This article was contributed to TechCabal by Rossie E. Turman III.
In November 2023, Will Stevens, the consul general at the U.S. Consulate General in Lagos, Nigeria, told the Global Tech Africa Conference that approximately 40% of venture capital (VC) investment in Africa came from the U.S. and 60% of African startups are incorporated in the U.S. He added that African startups raised $4.8 billion—an average of over $1 million every two hours—in 2022.
While Stevens’ comments were intended to highlight the importance of Africa and its VC ecosystem to the U.S., his reported comments are misleading without further context.
Investors and founders seeking to fully understand the African VC ecosystem must educate themselves on (i) the trends and factors behind these numbers; (ii) the legal and regulatory framework impacting the structuring of Africa-focused VC investments; and (iii) how the factors impacting investment in Africa specifically drive VC investment.
Africa operations, U.S. domicile
The U.S. VC ecosystem represented approximately 51.49% of global VC capital invested in Q2 2023, according to KPMG. In addition, the U.S. population of the African diaspora is larger than Africa’s 10th largest country. So it is unsurprising that U.S. VC investment represents a significant portion of investment in the African ecosystem. The more pertinent question is: Why is there so little U.S. VC investment in the African startup ecosystem?
One factor inhibiting more investment in African startups is global investors’ expectations of preferential rights in their investments, memorialised through contracts and revisions to emerging companies’ organisational and governance documents. To reduce transaction costs and legal ambiguity, investors typically invest using familiar transaction structures and contracts, with a consistent choice of governing law and venue. This mitigates the risk of unanticipated or unintended outcomes from courts in atypical jurisdictions or courts applying an atypical choice of law.
The preferred choice of law for transactions in the U.S. VC market is Delaware, which provides clarity on how provisions affecting investors’ preferred rights are interpreted and enforced. In fact, many global investors in U.S.-based VC funds require that the investments of such funds be made in Delaware-domiciled companies.
Investing in the parent of an emerging company allows the capture of all the value associated with rapid scaling and growth. Investors and founders increasingly engage in transactions that restructure existing African startups to create Delaware parent companies.
While African startups may be based or have significant operations in African countries, if the company’s ultimate parent or holding company is a Delaware corporation, investors reduce their risk by investing in a U.S.-based company subject to Delaware and U.S. laws and regulations, with protections for preferred equity and debt investments and favourable tax treatment.
A corporate structure with a Delaware-domiciled parent company and a local African-domiciled operating company or companies allows the emerging company to raise capital in the largest VC market in the world while maintaining the benefit of local operations. Local operations are necessary to establish product-market fit and may also provide a reduction in cash burn if critical services and personnel for the emerging company are available in the African countries of operation.
The appeal of African startups to U.S. investors
Investment in African startups is driven by the same factors that drive VC investment in other markets:
- Total Addressable Market: The current population of the continent of Africa is estimated to be approximately 1.48 billion people. Literally, over 40 of the world’s newest consumers will be located on the continent of Africa. Add in the African diaspora and the TAM grows.
- Need for Innovation: The continent of Africa is large, creating a drive for technological innovation. For example: Fintech limits the need for a cost-prohibitive physical network of bank branches across a large geography.
- Global Market Conditions: The global IPO market and late-stage VC financing continue to struggle, but global early-stage VC maintains a healthy, although muted, run. Currently, African VC activity is overweight in early-stage investor activity.
- African VC Ecosystem Structural Hedge: The spectacular meltdown of certain late-stage companies due to fraud and malfeasance is underrepresented in the African startup ecosystem, in part due to the additional due diligence most investors conduct when investing in African startups as well as the smaller number of African late-stage venture-backed companies.
- Operating Company Cost: In an environment where capital is scarce, an emerging company’s ability to manage its burn rate is prized. The African startup ecosystem supports fiscal austerity; its founders are well acquainted with resource scarcity and have adapted to it.
Not all historical trends are positive
U.S. VC investment in the African startup ecosystem is likely to continue in a direction consistent with historical trends. Without thoughtful and intentional intervention, however, less positive trends may also emerge.
- Companies led by white males or Africans with strong “Western” backgrounds will attract more VC investment than comparable companies in the African startup ecosystem, as investors undervalue the need and advantages of local knowledge.
- Companies will be predominantly male-led, ignoring the outsized opportunity to invest in female-led companies, given other indices of gender advancement on the African continent.
- Global VC will continue to underinvest in the African VC ecosystem compared to other VC markets.
- The global VC market will be surprised by outsized exits and returns emanating from the African VC ecosystem, leading to fear of missing out and less disciplined investment in the next wave. More copycat, trend-based, or under-researched investments, combined with poor due diligence, will lead to a lowering of returns in the African VC ecosystem.
- African emerging companies will be challenged by the need to scale to meet investor expectations and by founders’ limited knowledge of and access to regional markets beyond their own.
- Investment may increase in themes that attract VC backing in Western markets but that do not translate well operationally in many African markets.
To fully realise the promise of the African VC ecosystem, both investors and founders must continue to educate themselves on optimal frameworks, factors, and influences that may perpetuate positive outcomes.
Rossie E. Turman III is a Partner at Lowenstein Sandler; Chair, International Finance; Co-chair, Africa Practice.
