Amit Out of the Office

Venture Does Not Equal Business

Venture is not the only way

As a private investment firm focused on Africa, we get a lot of inbound requests for investment. I appreciate getting these, and usually give them a quick glance to gauge interest. Many of these requests are thoughtfully written and include the right kind of details. Others ask for money without even telling me what their business is or calling me by the wrong name.

One thing that is consistent, however, is that they all assume their businesses are appropriate for venture capital, and that we are a VC firm. In the vast majority of cases, this is not true. I want to share some thoughts on why this is the case, why we don’t invest in these, and how we invest instead.

Venture capital is often portrayed as the only way to raise funding, but it is rarely the right way unless a business has a particular capital structure, outsized growth trajectory, and a singular outcome in mind. The end of the zero interest rate years brought a new wave of writing about alternatives to venture funding. However, decades of content marketing and TechCrunch fundraise announcements have ingrained the idea that 'venture' equals 'business.' When an entrepreneur today, whether in Austin, Texas or Lagos, Nigeria, wants to start a business (assuming it’s not a small local business like a laundromat), they typically believe that one of the critical steps is to sell a small portion of equity for a large sum of investment capital to a VC.

Do other investors exist?

My friend recently introduced me to an ex colleague of his that is now building a new business (I should clarify that for now its still in the idea stage). Minutes before we spoke he had gotten off the phone with a Silicon Valley VC. He told me the two main questions that the VC asked were: a) “what kind of exit multiples do you think this business can command?” and b) “what technology based moat do you have?”.

Now I have nothing against this VC. These questions seem reasonable, for a VC. In fact, these questions are so appropriate that they are almost ironic. They display such a pure expression of self interest that they have an almost admirable efficiency to them. It would be like showing up on a date and saying, “do I look good in these shoes?” or “are we going home tonight or not?”.

I admit that I went on a small rant at that point, expressing frustration with these questions considering that it's unclear whether there is even a business here or not. There are so many steps between an idea he was validating and an exit multiple that asking about it seems like some kind of VC reflex. As my rant was coming to an end, I told him that his business might make more sense with an alternative funding approach, rather than venture.

The look on his face was as if I just told him that Elvis was still alive. It’s not that he hadn’t considered the possibility. It’s that he didn’t know it was a possibility.

His conception of an investor is a VC. His conception of who can invest in his business is a VC. His conception of what his business needs to be successful is the conception of VC.

His conception of the capital markets is perhaps investment bankers (though with little idea what they do), maybe private equity (buying and destroying a business but somehow profiting?), and VCs. When I mentioned family offices, I think he thought I was suggesting taking money from the mafia.

How did we get here?

I think we’re here because at this point in the minds of most entrepreneurs “venture” is synonymous with “business.” It is a consequence of the depth to which venture capital has pervaded our culture.

Just thinking that you are in the category of requiring venture capital means you are making a whole set of assumptions that must be validated.

The truth is only a very small subset of companies, including startups, need venture capital. This type of capital is perfect for tech startups that can scale to tens and hundreds of billions of dollars of enterprise value, which requires large addressable markets and certain efficiencies that come with scale. It simply doesn’t make sense for the majority of businesses.

Strike That, Reverse It

I had another conversation with an entrepreneur recently who said something similar. I turned the tables on him. I said, put yourself in my shoes, what do you think is valuable about owning a piece of your company? What do you expect to happen? If you were investing, what would you want to get in return considering the circumstance? Do you believe your company can scale to billions of dollars of equity value? Do you seriously expect an IPO? Are there extremely large acquirers that you can identify that would, in principle want to purchase you?

VC Equity Math

About a week after that conversation, one of our partners was telling me about an entrepreneur he spoke with who was building an advertising business. The entrepreneur was inquiring about an investment. What kind of investment? He wanted to sell 5% equity in his business for $500k. Let’s do a little math!

It’s “Liquidity, Stupid”

Unfortunately, even the above exercise misses the main problem here, which, now that the zero interest rate years are over, lots of VCs and other investors are being very clear about. What matters in VC is achieving liquidity. Equity appreciation is theoretical and only becomes real when you sell the equity and harvest the gain (or loss). In the public markets that means waiting for an outstanding overpricing of that equity. In private market investing, it requires an IPO, an acquisition, company stock buyback, or a secondaries sale.

In Africa, you can pretty much take IPOs off the table. Acquisitions are rare. So rare in fact that any company that is healthy enough to be sold, probably should be held onto. For a company to buy back stock from existing investors, it has to be in such a healthy position that it would likely exceed what is necessary to get acquired. And investors will not buy equity in secondary transactions unless they have a straightforward path to one of the above three outcomes.

In other words, liquidity of the type that these investors expect in mature capital markets, which they are now complaining is hard to come by even there, is virtually nonexistent in Africa.

Breaking the #1 Rule of Investing

Different types of investors often have rules that approximate how to succeed with their style of investing.

Warren Buffett says the #1 rule of investing is: “don’t lose money.” The #2 rule is, don’t forget rule #1. There are no more rules. An instructive guide for value investors. Or perhaps you prefer Charlie Munger’s most important rule of investing: “never interrupt compounding prematurely.” For VCs the All-In crew summarize the rule as: “always double down on your winners.”

There is an African VC fund I know, I won’t mention the name, which pitched us to invest as an LP. In their presentation they mention that their method of generating liquidity is to sell out of their valuable investments at an early stage to follow on investors, when the company is doing well and there is still ongoing interest to invest in the company. Essentially, this VC (and many others like them) are confirming that they violate the only inviolable rule of venture. They’re selling out of their best investments early. Their best investments are the only ones that investors will be interested in. So they are prematurely cutting off their opportunity to generate the type of returns that are required by VC.

During the zero interest rate years (zirp), none of this mattered. LPs were trigger happy and poured capital into African VCs. How did that work out? Not well. It simply never made sense. But in good times, and with specific mandates, sometimes investment managers just throw caution to the wind because nobody will get fired for hiring IBM.

In the last couple of months, VCs have said things to me like: “if we can’t generate liquidity soon, we’ll have to re-evaluate if we can continue to invest in Africa,” and “we’re hoping for a modest exit because if we it doesn’t happen for a business like this, we’ll never be able to attract commercial capital to Africa.” It’s a mixture of resignation, disappointment, and hope. But what is most surprising to me is why any of this was surprising, and why these investors didn’t consider this when they raised their funds.

Despite the somber tone, I share these investors’ feeling that commercial capital must continue to flow to Africa. Africa is simply too important to the world. And with the massive amount of young people energized but governments having taken on unsustainable levels of debt that have severely curtailed public spending and economic stimulation, a key input right now and for the foreseeable future, is stimulating private investment in Africa. So how can we do that?

Creative Equity or Debt

What if instead of simply getting equity in the business and waiting for a liquidity event, we invest in this company and get a royalty or dividend or revenue share to generate our return? In that case, the business doesn’t have to grow astronomically or dominate its market. It simply has to become profitable enough to pay us a nice return with its cash flows. What about focusing on debt? Or a combination of debt and equity, such that we get a stream of income and a clear return in addition to some future upside?

What I like about the potential of debt, or even a debt/equity mix, is that we can focus on making the financing modular, trying to achieve milestones, and building sustainability into the business from an early point. In order to use that kind of financing, it’s important to be very clear on the unit economics of the business and demonstrate clear demand that can be met with debt funded supply. This forces an entrepreneur to get very clear on their business fundamentals. That’s not to say it always works or makes sense to take on debt early in a company’s life, but we have to be flexible to operate in Africa.

An insight I like about this approach actually comes from Mike Milken, junk bond pioneer of the early 1980s. What Milken noticed, was that investors were vary averse to non investment grade debt securities. On the surface this seems understandable, why would you want to invest in subpar non investment grade securities? Until you realize that all debt securities issued by small and medium cap businesses are non investment grade. The same small and medium cap businesses whose equity makes up some portion of almost every investor’s portfolio. In other words, investors are afraid of these businesses’ debt, but not their equity. This makes no sense when you realize that for those businesses’ equity to be valuable, many things need to go right. Whereas for their debt to be valuable, they simply have to survive long enough to pay their bills. Thus, there is actually much less risk and mostly guaranteed returns from the income producing approach of non investment grade debt securities, rather than from equity appreciation of those same companies.

What Next?

In a future post, I will get into more detail about the specific approach that Akili takes to investing in private businesses in Africa, including how we tailor financing structures to align with the unique dynamics of specific African businesses and opportunities. For now, I keep getting my daily emails from entrepreneurs asking me for venture funding. And I will keep trying to work with them to find other ways to finance their businesses, whether they call me by the right name or not.