Venture investing in South Africa

It’s hard to believe, but it’s over a year ago now that my partner Erik and I decided we’d like to try and create a venture funding company with a focus on tech startups in South Africa. I think at the time we didn’t quite realise just what it would take, and what challenges would face such a seemingly simple objective. It’s not easy.

But here we are, 12 months later, and we’re almost ready to “officially” launch 4Di Capital in South Africa, an evergreen investment company that seeks to attract and invest foreign capital into South African opportunities using well-established international venture capital principles.

4Di Capital came to life both out of a need and an opportunity. As entrepreneurs, Erik and I at 4D Innovations Group had been incubating, mentoring and seed funding several entrepreneurs and startups in the Cape for some time, such as FireID (then known as Fireflight). In particular, as FireID’s potential started to become more clear and the demands of the business grew, we realised that it was going to need more substantial funding and resources to grow the company appropriately and ultimately to try to take it international.

At the same time, we were repeatedly being approached by young South African entrepreneurs who were seeking financing and advice. It became evident that early-stage funding and hands-on mentoring were hard to come by.

Clearly there was the increasing potential in South Africa for exciting world class tech opportunities to develop, driven by a new wave of young entrepreneurs inspired by their peers in Silicon Valley and elsewhere, who needed investment and assistance. Along with this potential however also came many challenges. Despite these, we decided we’d give it a go and see if a small handful of humble entrepreneurs from Cape Town could get it right, make a difference, and hopefully also make some money.

I don’t like the term Venture Capital, as I feel it carries with it many negative connotations in the minds of a number of entrepreneurs these days. We didn’t want to be an “us vs. them” type of investor. As entrepreneurs ourselves, we wanted a different feel, one of being on the same level and of being involved in the entrepreneurial space, rather than distant and from another seemingly intimidating world.

So we decided on another term which we felt was more friendly and more closely represented our approach and ethos: Nurture Capital. This, coupled with the slogan that was devised by Jonty Fisher and the guys at Traffic Integrated Marketing – From Garage to Global — just felt right for what we wanted to do and how we liked to operate. The team at HelloComputer came up with a really fantastic brand identity too, that felt young and current.

But that was all the easy part. Venture investing and trying to build global IP companies in South Africa isn’t all that simple, both for expected and unexpected reasons, as we came to discover. There isn’t a well-established and sophisticated venture capital ecosystem, like there is in Silicon Valley (one of the reasons for our involvement and funding of the Silicon Cape Initiative). A number of South African laws act as major impediments to the types of VC principles and mechanics needed to structure investments, for example, and other laws serve to restrict foreign exchange flows and the movement or monetisation of intellectual property. This also leads to heavy expenses as you need a lot of legal advice to make sure you aren’t inadvertently doing something illegal.

VCs internationally generally use a well-established and proven toolbox of clauses in their term sheets aimed at aligning the interests of the founders and the investors and attempting to assure a fair and equitable investment process and ultimate upside for all parties. Of course, some VCs have abused their negotiating positions in the past, and have taken some of these principles to extremes, but generally speaking they are very sound principles and necessary for the investment process. In the US, for example, no one thinks twice about using them as they are commonplace and perfectly legitimate and legal.

Silicon Valley dot-bomb-era VC humour courtesy of www.thevc.com

Try and apply some of these principles in SA though, and suddenly you find yourself at risk of tripping up on local laws, making them nearly impossible to use. The vesting of founder shares over time and the vesting of ESOPs (Employee Share Options Schemes) over time are a prime example. This process aligns the interests of founders and investors, ensuring all involved remain motivated, and also protects co-founders from each other. If one of the founders were to leave early, for example, you wouldn’t want to be in a position where he or she left with all their shares but no commitment to the business.

This is common overseas, but under South African tax law, every time founder shares are vested and placed in the founder’s hands, it triggers a tax event at full value. The relevant section of SA tax law seems to be aimed more at large, listed companies, which in the past have tried to use shares in lieu of remuneration or bonuses, but at the same time penalises small privately held startups.

Foreign exchange controls are also a current obstacle. They don’t just apply to flows of currency, but also to intellectual property. IP created in South Africa cannot just leave the country, or be sold or licensed outside of the country, without South African Reserve Bank approval. Again this creates complexity, expense and delays, and also makes it harder for the investor to structure things efficiently for globalisation and for optimising the exit value. This situation discourages venture investors from coming to South Africa, and incentivises entrepreneurs at the moment to leave the country and rather work, invent, create and register any resulting IP overseas. This is not something that we at 4Di Capital would like to see.

Another plaguing issue is that as a VC you fall under FAIS regulations and are required to register and be subject to controls that are not designed for the VC environment, but rather to protect the South Africa consumer at a retail investment level. Again, more expense, overhead and delays.

These are some of the obstacles facing VC in South Africa. However, I feel that the opportunities outweigh the problems, and that there is room for some creative and smart thinking to deal with some of the challenges. South Africa would do well though to look closely at revising its legal environment, to encourage rather than impede venture investors setting up in the country. Hopefully entities like SAVCA and the Silicon Cape Initiative can act as a platform to raise awareness of these issues and engage with our government.

Despite the numerous challenges facing venture investing in SA, and some of the critics that I know we have who think that we’re crazy, here we are, giving all of this our best shot, and I’m very excited to say that we’re currently taking FireID international, legally and legitimately, although not without massive effort and some quite heady legal bills. The core IP and intrinsic value of the business has been built-up and is being retained in SA, which some say in the current environment might cause the ultimate potential exit value to be discounted, but I think that Mark Shuttleworth’s exit of Thawte to US company Verisign (and other, less well known exits) has demonstrated what is possible for a South African business on the global stage.

We’re also close to making our first very-early-stage investments from our seed fund, something that is close to my heart as a startup entrepreneur. The seed fund is designed to directly address the “funding gap” that my friend Justin Spratt at IS Labs often talks about. Unfortunately, we’re just one player in SA, which can only invest in a handful of opportunities for now, despite the many, many interesting pitches we have already seen.

Hopefully our activity in founding and supporting the Silicon Cape Initiative will serve to highlight what’s happening down here at the bottom of Africa to the rest of the world, and start to attract other players to the region, ultimately leading to the creation of the tech startup / venture investing ecosystem that myself and Vinny dream about.

One thing I can say, is that South African entrepreneurs are definitely thinking beyond their own borders, and we are seeing more and more pitches with global or at least continental ambitions. The low cost and easy accessibility of cloud computing I believe now makes it possible for anyone anywhere to launch a global online business. These are the types of business plans that venture investors want to invest in!

I look forward to seeing what the next 12 months has in store.