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Investors turned vultures: Disquiet as venture capitalists prey on Kenya’s start-ups

FINANCIAL STANDARD
By By JEVANS NYABIAGE | December 3rd 2013

By JEVANS NYABIAGE

KENYA: Kenya is in the middle of a technology revolution. It is bustling with innovations driven by the strong entrepreneurial spirit of people hoping to replicate the successes of the revolutionary M-Pesa service or Ushahidi technology company.

As a result, the country has attracted its fair share of investors looking to harness the wealth of potential on display. From one incubation hub to the next, entrepreneurs are proving to be bursting with creativity and mind-boggling ideas.

But due to a lack of capital, many start-ups remain just that. Which means that in too many cases, some hawk-eyed companies and investors have swooped in and taken over.

There have been reported instances of big companies stealing ideas as soon as a start-up is out of the protective nest of an incubation hub.

These hubs, primarily targeted at start-ups and early-stage companies, are designed to support the successful development of a firm through a host of business support resources and services offered by both the incubator and its network of contacts.

Increased interest

And as these kinds of spaces increase, there have been greater opportunities for private equity funds, venture capitalists or angel investors to own a piece of start-ups that offer promising returns.

In the last few months, there has been increased interest from investors looking to tap into Kenya’s start-ups with the conviction that they could be a part of the next Google, Apple or Facebook.

This crop of investors scouts for promising start-ups and companies with the potential for huge profits. The East Africa-focused funds are targeting high-growth small and medium enterprises in consumer-driven sectors.

In exchange for much-needed capital and mentorship, investors negotiate for a share of the company, either for the short or long term.

But in the last two years, there has been a growing disquiet.

What initially appeared to be a promising opportunity for a number of start-ups to scale up their ideas is now turning out to be their biggest nightmare.

A number of entrepreneurs claim they have been short-changed by some venture capitalists. A few have been fortunate enough to be able to buy back the stake held by investors, following what they term a mismatch of company vision and aspirations.

In some instances, venture capitalists and private equity firms do not always share the same vision with entrepreneurs.

Some of the divorce proceedings are amicable, the acrimony in others hits headlines, but most remain well guarded due to confidentiality agreements.

A blog post by entrepreneur Joel Macharia in January this year gave the public a peek into the sector. 

“When most entrepreneurs write this kind of post, they are usually sitting in a bathtub, cigar in mouth, counting their dollars after a successful buyout of their start-up,” wrote Mr Macharia.

“This, unfortunately, is not the case for me. I chose to leave Pesatalk, the consumer finance info business I had started.”

Raw deal

88mph, the investors he thought would help him grow his venture, did not stick to their end of the bargain, he says. Part of the deal he had with them was that they would set up a completely new company, with him as a minority shareholder but with majority control.

 “We signed a basic MOU to hold for three months while we got the incorporation and other documents underway, with the fund setting up the company in Mauritius,” he said.

“This was a big mistake on my part. I was eager to get started, and didn’t take sufficient time to make sure we were on the same page, and to legally cover myself. Our discussions before signing must have taken a total of six hours, spread over three or so days.”

After some time, Macharia realised that he and his investors had started off with different ideas on what his role would be.

“To the fund, I was a cheap employee. To me, I was investing a couple of years to gain invaluable exposure, experience and shareholding in a business that I could count among my assets.”

After three months lapsed without the company being set up, and with no clear plan or evident effort to resolve that, they drifted apart.

But 88mph holds a different view.

“Pesatalk was a company that 88mph founded and owned 100 per cent, and we hired Joel to be the CEO and offered him up to 20 per cent equity over time if he did a good job. Pesatalk never took off the way we expected and as the CEO, the responsibility eventually fell with Joel. We terminated Joel’s contract and eventually shut down the site. This happens all the time with start-ups and we had no particular issues with Joel and we acknowledged that there were many factors outside Joel’s control that lead to the failure of Pesatalk. That’s just the way of start-ups. Most of the time, you fail,” the company said in an email response to Business Beat.

Legal experts say part of the problem in the start-up investment sector is a lack of legal education among business owners. Several entrepreneurs present their ideas to investors without a non-disclosure agreement.

“Pesatalk is the unfortunate victim of teething problems in Kenya’s nascent tech start-up funding environment. There will be several more as the field evolves, undoubtedly. Some VCs come into the country with a god mentality, and this will lose them money,” Macharia said, adding that he at one point tried to buy out the investor but they were asking for six times what they had put into Pesatalk.

When we talked to him over the weekend, however, he said that although Pesatalk is no more, his dream of building a successful consumer finance information business is still alive.

Successful tech companies Craft Silicon and PesaPal are among those who were in a position to buy out their investors.

Craft Silicon, one of Kenya’s largest software firms, bought back the 30 per cent stake held by Fanisi, a venture capital firm, that had cost $2.5 million (Sh215.5 million by today’s rate) in November 2009.

Buy out investors

One-and-a-half years down the line, the two parties were not reading from the same script, leading to an agreement whereby the software company, which focuses on banking software, would buy back the shares held by the venture capital firm. Ordinarily, Fanisi invests for three to five years in companies. The sale deal was concluded on July 20, 2012.

Mr Kamal Budhabhatti, the founder and chief executive officer of Craft Silicon, notes that investments, especially in tech firms, are generally long-term, with the plan, development, launch and subsequent rollout of a product being an expensive affair.

“Our investors did not see the future, and they wanted to make returns immediately. We realised that their goal of short-term quick returns was not in line with our long-term goals, so we had to buy them out,” Mr Budhabhatti said.

“The break-up was not easy, especially from the cash flow point of view. However, we managed it and we are strong now.”

But Mr Ayisi Makatiani, the managing partner at Fanisi Capital, an Africa-focused private equity and venture capital fund, said after two years, their investment in Craft Silicon had paid off and it was time to put the money elsewhere.

“We got to the point where we thought it was time to move the investment to another segment that could pay better,” he said. “We had helped the company to grow, and since it is a free market, it was time to quit.”

Mr Makatiani, who made his first fortune by co-founding Africa Online, one of the earliest Internet service providers in Africa, says Fanisi reinvested the funds in a Kenyan chain of retail pharmacy stores in Nairobi, a segment he says promises to offer faster and higher returns.

He said that last week, they opened a new store in Kasarani with others set for Zimmerman and Ongata Rongai. The firm is eyeing about 20 more stores in the next six months.

Fanisi, which currently has a fund value of $50 million (Sh4.25 billion), has also invested in the high-end private Hillcrest Schools, and a maize milling firm and wholesale pharmacy business in Rwanda.

The fund also has interests in energy and mining. It plans to invest in a mobile phone-based money transfer business in Uganda, a logistics business in Kenya and an animal feeds producer in Tanzania. 

Fanisi’s first fund was backed by the International Finance Corporation, Norfund, Proparco, Finfund, the Soros Economic Development Fund and Ludin of Canada.

Makatiani added that the notion that venture capitalists are impatient for a return on their investment is not true.

“There is a measure of return on investment in the market — the speed of return. All investments have to compete with other returns,” he said. “The question is, are entrepreneurs bringing the kind of returns required?”

Makatiani added that the money investors put into a company is not a grant.

“In countries such as Taiwan, where the government gives grants to companies, that’s CSR [corporate social responsibility]. When people complain, they should know that it is a two-way street; we are in business for better returns.”

Just like with Craft Silicon, Mr Agosta Liko, the CEO of PesaPal – which allows users to make secure payments online using mobile money, Visa or Mastercard – had to buy out Eva Fund, which had invested in his firm. However, Eva Fund still holds a stake in Verviant, a software development company that Mr Liko also owns.

“You should know that nine women don’t make a baby in one month. When you raise money from investors, there are high expectations that the following day, you are going to be paid. But it takes time. There is a lot of work that has to go into building a company,” said Liko.

“When I was starting Verviant in the US, I started a spreadsheet and calculated how I was going to hire cheap programmers and make millions so that by year four, I’d have my jet. But the world doesn’t work that way.”

He says either your investment partners have to adjust their expectations, or you will end up with an exit scenario.

Liko says in most cases, the problem is that entrepreneurs look over contracts without a lawyer, which means they could end up signing away their life’s work.

 “A lot of people who claim to be investors tell you a lot of stuff like how they will give you money, networks and coach you, but the reality is that they are not going to have that time,” Liko said.

Horror stories

He recalls a local venture capitalist approaching him earlier on and offering a certain amount of money for a stake in his firm. He agreed, only for the investor to put up just 20 per cent of the amount and disappear.

“There are a lot of horror stories, but with time, there will be serious VCs in the market.”

Looking back, Budhabhatti believes going for a VC at that time was not the wisest decision for Craft Silicon.

“However, that was a one-off case. We are not against outside investments,” he said, though he added that he is not aware of any technology investment that has gone well.

“Ok there are many small investments that have happened, but none of them are large and noticeable.”

Still, Budhabhatti, whose firm is now worth more than Sh4.5 billion, believes that some venture capital funds can help businesses excel. However, the entrepreneur needs to be practical, as does the investor, to ensure expectations are similar and achievable.

“Many times, when the expectations on both sides are not set correctly, the partnerships end in disaster.”

[email protected] Twitter: @jnyabiage

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