small business — that creates good-paying jobs; that puts rising economies on the path to prosperity, and empowers people to come together and tackle our most pressing global problems, from climate change to poverty.
When people can start their own businesses, it helps individuals and families succeed. It can make whole communities more prosperous and more secure. It offers a positive path for young people seeking the chance to make something of themselves, and can empower people who have previously been locked out of the existing social order — women and minorities, others who aren’t part of the “old boys” network — give them a chance to contribute and to lead. And it can create a culture where innovation and creativity are valued — where we don’t just look at the way things have always been, but rather we say, how could things be? Why not? Let’s make something new…
…And part of our job, part of this summit’s job is to make sure that we’re putting more tools, more resources into the hands of these folks who are changing the world, and making sure that all of you know each other so you can share best practices and ideas, and spread the word.
Our experience has shown us that, in order to build the businesses that will help alleviate poverty and create prosperity, entrepreneurs in developing countries need both capital and strategic and operational support.
This is an area that requires concerted efforts. The needs and the challenges are significant.
To all of us already investing in developing countries, the onus is on us to prove that we can deliver competitive returns by investing in these markets. I know it takes time for investments to mature and for exits to materialize, but the better capitalized a company is, the less time the management team has to spend raising money, the faster the company can grow, and this increases the likelihood of achieving a profitable exit.
To all of the early stage investors that are not investing in businesses that solve real problems, who invest blindly without seriously thinking about the viability of the business model and/or concept, those who do not consider the social good being created and overall impact on society and the world, I strongly encourage you to refine your investment thesis and strategy. You can earn competitive returns while making a difference in the world.
Remember that a world in which everyone is more prosperous is stronger and more secure for everybody.