The global venture capital (VC) landscape is shifting from a period of high activity and optimism to a more measured and introspective phase. Africa is no exception. The continent is seeing reduced traffic due to recent interest rate hikes over the past 18 months. Investors are turning away from risk-seeking asset classes in favor of more secure investment vehicles. This shift has significant implications for both founders and investors, leading to layoffs, down/flat rounds, and in some cases, startup failures.
In these uncertain times, there are key considerations that can make all the difference between sinking and sailing through the storm. Let's explore these critical factors:
All markets are not created equal. The size of your target market, whether it's large, small, emerging, capped or uncapped, plays a significant role in assessing its current and potential value.
The success of a startup is significantly influenced by the market in which it operates. The dynamics of different markets vary, so founders need to strategically choose the most attractive markets. These come in two forms:
Big, Uncapped Markets: A large, continually expanding market provides a great playground for startups. It's not about exponential growth, but consistent, predictable expansion. In these markets, multiple players can coexist, unique business models can be created, and you can reach your target market in new ways. Take agent banking as an example. Before the turn of the millennium, it was non-existent. It began in Brazil and later expanded to the rest of Latin America, Asia, and Africa. By the 2010s, Africa began to have a small but growing alternative banking system made up of agents who served as human ATMs and micro-banks. Today, unicorns have emerged in Africa from agent banking and its close counterpart, mobile money.
Emerging and Growing (Expandable) Markets: At first glance, these markets may appear small, but they show clear potential for substantial growth. This growth might stem from investment or the discovery of new opportunities. Two or three decades ago, the renewable energy sector wasn't a significant market. However, as concerns over fossil fuels grew, technology advanced, and upfront costs reduced, the solar energy market began to flourish. Despite its small beginning, it's now an attractive sector with many possibilities. Emerging but growing markets are better able to make larger double-digit leaps, and early innovators reap the greatest rewards.
Adapting to the market landscape and finding the right opportunities are fundamental to achieving success in this winter.
Macroeconomics - Devaluation and Inflation
Many African markets are grappling with foreign exchange challenges. Global investors are becoming more cautious about investing in emerging African markets, leading to a decrease in foreign currency inflow. Additionally, African governments are experiencing reduced forex reserves and volatile forex rates, including the Big 4 African markets - Nigeria, South Africa, Egypt, and Kenya. Elevated fuel prices are leading to higher import bills for countries like Nigeria and Kenya. As a result, these governments are focusing their limited foreign currency reserves on essential items, causing an increase in exchange rates for the public.
In June 2023, the Nigerian government floated the Naira against the US dollar and other global currencies at the Investors and Exporters' (I&E) Window of the foreign exchange market. This action devalued the currency by 40%. Since then, the currency has fallen by another 40% in the parallel market. With an inflation rate of 26.7%, startups in Nigeria are faced with unique challenges that require a reevaluation of traditional investment and business approaches. The devaluation of the currency and soaring inflation rates mean that businesses must achieve a growth rate of at least 2x this year to maintain a neutral financial position. Simply put, if your business isn't growing this fast, it's effectively shrinking in real economic terms.
To thrive in this environment, founders need to implement strategies to mitigate these risks. This might involve diversifying revenue streams to reduce dependency on the local market and earning foreign exchange (FX) revenue, which acts as a buffer against the volatile local currency. Demonstrating robust traction and growth to potential investors and partners is also crucial. Strong traction can inspire confidence and attract investment, even in challenging economic conditions.
Navigating a devalued and inflated economy requires a shift in investment and business strategies. The ability to adapt to these conditions, mitigate risks, and meet investor expectations is crucial for long-term success. In the end, those who can demonstrate resilience and innovation in such economic climates will be better positioned to thrive in adversity.
It's important to be aware that conventional multiples based on revenue and valuation models may not be accurate. This is because high inflation and currency devaluation can distort these figures and affect the accuracy of financial assessments. As a founder, you should look out for investors who are aware of these economic realities and are willing to adjust their valuation metrics accordingly.
Founders should also shift their focus from headline valuations to addressing dilution. Dilution can significantly impact a founder's ownership stake in their company, and this becomes relevant at each funding round. For instance, at Series A, founders should ideally maintain at least 50% ownership after Employee Stock Option Plan (ESOP). Maintaining a significant ownership stake is crucial not only for financial benefits but also to ensure founders stay motivated and committed to the company's growth. We encourage founders to be flexible on valuation but clear on the minimum amount needed to achieve their key milestones and remain capital efficient after the raise. Engaging with investors on this topic at each fundraising stage can lead to more favorable outcomes for both founders and investors.
Build with an Exit Mindset
A clear path to exit is more critical than ever. In Africa, a majority of exits occur through mergers and acquisitions (M&A). Therefore, founders need to demonstrate that potential acquirers are interested in their business. Founders should familiarize themselves with similar business models and industry players, ensuring that their strategies align with a potential exit.
They can even go the extra mile by establishing contacts in potential acquirer companies to understand the critical factors that will make them an attractive target in the future. This can help them create an ‘exitable’ business model.
The third quarter of 2023 paints a striking picture of the current landscape. Startups managed to secure around half a billion dollars, comprising $324 million in equity and $176 million in debt. However, what stands out is the broader context in which these figures exist. In total, startups have raised $2.3 billion this year, consisting of $1.4 billion in equity and $0.9 billion in debt. Despite being a substantial amount, it's less than half of what was raised in 2022.
For the first time since mid-2020, no mega deals were recorded in Q3 2023. This underscores the growing complexity of securing large-scale investments. The investment ecosystem is changing, and entrepreneurs must adapt by seeking more efficient ways to manage the capital they secure.
Startups must optimize their use of available funds, diversify revenue streams, and focus on demonstrating traction and growth. We’ve moved away from the era of blitz-scaling to sustainable growth. This involves carefully assessing growth strategies, understanding which markets to enter, and when to do so. A capital-efficient Go-To-Market (GTM) strategy is lean, focusing on reaching the right customers with the right message using the least resources. A good rule of thumb is a 3:1 ratio of Lifetime Value to Customer Acquisition (LTV:CAC). Up to 4:1 indicates a good business model.
Capital efficiency also involves hiring the right people at the right time. A lean team of top talent will outperform a larger team of average employees. Streamlining your supply chain, logistics, and internal processes can significantly reduce costs. Constantly monitor your operations and financial health and be ready to adjust your strategies as market conditions change. If certain initiatives are proving ineffective or inefficient, don't hesitate to cut them loose and focus on what's working.
Keep your house clean for Due Diligence
The bar for startups seeking investment is significantly higher in this economic climate. Investors are under pressure to deliver positive returns to their Limited Partners (LPs), particularly given the unique concerns associated with African markets. As a result, investors are scrutinizing opportunities more rigorously. This means deeper due diligence, stricter investment terms, and overall more risk aversion from foreign and local dollar-denominated funds.
So, what does this heightened scrutiny mean for founders? It's time to ensure that your "room" is spotless. . This involves not just tidying up your finances and operations but building a robust framework for transparency and accountability. Be prepared to answer in-depth questions about your business model, finances, and scalability.
Despite these challenges, our commitment to Africa remains unwavering. Investment vehicles often operate on 5-10 year horizons, meaning market downturns are typically encountered along the way. However, these downturns serve as lessons, opportunities for growth, and occasions to craft innovative solutions to address the challenges. This is just the beginning of the journey of VC in Africa, and we remain excited and privileged to be a part of it.