Venture capital and early stage investing is a well-established industry and asset class in many developed markets, but remains relatively new in South Africa, where multiple opportunities await new investors.
Ian Lessem and Grant Rock, founding partners of a Cape-Town based venture capital and advisory firm Havaic, told a GIBS forum that South African tech start-ups are attracting the attention of local and international venture capitalists. These businesses, which are about creating efficiencies and disrupting markets, can be scaled without a significant increase in fixed costs and often have the potential to expand into international markets.
Havaic, which specialises in early-stage, high-growth African businesses, has invested in nine companies since its incorporation in 2015. These include Instant Property, an online commercial property platform; Aura, a cloud-based security and safety platform, and Kenyan virtual postbox startup MPost. The company intends to invest in a further three ventures in 2019.
Venture Capital, Private Equity and Angel Investing
Rock explained that venture capital is a subset of private equity in that it looks for young companies with growth potential and high returns. However, private equity typically invests in businesses in mature markets with existing market share and often uses gearing to optimise and enhance returns.
Venture capital invests in early stage companies, and targets higher returns from projects that don’t qualify for traditional external debt. Venture capital often funds businesses without a proven track record.
The third category of early stage investing, angel investors, take a risk on a team or business founder pre-revenue when a company is often still in concept or prototype development stage. These investors offer capital on very favorable terms. Rock said angel investors can be difficult to find locally and are often sourced from within the entrepreneur’s personal network.
South African Venture Capital Opportunities
Lessem said venture capital is a well-established asset class in more mature markets such as the United States, where the market is equivalent to South Africa’s entire gross domestic product.
While early stage investing in South Africa’s smaller economy is a new subset, “this is where the opportunities lie. Although it is off a low base, interest is increasing.” Approximately 73% of new businesses require funding, and the mismatch between funding supply and demand presents an opportunity for investors.
Venture capital returns on a dollar basis average between 10% and 14% in the United States and between 3% and 10% in Europe. However, in the rest of the world, including Asia and Africa, this rises to between 12% and 17%.
“Venture capital is a risky alternative asset class and you want the returns to match that,” Lessem said.
Potential Venture Capital Investors
Venture capital’s risk profile means it is “not for everyone,” Rock explained.
Venture capitalists are often private individuals of the appropriate risk profile looking for alpha returns that are above a market index or benchmark.
There is a role for the individual venture capital investor in the domestic market, Lessem argued, as “a little money goes a long way to starting a business in South Africa and costs can be kept low.” Furthermore, technologies built locally and exported into other markets can give investors foreign exchange exposure and offer portfolio diversification.
Rock explained that for venture capital investors, the potential returns and a well thought out exit strategy of between five and seven years are the two most important factors when considering an investment.
“The exit is where you ultimately realise value as all free cash flow is reinvested into the business during the course of the investment. You do it for the exit, not for the dividends. We are looking for supernormal returns or we are not interested,” he said.
Lessem added: “Investing in this game is all about the exit, and it doesn’t happen by luck. You have to have potential exit partners in your line of sight and have a joint working strategy as to whether the ultimate aim is to list in an initial public offering, sell to a private equity investor or to a trade buyer.”
International exit investors were preferable, as this would maximise the value of the investment. “Havaic’s strategy is to invest in rands and exit in dollars,” he explained.
Entrepreneurs and Funding Partnerships
Venture capital funding is appropriate for companies Lessem described as “boot straps” that have been started with personal and family money and require a capital injection to expand to the next stage of growth. These businesses already have a product and clients and are looking for external funds to scale the business.
The investment process takes approximately four months and consists of initial filtering, a detailed due diligence, market review and technical analysis.
Only 1% of 1000 potential investment opportunities result in negotiations for a deal.
“It is better that potential investors take time to pick the winners. As there isn’t much venture capital money available in South Africa they can afford to be more discerning,” Lessem said. As a result, the local failure rate is lower than in more crowded established markets.
Havaic invests in a maximum of three to four companies a year: “You are essentially investing in people and in management teams. They have to have execution ability and a team time horizon of between five to ten years to implement strategy,” Rock said.
Lessem said entrepreneurs should choose their funding partners wisely as venture capital partners are bringing more than just capital to the business: “It is not just an exchange of money. Funding partners are also bringing investing experience to the table and are a partner for growth.”