Why venture capital is difficult in SA (and Africa)

Venture capitalists don’t invest in products or jockeys. They invest in exits.

The only way to justify the high investment failure rate is to have regular exits at valuations much greater than 10x.

When taking into account the time value of money, dividends don’t cut it. Only selling the business can realize sufficient return for a VC to compensate for all its failed investments and still provide a healthy return to investors.

Here is some math:

CompanyRand amountPeriod (yrs)ExitProfitROE
A 500 000 3 – –0%
B 500 000 3 – –0%
C 500 000 3 – –0%
D 500 000 3 – –0%
E 500 000 3 – –0%
F 500 000 3 – –0%
G 500 000 3 – –0%
H 500 000 3 – –0%
I 500 000 3 – –0%
J 500 000 3 7 000 000 6 500 0001400%
Total 5 000 000 7 000 000 2 000 00029%

If you invest R500,000 each in 10 startups, all of which fail except one[1], then you need to realize a 1,400% profit on that successful startup in order to generate a 29% return on your overall fund.

Slow and steady dividend payouts will never equate to a 1,400% return on investment. Only an exit (at a price/earnings multiple far in excess of the average private company PE of 5) will create the necessary returns for a VC to make money.

So, if its all about the exit, then the number of startups in your pipeline is far less relevant than the number of potential exits.

This is the part where Silicon Valley crushes the competition. There are a plethora of exit opportunities in the Valley. Angels exit to early stage VC. Early stage VC’s exit to late stage VC’s. Late stage VC’s exit to private equity, or list on the Nasdaq, or sell to a multitude of cash-flush tech giants that are not afraid of infinite PE multiples, such as Google, Amazon, Facebook, Yahoo, eBay, PayPal, Netflix, Twitter, LinkedIn, and many more.

Where are the exits in SA? Firstly, there is no investor food-chain to speak of. You come in as an angel/VC and you stay in until the business flips. And, if you look at the 20 year history of tech in SA, the exits are limited to Naspers, MTN or Vodacom (with the occasional miracle of exiting to foreign firms like VeriSign, Oracle or MasterCard).

Regardless of the appetite of local companies for high multiple valuations (an appetite which is comparable to my 3-year old’s appetite for broccoli), having only three potential buyers doesn’t make for wildly optimistic odds of an exit.

That’s why venture capital in South Africa is difficult. Its not that the money or startups aren’t available, its that the exits are not.   [1]A 1 in 10 success rate is pushing the envelope, its more likely to be 1 in 30.

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