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How the country’s Silicon Savannah side-lines start-ups

By Frankline Sunday | Published Tue, September 12th 2017 at 12:13, Updated September 12th 2017 at 12:26 GMT +3
A Student at Science and Technology Park, an Incubation Hub in the University of Nairobi. The premises is a home to students and non-students who have Technological Ideas to nurture their talents further.Since its inception in 2004, the Incubation has been vocal in advancing Technological Innovations among the youths in Kenya. PHOTO DAVID NJAAGA

IN SUMMARY

  • Business owners are losing out on lucrative opportunities to raise capital and grow their fledgling enterprises, contributing to the high rate of failure recorded in the country
  • More than 60 million people in East Africa still do not have accounts at formal financial institutions and around half of small businesses lack access to formal credit

Over the last decade, Nairobi has drawn praise and commendation from across the world as Africa’s technology hub, earning the country the nickname — Africa’s “Silicon Savannah”.

In the last 14 months alone, Nairobi has played host to Mark Zuckerberg, founder of world’s largest social networking site Facebook, as well as Jack Ma, founder of the world’s biggest e-commerce firm, Alibaba.

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Jack Ma, who also doubles as the newly appointed ambassador for the United Nation’s Conference on Trade and Development (UNCTAD), told starry-eyed start-up founders at the local incubation hub - Nailab - that the potential and drive that greeted him on his first visit to the country and the continent was overwhelming.

But behind this rosy picture of a thriving local technology scene is the latent concern that much of the high-value investment flowing into the sector disproportionately benefits foreign start-ups over local ones.

Local start-up founders are losing out on lucrative opportunities to raise capital and grow their business - contributing to the high rate of failure among the businesses in the country. A study published recently by Village Capital established that out of 60 deals signed with tech start-ups in East Africa between 2015 and 2016 valued at Sh8.5 billion, 72 per cent went to just three companies.

A closer look at the country’s history on private equity inflows into the technology sector vis-à-vis the market opportunities that exist shows locally-owned firms have been losing out to their foreign-funded and better connected rivals.

A case in point is the development of digital financial solutions. “More than 60 million people in East Africa still do not have accounts at formal financial institutions and around half of small businesses lack access to formal credit,” explained the report in part.

Technology adoption

The researchers sought to answer why few homegrown digital financial companies were emerging out of the East African market despite such enormous market opportunities and a demonstrated history for technology adoption.

One of the reasons was cited as investors’ tendency to place untenable demands on young and inexperienced founders before considering funding.

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“Investors often won’t invest unless they’re confident about a team’s ability to scale their business and provide a return,” said the report. “However, because specific skill sets are harder to find, companies can’t afford good talent without raising capital.”

This means to receive funding, founders need to hire good engineers, which costs money. This already shuts off majority of start-up founders who are on shoestring budgets in the initial phase of their enterprises.

To compound the challenges further, foreign investors have been accused of giving preference to companies headed by foreigners when making investment decisions.

Nine out of 10 start-ups funded in East Africa between 2015 and 2016 were headed by at least one European or North American founder, according to Village Capital. Start-up founders are, thus, pressured to mould their companies into a certain “pattern” that investors can easily identify with, get into an accelerator programme and hire a European or North American executive to attract funding.

This not only limits the capacity for the young founders to take risks and explore diverse solutions, but it also creates a closed system where approval and investment is doled out based on who knows who.

“Because of the high cost of early-stage due diligence in India and East Africa, investors often fall back on pattern recognition to find companies and make investment decisions - relying on networks and indicators like whether the innovator attended a prestigious university or accelerator programme,” said Village Capital in the report.

One Fintech investor interviewed said: “I’m a busy investor. So how does a Kenyan entrepreneur cut through the noise of other companies that are emailing me cold or through people in my network? I need a filter.”

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The “filter” in this case is a pattern that the investor will revert to in establishing a rough estimate of a start-up’s potential. For instance, did the founder attend a prestigious university is the big question must first be addressed. The other questions are whether or not the company is affiliated with highly selective and credible business networks, was the company recommended by a trusted source in my network and have other reputable investors invested?

These are some of the questions investors ask themselves as they sift through the numerous requests for funding and shortlist grantees. This works against the majority of the local start-up founders who often hold various qualifications, including degrees from local universities and lack the networks for recommendation that can push up their visibility.

“In East Africa where majority of the early stage investors are foreign, financiers tend to rely even more on in-group bias,” said the report. “Close to 90 per cent of disclosed investments in 2015 and 2016 went to start-ups with one or more European or North American founders.”

This excludes the many US-based Digital Financial Services (DFS) start-ups that raised capital and have a large portion of their operations in East Africa, including Branch - which raised over Sh920 million in 2016 - Tala (Sh1 billion) in 2015, and First Access (Sh150 million).

It has been a long-running observation in the sector that having one or more foreigners in one’s team or top-level management raises the chances for attracting funding. In addition, investors rely on networks when making investment decisions with nine out of 10 investors listing personal networks”” as one of their sources for investments.

About 57 per cent of the investors in a study by Disrupt Africa on start-up funding in East Africa listed their networks as their primary or only source of deal flow. This creates a closed community of investors who trust each other and invest in the same small number of companies - leaving the greater majority of companies that can equally grow and succeed to fail.

Recent shareholder wrangles between local start-up founders and foreign investors have exposed what goes wrong when this pattern fails.

The first such case involved Angani Ltd, one of the region’s first cloud service providers that came into the public limelight in a dramatic high-profile war between its new founders and new investors.

After going through the initial stages of forming their company and attracting the first clients, the founders - Phares Kariuki and Brian Muita - reached out to their network for the first round of seed financing.

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The network helped the two attract a diverse pool of up to 14 shareholders over the course of several months from both the local and external field.

Top among the new high-profile shareholding structure aside from the two founders included US hedge fund BSP Fund, newly acquired investors, Riyaz Bachani and Ripduman Sohan as well as venture capital firms - Africa’s Talking and Savannah Fund. A few months after the new investment was signed, the two founders found themselves out of the company - the result of a shareholder tussle that has since ended up in court.

Erik Hersman is one of the partners at Savannah Fund and who together with Bachani were accused of pushing out the founders from their company.

“Unfortunately, at Angani, an all too common story emerged of inexperienced founders (knowledgeable, but inexperienced in management) who were unable to overcome personal differences in order to run a company and had seen a decline in revenues over the preceding three months (37 per cent in June, 17 per cent in July and in August),” said Hersman in a blog post at the height of the controversy in 2015.

“When you take a sizable investment, your company isn’t the same anymore. If things get tough (as they often do at some point in a company’s life), then you’ll have others outside of the original founding team weighing in to solve issues with you,” he explained.

Mr Kariuki said problems between the founders and the new investors stemmed from the fact that the former wanted to grow the company while the latter wanted to flip it. “Our incentives were diametrically opposed because while for me Angani was a 10-15 year business, the other investors were thinking buy and flip,” he said.

The two camps are fighting out their differences in court, in tussle that will be keenly watched by both local and international observers.

In June this year, Danson Muchemi, founder of Kenya’s online payments service provider JamboPay won a three-year court dispute over an attempt by an external investor to bankrupt him and steal his trademark and company.

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Back in 2012, Mr Muchemi, the company’s 33-year old founder and CEO, was looking for investment when a friend introduced him to a Ariff Manji Akber who offered to invest in the company.

Mr Akber offered Sh2 million for a share deal and in return asked for undated cheques for the same amount while they negotiated a joint venture.

The deal fell through and Akber banked his cheques even though his had not cleared, proceeded to form a new company by the name JamboPay Express incorporated in Kenya and India and hired Muchemi’s former workers.

The full impact of the betrayal became apparent when an engineer brought by Akber from India during the equity negotiations and had gained access to JamboPay’s network reverse-engineered the whole system and made a copy that was virtually indistinguishable to users.

The court found Manji to have acted in bad faith and connived to exploit Mr Muchemi by stealing commercially sensitive intellectual property. Despite these challenges, Kenya’s standing as a hotbed of entrepreneurship and as the start-up hub of the continent is not in doubt.

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