Solving the VC funding gap

Justin Spratt

[By Justin Spratt] Large sums of money are available to technology start-ups in SA. But there are almost no technology start-ups getting funded.

This is a big problem for the country, both socially and economically, as it strives to lift its long-term growth trajectory. Foreign direct investment and portfolio investment flows will never achieve this alone. Strong growth in new businesses is paramount for growth and social upliftment.

Start-ups in the technology sector offer the fastest growth opportunities, simply because of faster economies of scale and usually require lower capital investment, making it the perfect industry to target start-ups. So it’s worrying that so few are being funded.

There are two schools of thought as to what the problem might be.

The first is that the capital available is too risk-averse, that money is not available early enough in the start-up process.

The second reason given is that SA start-ups don’t have sufficient skill in product development and management. Theories on why this is the case range from corporate SA sucking up all the talent, to culture, and to lack of training in these disciplines in tertiary institutions.

Before we unpack each of these theories, we should take stock of the evolutionary stages that start-ups go through. They usually start by “bootstrapping” themselves. This means self-financing or borrowing money from friends and family.

More often than not, start-ups usually get to a point where they need external, structured capital. It’s at this point they usually require seed funding.  Depending on how well they have bootstrapped themselves, this could be through angel investment or the more structured venture capital.

Angel funding is usually provided by successful businesspeople who lend money on less stringent and more favourable terms to new entrepreneurs — Johann Rupert is a notable example in SA.

More sophisticated types of capital come in the structured forms known as venture capital. Within VC, there are “tranches” of money provided, depending on the “round” of investment. Each round is designed to give more scale, in turn to take the startup closer to the money making “exit”– often a stock market listing.

So if we plot out the types of financing for start-ups, we get what I call the “financing continuum”.

The finance continuum

With capital being too risk-averse, it means that money is only available closer to the “exit” stages.  In SA, there is very little demand at this late stage from new businesses. Conversely, there is almost no source of capital at the seed (early) stage. Clearly this gap is problematic as we try and foster a culture of entrepreneurship to obtain the growth and upliftment needed.

The supply of start-up businesses for latter-stage investment is scarce because of the lack of skills to develop slick “productisation” (ability to price and market products) and go-to-market strategies.

In the words of the talented Vinny Lingham, founder of Yola.com, “product management skills in SA start-ups are almost non-existent”.  He says people with these skills tend to be drawn into the corporate world by big salaries and then don’t bring those skills into the start-up ecosystem.

Andrea Bohmert, Managing Partner from HP-Ventures, a venture capital fund with money from SAP co-founder Hasso Plattner, expresses a similar concern.  She sees many great ideas from smart people in SA but they lack key elements of being able to bring those ideas to market.

As a result, and in order to offer a solution, there is an increasingly popular form of investment financing that focuses on nurturing these skills. They’re called incubators. Notable examples include 20FourLabs (part of the MIH group); Vodacom Labs; Internet Solutions’ ISLabs (internal and external projects); and, to some extent, Stellenbosch’s Media Lab.

These incubators provide almost no financing but rather focus on mentoring, providing strategic input, and opening doors to opportunities. The paragon examples internationally of this nascent form of funding are Paul Graham’s Y-Combinator and Guy Kawasaki’s Garage Technologies.

It’s early days yet, but if Y-Combinator’s success in America is anything to go by — 10% companies already funded with only 20% failing — it looks like the incubator model will fill the gap in the start-up financing ecosystem.  — Justin Spratt

  • Spratt is co-founder of ISLabs

Share this article

  • http://www.whitewallweb.com Pete Flynn

    Also worth a look are http://www.raizcorp.co.za/ and http://www.rampgroup.co.za/get-funded/ doing interesting work in this space

  • http://www.sandboxsavant.com justinspratt

    Absolutely Peter. Dont know much about Raizcorp, but your RAMP initiative absolutely deserves a mention here.

  • http://xergames.com Cathi Lamberti

    Great insight into this issue. I am gleaning my own perspective based on the what I am experiencing in the US. Our situation is very different but there is a huge problem getting new initiatives funded. One real problem is the fact the loss of liquidity has given those with the cash tremendous leverage over the talent base. My fear is the huge equity demands for cash is resulting in the talent base maintaining far too little of their companies which makes for a fragile entrepreneur base. We all know that entrepreneurs will endure anything to give life to their creations but take away the upside incentive and they may not have the stomatch to hang in.

  • http://hittingthewire.co.za Dave Gale

    Nice topic – good thoughts Justin. I see Duncan is losing no time in roping people in to the virtual cocktail party here! :)

    I’d certainly agree with you on local capital being risk averse. There seem to be a number of options open for “seed” funding, but little available at the “bootstrap” stage – not surprising though – if it was my money, I’d likely be as cautious. Unless (as Henk Kleynhans of Skyrove was able to prove recently – http://www.geekrebel.com/2009/07/raising-money-in-a-recession.html ) you have people with money who trust you, you almost need to prove that you don’t need the money before a VC will commit.

    As far as Product Dev & Management go, having spent the better part of the last decade in that, I’d say “maybe”. There are people who have good ideas & products, and price & position them quite well. I think what is often lacking is the ability to define a clear strategy to gain market share, focus on one clear, tangible advantage (not a whole mishmash) and the ability to convert a plan into reality day by day.

    Too many SA small business owners spend no time working on their business as opposed to working in it. They also seem to lack the ability to at the same time take risks but apply uncommon sense to their decisions. There is a poor culture in our youth of investing in “assets” which generate income vs “liabilities” which don’t – if there is one thing I’ll drum into my kids if it kills me it is that! We’re also in too much hurry to reap benefits from a company instead of being patient, earning less than we could and plowing it back to potentially reap more later. Drive a Citi Golf for a few years more when you could buy that 320i dammit!

    A few proven Cape based incubators worth a mention:
    BandwidthBarn (http://bandwidthbarn.org/), CITI’s flagship project
    & Mambaven (http://www.mambaven.com/) a small, but successful private incubator.

    A mix of available funding at all stages of development plus mentoring is vital! I’m pleased to see Max Kaizen giving mentoring some focus (http://maxkaizen.com/2009/08/23/gathering-some-jedi-masters-the-magic-of-mentorship/) as too many of us have had too little.

    Personally, I’ve told my kids I’d like to see them start at least two businesses (and preferably have at least one of them fail) before they leave school – definitely before they leave varsity. What better time to chase big audacious dreams and take risks, getting a “real” education without too much pain.

    You get to my age, you fret over opportunities lost in the past and the stress of winning the daily bread while trying to convert dreams into reality day by day.

  • Justin Stanford

    Nice article Justin, and I think the incubators are doing very good work. I’m hoping that we’ll be able to start getting involved in this funding gap very soon with our seed fund at 4Di Capital created specifically for this… our first 3 seed projects have just been approved in fact!

  • http://www.geekrebel.com Henk Kleynhans

    Great article Justin! (And great comments from the usual suspects)

    Do you think that a Y Combinator model could work here? (That is, investing $5000 + $5000 per founder into a small company in exchange for 6% and then run a 3-month “workshop”).

    Would love to hear some of the pros & cons!

  • http://oneafrikan.com/ oneafrikan

    Great write up Justin ;-)

    From my perspective there are a few things that people in SA seem to be battling with (my focus is on web based software / products):

    1. the SA market is very small to build a software business for, unless you have a service with a very clear revenue model that can scale enough to pay the bills from very early on. I have seen very very very few of these.

    2. SA folks don’t seem to have a lot of experience in developing products for the global market; or doing localisation for global markets.

    3. definite shortage of product / dev / agile skills to facilitate the above.

    So even with funding, there is still a huge mountain to climb…

    Then, with funding, I don’t think that anything smaller than a years cash for one or two people (at minimum in classical y Combinator model) is going to be enough to make enough progress. Bootstrapping IMO is a good idea as it lowers risk for everyone, and I think is a process every budding entrepreneur should go through as it enforces reality ;-)

    My take is that we don’t need incubators as much as we need a deal flow for angel and seed investors to exit with, which is what would make raising money feasible. This of course assumes that we’re building something from scratch.

  • Mike

    Nice article Justin.

    My understanding of a true incubator is providing new businesses/start-ups with early support to get their business off the ground.

    Can you provide any examples of where 20Fourlabs or Vodacom labs have done so? Or at least have set aside specific budgets to do so? These brands may carry the “labs” title, but are focused on their own development needs only.

    Until that changes, it’s that inward thinking and behaviour that does nothing to close the gap you refer to.

  • Archangel

    High risk capital follows extraordinary entrepreneurs and ideas. South African entrepreneurs need to be super-extraordinary in order to overcome the additional burden of distance, oversight, global competition and perceived lack of historical success when compared to alternative entrepreneurial investment opportunities from Israel, India and China.

    The VC funding gap will begin to narrow when you reach a critical mass of entrepreneurs who believe and can build R500M businesses in 3 years with R5M to R10M in funding … and only one in a hundred of these proposals might actually get funding!

  • http://www.vinnylingham.com/silicon-cape.html Vinny Lingham

    Hey Justin

    Great post – love the graphic too! Your post dovetails nicely on my Silicon Cape post previously (http://www.vinnylingham.com/silicon-cape.html) – we should produce a comprehensive thesis . Looking forward to helping to solve the problems you mentioned and many others!

    Cheers
    Vinny

Why TechCentral?

We know that as a prospective advertiser, you are spoilt for choice. Our job is to demonstrate why TechCentral delivers the best return for your advertising spend.

TechCentral is South Africa’s online technology news leader. We don’t say that lightly. We believe we produce the country’s best and most insightful online tech news aimed at industry professionals and those interested in the fast-changing world of technology.

We provide news, reviews and comment, without fear or favour, that is of direct relevance to our fast-expanding audience. Proportionately, we provide the largest local audience of all technology-focused online publishers.

We do not constantly regurgitate press releases to draw in search engine traffic — we believe websites that do so are doing their readers and advertisers a disservice. Nor do we sell “editorial features”, offer advertising “press offices” or rely on online bulletin-board forums of questionable value to advertisers to bolster our traffic.

TechCentral, which is edited and written by award-winning South African journalists, cares about delivering top-quality content to draw in the business and consumer readers that are of most interest to technology advertisers.

We’d like the opportunity to demonstrate the value of directing a portion of your advertising budget to TechCentral, whether your company is in the technology field or not. Numerous opportunities exist for companies interested in reaching our audience of key decision-makers in South Africa’s dynamic information and communications technology sector. We offer packages that will deliver among the best returns on investment available in the online technology news space.

For more information about advertising opportunities, and how your organisation can benefit by publicising itself on TechCentral, please call us on 011-792-0449 during office hours. Or send us an e-mail and ask for our latest rate card and brochure.