Series A crunch blah blah… Get over it. Learn from Africa’s example

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put on your big girl pants

If you are a startup junkie (yes there is such a thing), chances are you have been hearing about the ominous Series A crunch. It’s all anyone seems to be talking about these days — the doomed startups that must find new ways to fund their businesses, the possible ways to do this and the investors giving advice on how to survive the dreaded crunch.

The issue is so important that Forbes has posted two articles arguing opposite points. The general consensus on the crunch debate is that where the ratio between seed funding and Series A used to be quite levelled, it’s now quite wonky, leading to a “flat line” in Series A while seed booms.

Forbes’ Ryan Caldbeck explains the crunch perfectly.

“…the Series A crunch is the widening gap between the number of angel/seed financings (growing) and the number of Series A financings, the second round of fundraising start-ups typically raise (not growing).”

Also on Forbes, Tanya Prive says that “Series A investments are in a crunch, with investors shying away from taking risks via internet companies seeking funds.” She argues that crowdfunding will save startups caught in the gap created by the crunch.

“While this sounds like bleak news for the startup community, every cut has its silver lining. In this case, investment crowdfunding is rising as a good prospective option.”

Caldbeck disagrees:

“If a tech startup turns to crowdfunding, in all likelihood, they have been turned down by many professional venture capitalists [VCs] and angel investors. Why? Because they probably don’t have a sustainable business.”

This is causing a lot of issues in Silicon Valley with startups running to Kickstarter to get some cash, while VCs are getting investment phobia and tightening the reins on their wallets.

Meanwhile, in Africa…

Obviously the crunch has yielded much discussion in the Ventureburn offices. Does Africa (or South Africa, to be exact) have the same problem? VCs have often jokingly, or maybe not jokingly, said that they are “broke” and in search of funds. This has been going on for a while.

Many incubators offer seed capital and the angel investment game is starting to find its feet. After these startups get the initial burst and the media frenzy however, crickets.

Truth is there are not enough Series As in South Africa and it has been that way for a while. Not every tech startup is getting the Silicon Valley experience in Silicon Cape.

Andrea Bohmert of venture capital firm Knife Capital says it’s not because VCs don’t want to invest, but that “one of the key reasons for not enough Series A is that there is not enough Series B”. She reckons what most VCs are thinking is why “put money into a company if you know that the chances of getting the next funding round are slim?”.

According to Bohmert it’s not that VCs don’t have less money than before — it’s more that they’ve never had enough to begin with. Convincing international investors to invest in Africa has also been a major issue in the last few years, as apparently the continent is a hard sell.

Looking at Kenya, Mbwana Alliy, a managing partner at Savannah Fund agrees that trying to sell Africa and the emerging market to international investors is a lengthy process.

“Savannah participated in a seed/Series A with Binu Mobile just because it was more efficient to raise the whole thing in one go because of how long it takes to convince investors of the emerging market story [due to the] image problem, etc. In fact, that’s one of our roles as a Savannah Fund, as a signalling mechanism to our investors such as 500 Startups and links to VCs such as DFJ,” he says.

So Africa is not broke, it just doesn’t have Silicon Valley cash. If Africa is a hard sell to international investors though, it makes investing rather tricky especially in the tech space where returns are not as tangible as other sectors.

“Investments in technology such as software, even if it is used as an enabler across industry verticals, is often considered too risky,” says Bohmert. “The earlier stage a fund wants to go, the riskier the investment is perceived and therefore often excluded from the investment mandate. ‘Technology and Africa’ is still an oxymoron for a number of investors into funds. Series A funding from institutional investors is therefore limited to a very small number of investors and as most of them have small teams the number of transactions a team can handle is low.”

According to Alex Fraser of investment company Invenfin, it’s difficult to compare South Africa’s VC market to that of the United States simply because it is still an emerging space.

“Even though there are an increasing number of new startups in South Africa, we are still a relatively young venture capital industry. Many of these startups will successfully raise seed funding through incubators, angel investors or funds,” she explains. “Some will be successful in raising funding in the next phase of their life cycle but many won’t. These types of businesses are high risk and many fail within the first few years. Globally, and in South Africa, there have always been fewer later stage deals than early stage deals — here this is not due to the Series A crunch, but a normal characteristic of the industry,” she adds.

Fraser reckons because investing in tech startups has always been risky it causes investors to be very sober about the type of investments that they make.

So Africa has had this problem for a while now. Sure, it would be nice to have buckets of money to throw at every startup in the early stages, but it seems that lack of funds helps weed out the bad startups without sustainable business models.

That’s Africa’s model for success.

“The trick is to invest during the ‘shakeout’ phase and use due diligence to uncover traces of real traction and ensure you pick the winners,” adds Keet van Zyl, founding partner at Knife Capital.

Keep calm and look at Africa

So Silicon Valley, what are you carping about? Surely the so-called crunch presents an opportunity for the Valley.

“The perception of a Series A crunch in Silicon Valley is simply because so many startups are getting seed funding, and the bar is just higher for traction. The same principles apply: show a company with traction vs vanity metrics of downloads and hits,” says Alliy.

“If the startups have the right metrics, the Series A investors will expand and raise more money from their limited partners in a good market — you just have to compete against more startups for the given quality level,” he continues. “Don’t forget the quality issue — a bad startup should not get Series A funding. Also don’t forget business cycles, boom and bust. It’s always harder to get funding in a bust than a boom and these are natural throughout history… All these dynamics affect startup funding and there are even more like track records, hot sectors (consumer vs enterprise, social networks) — its easy to generalise and focus on one metric, [but] it’s never that.”

One of the solutions that Silicon Valley is looking to is for seed funders to move up into early stage investments and not specialise.

Fraser says that is how it has always been in South Africa.

“Because the South African VC industry is relatively young and there are fewer funds, they tend to fund businesses in more than one or two stages of the business’s life cycle. Many fund managers know and plan to allocate additional funding to a potentially very profitable investment to ensure that there is enough capital to grow the business and reach a stage were other later stage or institutional funders can be brought on board.”

The “problem” in Silicon Valley is that there are too many seeds and too few Series A. The truth is it’s not really a crunch, just reality. There was a bubble where investors were giving out seed money despite unsound business models. Now it’s stopped. Africa isn’t seeing this phenomenon because investors have been much more averse to early stage investments. African investors have historically been a lot more careful when backing startups, making sure the startups can raise subsequent rounds.

What’s happening now in the US is that things are going back to normal. Seed funding is easier to justify because of the smaller amounts, so there will naturally be more seed funding. During Series A, investors have to cough up more and the reality is that there just aren’t enough startups with sound business models — and the same investors probably would not have backed these startups at seed stage.

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