Why funding matters at early-stage, and why more funds are active in this area

0

Early-stage funding has proven a problematic gap within Africa’s startup space, but developments in 2020 went some way to addressing that. 

The funding gap in the early stage of a startup’s life is sizeable, and poses all sorts of challenges. At best estimates, less than 20 per cent of all VC funding in Africa in 2019 and 2020 went to early-stage ventures.

Zach George, leading African angel investor and chief investment officer at Startupbootcamp AfriTech, says because very few institutional investors participate in funding rounds that are pre-Series A, this portion of the funding landscape is almost entirely filled by friends, family, and local angel investors. 

“Accelerators provide much needed financial and non-financial support too at this junction. But it is definitely the one area of equity funding in Africa that has the biggest opportunity for further development,” he said.

There are signs of further development, however, with the gap definitely beginning to close during 2020. Jake Kendall, partner at DFS Lab, says he sees positive steps being made in the early-stage funding space.

“There could be more capital for sure at the pre-seed and seed stages. But it’s actually getting much more competitive at pre-seed than it was. I would say that the gap is not nearly as big as it was a few years ago, with both international and more local angels too,” he said.

A host of new funds targeting startups at the pre-seed and seed stages launched in 2020, key among them Sherpa Ventures, Acuity Ventures and the Future Africa fund, the latter founded by Iyinoluwa Aboyeji of Andela and Flutterwave fame.

Meanwhile, seed fund Kepple Africa Ventures is probably the most active VC on the continent, having backed almost 40 startups in 2020 alone. Coupled with the growth in angel investing – and the increasing number of angel investor networks across Africa – it means there has never been a better time to seek funding as an early-stage startup on the continent.

But why is early-stage funding so important?

Aaron Fu, who co-founded Sherpa Ventures and has been an active investor in African tech with previous companies MEST and Nest, as well as in a personal capacity, says funding at the earliest of stages is critical for a thriving ecosystem. 

“The results bootstrapping founders have achieved in the last 10 years have been incredible, but imagine how many good outcomes could’ve been phenomenal outcomes if there was more capital accelerating their progress, enabling them to take bolder risks, strengthen their talent base, invest in stronger design and software architecture,” he said.

The lack of funding means startup founders are forced to spend a disproportionate amount of their valuable time chasing it.

“This takes away the focus of founders from operations and customer acquisition to fundraising – which is not good for the ecosystem at all,” said George.

The impact of raising early-stage capital also goes beyond the mere financials, with investors at this stage bringing more than just money to the table

“Strong active early stage investors are able to synthesise tools, frameworks and learnings from a range of startups they’ve worked with to give founders that peek around the corner, anticipating challenges and building mitigation strategies from day one,” said Fu. 

“They’re also able to leverage the trust and understanding they’ve built with potential partners delivering supporting services or go-to-market pathways to give their portfolio a headstart working with these partners. Many also bring to bear a significant talent network of startup operators, leaders, professionals who they’ve worked with in the context of other companies and have a deep understanding of the results they can achieve in different contexts.”

George agrees the network of an early-stage investor can prove crucial to a startup.

“Investors at the early stage should offer access to very clear, defined networks in the industry – such as corporate divisions that can run pilots, proof-of-concepts or commercial transactions with the startup to validate and verify a problem-solution fit,” he said. 

“Investors should also be assisting with guidelines around industry best-practices that often the founders don’t have much experience or expertise in. Lastly, investors at the early stage should be able to clearly open doors to a rolodex of later stage institutional investors once certain KPIs around revenue, transaction volumes etcetera are met from the seed round.”

There is no getting away from the fact early-stage investing is a risky business, however. Fu says individually these investments are very risky.

“Not only are failure rates high but even if the startup is doing incredibly well, there’s still a persistent risk of there not being a liquidity event. M&A activity is certainly increasing but there still isn’t a deep pool of active acquirers of later stage startups at the valuations they need to transact at, secondaries are growing in popularity but are still far from mainstream,” he said.

There are ways of alleviating that risk, however.

“Things get better at a portfolio level though- spreading out country risk, industry risk, partner risk etcetera. Early data from a number of investors who’ve been active in the last 10 years certainly show strong portfolio level outcomes,” said Fu.

George says that while early-stage investments are indeed pretty risky, they also offer by far the greatest opportunity to make returns of between 3x and 10x, and often much more, within two to three years of the investment being made. 

“What is critical to note is that, historically, a large portion of early-stage funding dollars have been used by founders to sort out their legal structures, IP, clean up their HR, fix their tech and UX/UI. And this has prevented companies from rather focusing on scaling and acquiring customers,” he said. 

“That is a key reason why incubators and accelerator programmes are a great filtering mechanism for early-stage investors to source what ventures they can back whereby their investments do not go into non-value adding elements such as the ones described above.”

So with all the opportunities, why are some still so sniffy about small ticket sizes? And what can be done to overcome it?

Fu believes leading factors include cost of due diligence, cost of sourcing, and elements of the risk/return equation. 

“Especially if funds have institutional LPs, the base requirement for due diligence on investments is significant, and so often we’re faced with situations where the cost of the investment process on a US$1 million ticket is only marginally higher than that of a US$100,000 ticket,” he said. “Pair that with typical economics where fund managers are compensated based on AUM, and it’s logical to concentrate resources on a smaller number of larger ticket deals.”

Sourcing startups when you are the first institutional investor is also effort-intensive, relying on grassroot efforts, on-the-ground partners, and often a well executed scout network. 

“Finally, investing a little later, for example post-seed through to Series A, still leaves significant room for return potential with risks being substantially mitigated – by then the model has proven certain elements and is on a pathway towards scale, and it’s more obvious where exit potential lies,” said Fu. 

“For example, if you participate in an US$8 million Series A round at a US$40 million valuation, and that investment exits one year later at US$200 million, that multiple is still a pretty strong outcome.”

George cites another issue that puts people off investing at an earlier stage.  

“Often, investing small ticket sizes as an angel does not give you too many rights apart from having a seat on the cap table – no board role, no pre-emption rights, limited minority protection… That is why investing through a larger Angel syndicate is often a better, more practical way of early-stage investing,” he said.

Regardless of these reasons not to, it seems more and more people are instead seeing the reasons for making early-stage investments, with pre-seed and angel investments becoming much more common. This is good news for the ecosystem as a whole, and a trend we hope to see more of in 2021.

Share.

About Author

Passionate about the vibrant tech startups scene in Africa, Tom can usually be found sniffing out the continent's most exciting new companies and entrepreneurs, funding rounds and any other developments within the growing ecosystem.

Comments are closed.