According to the 2022 Africa tech venture capital (VC) report, African startups raised $6.5 billion throughout the year. That's an 8% year-on-year growth. The number of deals also grew 6% year-on-year.
Despite a bearish VC market, interest in African startups continues to grow, and many players expect it to continue for a while. Yet, as many VCs will tell you, there aren't enough funds to invest in all startups.
Furthermore, not all startups fit the bill for venture capital investing, so how do you know when your startup is VC-backable?
What is a VC-backable business?
For many forms of business financing, the goal is to get a return on that investment. So, when you get a loan from a bank, they expect to receive their initial investment along with interest within a specific period.
However, that is not always the case for VCs. The nature of the business requires that the returns on an investment significantly dwarf what you would get from other investment classes like the stock market.
Understanding this is key for founders who are exploring VC as a financing source for their businesses.
The first question to ask is whether your business can deliver the value that VCs go after. For context, most VCs apply the 80-20 rule to startup investing, expecting that a handful of their investments return the most value to them.
Explaining how VCs arrive at investment decisions using a reference to the Power Law, Luke Mostert, Head of Investments at Future Africa, points out that venture capital is structured in a way that 10% of a firm's investments return the greatest value for it.
"The Power Law in Venture Capital basically means that the bulk of one's investment returns will come from very few inputs, so it's like the 80-20 principle that many people know of in life. The implication of that from a VC investors perspective is that they expect one or two startups out of the 10 to 15 in their fund's portfolio to bring about 90% to 95% of their returns."
A natural consequence of this is that venture capitalists are not motivated to chase startups that offer regular returns, instead choosing to invest in the few startups that are capable of delivering outsized returns.
For startup founders looking to raise capital for their business, Mostert advises that they identify the outcomes they'd like to see before determining the best source of financing that provides it.
"The first question a founder should ask themselves is 'what type of capital do I want for the outcome I'm trying to bring about?' If a founder is trying to get an outcome in the 1x to 10x range in terms of the valuation they get when they go to seek capital, it probably does not make sense for them to seek venture capital because it is highly dilutive on the business compared to other types of capital such as traditional SME loans or venture debt."
What do VCs look out for when investing in startups?
Generally, venture capitalists look for startups that can produce outsized returns. However, there are specific qualities they consider when making a decision.
The size of the market that a startup is playing in is, perhaps, the biggest indicator of whether it will receive investments from VCs. VCs watch out for not only the market size but also the portion of the total market that startups playing in that space can capture for themselves.
For startups in Africa, this is even more important. While there may be numerous problems that tech can solve, the macroeconomic environment isn't yet at a stage where startups in some sectors can command significant value. Consequently, it is common to see many investors spread their nets across different verticals as it improves their chances of success.
Caleb Maru, General Partner at Proximity Ventures, explains how this influences the firm's investment thesis.
"Being in a specific vertical limits the upsides you can have. Africa isn’t big enough to be theme-focused, I believe. There’s not that many big winners here, so if you’re limited to only fintech, you’re only going to get a couple who do those things well."
Nneka Eze, Managing Partner at Vested World, explains that investors want to know how big a market is and how a startup is positioned to capture this value.
"We always want to understand why the problem is interesting. Not just the fact that it exists, but also the market size and how well-positioned the company will be to address that."
A startup's team is crucial when pitching to investors. Typically, most investors would want founders who have a good understanding of the market they play in. This understanding could be obtained through experience in that sector or through deep research. Especially at the early stages, when the startup may not have any proof that their solution works as intended, the quality of the team is crucial.
Since many tech startups build solutions that rely heavily on technology, many VCs prefer startups with at least one technical co-founder. Having a technical co-founder on the team means a startup does not spend a significant part of the investment they receive outsourcing their technology needs.
But while many startups today have co-founders, a great number of startups still have solo founders. For this group of people, it's important not to rush into the decision without thinking of how it affects the business.
As Eunice Ajim, Founding Partner, Ajim Capital, mentioned in a previous conversation, "if you bring in the wrong person on your executive team just because you feel you need a co-founder, they will bring your startup to the ground."
Explaining how important a startup's team is, Eze says, "without a great team, even if you have product-market fit, you might not be able to get the company to the next level of scale, to take full advantage of that market opportunity and vice versa. If you have a great team, but the product is not right, you are also not going to be able to take advantage of that product-market fit."
Mostert adds that the mindset of a founder is crucial when deciding whether to back them.
"We want to back founders that have a unique understanding of the product and have the mindset that they want to become a unicorn founder. If they have the mindset of solving a multi-billion dollar problem at scale, then it automatically means that they want to build a 'VC backable' business – so the mindset of a founder is vital," he says.
In conclusion, venture capitalists have a diverse list of requirements that startups need to meet before receiving investment but building a great team and having a product in a huge market significantly improves your chances of success.
This is the first part in a series of articles about what investors look out for in startups. Keep a date with us next week for more on this subject.