6 days ago I wrote this on LinkedIn – “The SA VC model is broken. Correction – it has never been right. We need solutions that allow our entrepreneurs to get access to the correct type of funding on the correct terms. That means getting our entrepreneurs access to mature and offshore funding models or bringing these models to SA. Mark my words – the SA VC model is ripe for disruption and needs a wake up call. The 1-for-40 Club be warned….”
Here is the response so far – 70,709 views. 314 likes and 58 comments. And they keep coming in. Click here to go the LinkedIn post.
So why did I post this and why has it caused such an interest? What is wrong with the SA VC ecosystem?
Before delving into the details, let me also stress that there ARE good VCs in SA, but what I set out below is based on my general experience, corroborated by almost everyone I discuss the matter with. Just read the comments on my LinkedIn page.
- Lack of Angels and VCs
SA, and Africa as a whole, has very few Angels. No-one seems to know exactly, but anecdotally perhaps 100 in Africa with up to 50 in SA (if even half that much). Therein lies the first problem – there are very few Angel investors available to close the funding gap and break out of the startup “Valley of Death”. However, having said that, there are communities in SA where inter-community funding does take place – Jewish, Indian, Afrikaans (the so-called “Stellenbosch Mafia” in particular) and, to some extent, the emerging black diamonds. All well and good, but they aren’t spreading the love. The point is, however, is that there is Angel funding out there – it is just, for the most part, hidden in one way or another. The key, I think, is to find a way of unlocking this funding.
On VCs – 30-odd VCs in SA is just way too small a number to make a difference. Never mind their mindset (see below). Why is this? Is it a function of the above (communities backing each other); a lack of risk appetite; a lack of institutional appetite for VC; a lack of understanding of VC? I think it is a combination of all these. There are little or no push nor pull factors that will change this, in my opinion.
Further, the fund sizes are way too small on average. There is limited scope for meaningful investments and follow-on investments.
- VC mindset
From many years of working with large, listed entities a C-Suite level, as well as the institutional shareholders which fund them, I have been brought down rather rudely to earth over the last 3 years or so. Not only have I tried to raise funding for client startups and SMEs, I have also tried to raise funding for businesses in which I am personally involved in. I am completely nonplussed by the reception we have received from the SA VC crowd:
- For the most part, the attitude is that they are doing you a favour by talking to you – they can get away with this attitude because the supply/demand structure is skewed in their favour
- They generally sing from the same song-sheet – I call it the The “1-for-40” club – they’ll deign to invest in you for R1m but want 40%
- They generally have a PE mindset, but I think they go further because they all have a quasi-debt mindset too – invariably talk turns to some form of security
This is not VC investing! True VCs do not invest and try to protect capital at the same time. VC is all about taking risk. Sure, this can be mitigated by liquidation preferences (read this article by Mark Suster on convertible notes and liquidation preferences), but to ask for additional security normally found in PE deals, or, even worse, debt-type security found in debt-funded deals, is not VC.
Speaking of convertible notes, we were once shown a term sheet by a well-known SA VC crowd that proposed a convertible note. The standard mantra was given – your company is too early-stage to determine a valuation, so let’s leave this for the next funding round and we’ll convert our investment at a 25% discount to the pre-money valuation at that time. For all the reasons stated by Mark Suster in another of his articles we were against the convertible note. But what was really unacceptable was that we were told “this is a standard SA VC term sheet and widely used in Silicon Valley”. It shouldn’t be and nor is it. The galling aspect of this is that uninformed and unsuspecting SA entrepreneurs are going to believe this type of nonsense, and pay the price at a later stage.
- Entrepreneur mindset
Most entrepreneurs that I have dealt with have no clue how to build a business plan and financial forecasts, let alone how a cap table and funding roadmap (from Angel to VC to PE) works and can be planned for. Which means they are completely blind to the Valley and other global VC pockets. Which puts them squarely into the clutches of our 1-for-40s.
In addition, there are some cultural hurdles (generalisation, of course):
- South Africans tend to be insular and don’t really think on a global scale
- We don’t like giving away equity – dilution is a no-no and lifestyle/family businesses are the norm
Our entrepreneurs need to educated and exposed to a different way of thinking. This lack of knowledge is a serious impediment to them, and the worst is that they don’t even know what they don’t know.
- Corporate mindset & CVC
SA is missing out on the CVC wave that is still gaining momentum worldwide. I have written about CVC before and can’t see any discernible change in SA corporate behaviour. Our corporates tend to look north of the border or to other global markets, but are not looking internally at our own entrepreneur base. I think this is down to mindset and education – the market needs to be talking about it for public CEOs to sit up and take notice.
- Institutional mindset – Fund Management Industry
Our fund management industry has a huge role to play in changing the structure of the market. There is very little funding from them into the SME space. There is also little or no pressure on them to change this outlook. I am not sure if this is a Catch-22 situation and whether the market needs to mature first (creating the demand) or whether the industry should be pushed in whichever way possible (creating the supply). I also wonder whether the CFAs the local industry hires are even aware of VC investments and the pre-IPO world…
- Accelerators / Incubators
A new one seems to pop up almost every month. But 99% of them have one glaring gap – the inability to provide meaningful, direct funding. And because of the structural constraints, they find it almost impossible to source such funding from elsewhere. So, with the best will in the world, they only help to a limited degree.
There have been many new S12J vehicles (more than 30 when I last checked a few months ago), but hardly any have raised significant funding. There can only be a small handful that have managed R100m, with most, I think, less than R50m. We need larger S12J vehicles with enough firepower to fund a whole lot more, with bigger ticket sizes and follow-on possibilities.
Although they do have their issues, S12Js need to be publicised and pushed by government and institutional investors. They really are a good tax efficient investment vehicle.
- Excon and SARS
In the last budget speech, the (ex-)Finance Minister mentioned the relaxation of IP-offshoring rules in his budget speech, but I have yet to see any detail on what this entails, or if it has been followed up with any changes to the legislation. This is vital for SA entrepreneurs if they are to be able to attract offshore investment interest.
- Exits – IPOs in particular
I used to work at the JSE and sat on its Listings Committee for many years. It is a great organisation and has served the SA capital markets well for a long time.
However, in my opinion, as an institution it has failed in 2 very important areas: i) getting retail investors interested in investing; and ii) providing a meaningful, efficient and effective IPO platform for smaller companies. In comparison to AIM (the LSE junior market), I think AltX has been a failure.
The new exchanges that are coming to market may change this. But it is no surprise that most entrepreneurs in SA don’t think of a JSE exit as an IPO and, even if they do, limit their thinking to the JSE alone. They don’t think of NASDAQ or NYSE or LSE or even Mauritius. This requires a mindset change, which can only come about via education.
So what needs to change?
Like everything in this wonderful, maddening country of ours, nothing is simple. There are many moving parts in my narrative above and we are facing political and economic uncertainty headwinds.
But there are some clear threads, I think:
- Education of our entrepreneurs and investors and exposure to global best-of-breed practice
- Retail investors need more exposure to pre-IPO markets. I believe that S12J is a good vehicle for this
- Institutional investors need to invest more in the pre-IPO space
- Corporates need to embrace the CVC model and start investing in local entrepreneurs (and no, the general SD and ED spend on BEE scorecard points is not CVC)
- We need our VC ecosystem to evolve and mature
I know of various plans to address the above and am personally involved in some. The more the merrier…
What do you think? I’d love to hear your thoughts.