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VC companies don’t necessarily have to set up a fund to invest – here’s why

Engaging with investors is often like trying to fit a square peg in a round hole.

This is the feedback we got from entrepreneurs in the early days of setting up venture capital company HAVAÍC. Often entrepreneurs were told by an investor that they loved their business, but that the investment didn’t fit their investment or fund criteria.

The entrepreneurs were seeking to access to funds from investors who demonstrate flexibility in terms of investment criteria and approach to evaluating businesses.

Based on these learnings we formed a view that a venture capital (VC) firm which really wanted to make a difference in the startup investment space in South Africa needs to act like an entrepreneur.

Namely, it would need to be flexible, while at the same time think like an investor with investments being allocated based on the business’s potential and in considering who might take notice as this would influence the likely exit.

With this philosophy, HAVAÍC engaged with investors, who agreed to back us. In parallel, we commenced evaluating opportunities with the objective of raising capital in the most effective way for both the entrepreneur and the investors.

HAVAÍC’s approach to VC investing stands in contrast to that used by most VC companies of establishing a fund

We show prospective investment opportunities to our investor network who then evaluate the merits of each opportunity independently, participating in those that they believe in and which, at the same time, meet their personal objectives in terms of risk and reward factors.

This approach stands in contrast to the industry norm of establishing a fund and raising committed capital based on a set of fund and investment criteria.

Business sense over tax considerations

In addition to the market norm being for a fund structure, we have seen the growth of interest in “12J funds” which allow investors to partially de-risk their investment outlay through a favourable tax rebate as provided for under section 12J of the Income Tax Act.

We have, to date, steered clear of this segment as we believe that financial decisions need to be made on the basis of making the most sense, as opposed to being driven by tax considerations, and are concerned that 12J rules may change in the future and its requirements could restrict mobility and flexibility that is important to both startups and investors.

Our approach, as opposed to the fund route, we believe, allows entrepreneurs access to a more flexible pool of capital.

Accordingly, we formed HAVAÍC General Partners, which acts as the manager of each investment whilst raising capital through a limited partnership structure on a deal-by-deal basis thus allowing us to approach investments in a bespoke manner and marry these investments with investors who have the appropriate appetite.

If we were bound by fund rules, we would be constrained in respect of the entrepreneurs we could work with, never mind the extent to which we could access funding for those entrepreneurs that we believe merit the support.

Together with good fortune, this approach paid off for us as we were fortunate enough to invest in a handful of exciting early-stage high-growth opportunities in our first year of operations.

Certainly we bring our own expertise to play, not relying solely on our investor networks to evaluate opportunities. We engage with entrepreneurs to develop an understanding of their businesses, the likely financial performance, the purpose of coming to market and the envisioned use of the proceeds.

Exit considerations critical

Of fundamental importance to HAVAÍC is the exit story that these entrepreneurs envision or which we believe could be achieved. After all, it is the exit that results in the investment returns crystallising. Hence, it is critical that exit be considered even at the point of entry.

Further, knowing the likely route of exit early in a business’s life will influence decisions made in building the company.

Committed capital powerful too

Two years into our VC business, however, we find ourselves questioning whether we truly are acting like an entrepreneur. And thus once again, we are interrogating the deal-by-deal model vs a fund approach, including the use of 12J funds.

While fund criteria may be a stumbling block to being able to pursue worthy investment opportunities, committed capital can be powerful as it can be mobilised speedily. This allows the VC business to respond to funding demands of entrepreneurs in a timeous manner.

Further, from an investor’s point of view, a fund has the advantages of reducing risk as the portfolio effect can smooth over returns from really well performing investments versus the ones that have not done so well.

It also delegates the investment decisions to those with the time to fully interrogate the business case and the expertise to evaluate the attractiveness of the proposition.

International limitations

We recognise that section 12J is a fantastic initiative by the South African government to foster investment in and support of domestic entrepreneurship. But we continue to have concerns that participation in 12J funds might limit our portfolio companies’ ability to grow and exit internationally.

The use of 12J impacts on the ability of companies which have benefited from its provisions to transfer their IP offshore and this in turn, may impact on the manner in which the investments are ultimately realised: international trade buyers, for example, may be reluctant to engage if they cannot easily access the IP.

However in those instances where the investee company will be purely local with local clients and probably a local exit, then the use of the benefits conferred by 12J could be a valuable manner in which to enhance those companies’ prospects to access capital.

Clearly the venture capital market is not a case of one approach fits all, and there’s space for all sorts of investment philosophies, approaches and structures. In some instances a deal-by-deal model may be best, for example when a bespoke solution is called for, while a committed funds model is best when funds need to be deployed within a short period of time.

Finally, there are many instances when investments can appropriately be routed through a 12J fund.

So, in order to truly be responsive and to act in the best interest of both entrepreneurs and investors, the ideal would be for a VC company to offer various structures approaches with the objective of applying the most appropriate for each specific potential transaction.

This overarching approach would enable the VC company to truly think like an investor but act like an entrepreneur. This is HAVAÍC’s approach.

Ian Lessem is CEO of HAVAÍC a venture capital company based in Cape Town.