99 Problems But Quick Cash for African Venture Shouldn’t Be One
The fast funding trend in venture capital has now reached African markets. Cheap capital has made for lazy investing. Covenant light agreements such as SAFE (simple agreement for future equity) notes are multiplying, which leads to the misalignment of incentives among founders and investors. In an effort to create simplicity and expediency, venture investors are seeding future problems in Africa’s nascent funding ecosystem. While it may take longer and demand more relational capital, investors must have hard conversations with founders about valuation, governance, and ownership structures before they invest.
Questions of valuation are at the core of venture capital investing. The multiples being used and comparisons made have huge impacts on the capital structure of a company and, consequently, founder equity. Between 2016 and 2017, venture capital fundraising in Africa increased by over 50%. As the number of active fund managers in Africa grows, competition over investment targets among homegrown and foreign investors is strengthening. The use of SAFE notes and KISS agreements pioneered by Y Combinator and 500 Startups, respectively, has become popular as investors rush to gain access to hot deals. In the rush to raise money through mini-rounds and convertible notes, founders are often overlooking the impact on future valuation. What is seen as flexibility for the founder in the short term can turn punitive in the near future.
Improving firm governance is core to successful investing in African markets. Rather than being seen as a “nice to have” or a luxury, good governance can drive value creation. In small and medium enterprises, improved corporate governance can account for 20 to 30% of value creation generated from an investment, a finding supported by a 2012 INSEEC study. According to a recent survey of PE investors, 55% of respondents indicated that they would pay at least a 10% premium for good governance in emerging market countries. Professional, well-managed advisory boards can give industry-specific advice and expand the business networks of founders. In a 2016 speech at Stanford, Mary Jo White, former U.S. Securities and Exchange Commission Chair, noted that “as the latest batch of start-ups mature…. it is important to assess whether they are likewise maturing their governance structures and internal control environments to match their size and market impact.” Developing human resource management within small companies not only addresses compliance issues, but can also lay the groundwork for firm competitiveness. Since the quality of corporate governance will also be an important consideration for follow-on investment, addressing some of the issues in seed rounds has clear payoffs for both investors and entrepreneurs.
Founders also need to maintain enough skin the game to ensure alignment of incentives with investors. Capitalization math can be difficult through the traditional rounds of fundraising. By adding SAFE notes and other convertibles, it becomes far more complex and can often result in unanticipated founder dilution. VC firms in Africa frequently encounter capitalization tables filled with SAFE notes, each at a marginally higher cap. Too often, founders will find their ownership interests dwindle to 25% when their companies are eventually priced Although founders should generally own the majority of their equity pre-Series A, founders seldom appreciate the variance between the SAFE note valuation caps and what the market is actually willing to pay.
Seeing “skin in the game” is essential for any VC. More and more African startup founders are trading away too much equity too early to accelerators, advisors, intermediaries, and local angels. Despite the difficulty of early-stage conversations on equity and valuation, without them, companies can find it challenging to raise capital in the future when management will have little incentive to further grow the company. A cryptocurrency startup recently overcame this challenge when a number of new investors helped the management company buy-back shares for the company’s management and in turn create liquidity for some early investors. Recently, Zinox, a Nigerian technology firm, acquired Konga, one of the country’s leading e-commerce companies. Shola Adekoya, Konga CEO, has since stayed on as CEO under the company’s new ownership. Zinox, which now owns 99% of Konga has clarified that there will not be any mergers with its existing e-commerce affiliates leaving the impetus for value creation solely on the shoulders of an entrepreneur with a limited equity stake in his own company.
Vague understandings and open-ended documents lead to uncertain outcomes. Given the historically opaque legal environments in African markets, ambiguity poses a risk to investors and founders alike. Building long-term business relationships on solid ground is preferable to fast tracking agreements for quick cash. A healthy and profitable ecosystem benefits everyone in the long term. It is imperative that investors embrace the serious responsibility of due diligence and governance enhancement as they seek to fund, nurture, and create value alongside African founders. Founder commitment and investor discipline are vital to the early success of companies and kicking the can down the road on hard issues is in no one’s best interest.