Venture Capital investment is on the rise globally in recent years, however, South African VC has caught the eye of investors looking for more lucrative options. Multiple factors are feeding this unprecedented rise in venture capital in South Africa. The region is just beginning to enter a phase of development the likes of which it has not yet seen. Investors are standing up and taking note of the substantially higher likelihood of higher returns on their investment in South African VC, but it's essential to understand the orchestration of events and changing conditions that contribute to the changing economic and social environments within the country. These are the conditions that have made it possible for SA to experience this economic growth and increase in the development of technology.
The advancements recently made in SA have opened up new vistas in a manner that has produced a domino effect for new growth. VC investment becoming a more attractive proposition in this small part of the global market that remains dwarfed by some of the larger economies. When it comes to investment, size no longer matters, but rather, growth potential based on a plethora of impactful and related events that show promise that new startups are in a superior position for growth, expansion, and success. With VC the most prominent means of funding these emerging markets, we're seeing new opportunities for investors populate the market with the likelihood of a continued explosion in development.
The rise of VC in South Africa since 2018
US annual returns on VC averaged between 10% to 14% in 2018 with European VC returns averaging between 3% to10%. This doesn't inspire a lot of confidence when investors stop to consider the fact that the majority of South African VCs target annual returns at a minimum of 30%. This draws attention to investments with the highest potential for a larger ROI. It's impossible to ignore the superior investment options, albeit, early-stage company investment represents a greater risk. According to Havaic, South Africa is at a point of development that is unprecedented with new technologies unfolding, advanced automation, and machine learning that better connects countries across the globe through the internet. More of South Africa is opening up with new startups launching. Over 400 tech hubs have launched throughout South Africa and Africa with the result of an acceleration in SA's socio-economic development. The open space across the region is ripe for development.
Industries impacted by political changes and the influx of technology
With increased technology and access increasing, impacts in telecommunications, security, hospitality, finance, healthcare, agriculture, and other industries are becoming evident. Tech centers in Cape Town as well as Lagos and Nairobi have become recognized by the governments. The launch of the African Continental Free Trade Area in April of 2019 brought more promise of a stronger economy shortly. South Africa's government announced its new Affiliate Centre of the World Economic Forum's Centre for the Fourth Industrial Revolution paving the way for early-stage high growth opportunities for new startups and technologies arising out of the region. Currently, Venture Capital in SA is set with a supply and demand feature that favors the investor, hence its attractiveness has been enhanced as a tech in SA is advancing internally and springing from homegrown sources.
What about the risk of new startups in emerging SA markets?
Risks are somewhat mitigated by the changing political climate and the environment that fosters growth. With 90% penetration of mobile internet in Sub-Saharan Africa, a rise in smartphone accessibility opens up more opportunities for innovation in rural regions with more markets opening in these areas. Niche investment opportunities are becoming more pervasive with a greater potential for delivering foreign revenue with enhanced VC investment returns. All investments come with risks. The higher the profit potential, the greater risk involved. The same observation applied to investments in South African VC, however, the risks do appear to be mitigated by the favorable environment that we see arising with the changes that have taken place in the political arena, socially, and economically within the country.
Characteristics of the venture capital market in South Africa
According to Thomson Reuters UK, Private equity is SA is well-established. The structuring of funds is in the form of commonly limited partnerships. These partnerships invest capital that has been raised from both local institutional limited partners and international partners. Venture capital is in its infancy with characteristics relying less on institutional capital. The deal sizes are smaller, however, the sizes are growing over time.
Significant growth in the SA venture capital industry has occurred in recent years with notable growth and a spike between 2015 and 2018 with the number of VC transactions doubling during this period. Funding from sources outside of the country is on the rise as foreign interest in VC funds is a current trend fueling the growth. There is increased interest in South African businesses the Venture Capital investments rising to support the growth and expansion of new startups in this regions which is fertile and environmentally sound for explosive growth, hence, the potential for substantial returns on investment in venture capital.
Which companies are the most attractive to investors?
Statistics show that most start-ups and early-stage businesses in South Africa obtain their funding from a variety of sources. The most common source is founder capital with angel investments that come from individuals with high wealth. The next most common funding comes from syndicates, followed by venture capital funding. Companies that most commonly receive venture capital funding are those participating in technology and those that are technology-enabled across the various industries. Businesses with high potential for international scaling are the most attractive with significant attention to Insurtech and the most favorable are companies in Fintech.
Are the terms of VC transactions in South Africa standardized?
Venture capital transactions in South Africa are characterized by standardized investment terms. In general, the South African model is borrowed from practices observed by the United States of America with some modifications. Although more established VC markets and market practices are not developed to the standards of those observed by the United States, and many of the older markets are not yet standardized, SAFEs and seed VC, along with both Series A and Series B round investments are more conventionally structured.
Tax incentives and other investment schemes
Incentives for investment in venture capital investment in South Africa are in place as the merging market continues to grow. The VCC tax incentive regime has been in place since 2008 offering a tax deduction for expenditures incurred by a taxpayer when acquiring issued shares by a VCC (Venture Capital Company). Limitations do apply with a limitation of ZAR2.5 million annually for individuals and ZAR5 million for companies making such investments.
VCC regulation in South Africa
Investors experience increased confidence through the regulatory mandates issued in South Africa for venture capital companies. The manner of operations is strictly regulated. VCCs must maintain the sole purpose of investing in companies that qualify under a set of strict criteria. These businesses must be a ta resident of SA with proper tax affairs in order without impermissible trade on record. Impermissible trade refers to transactions related to immovable property, by a bank, and related to financial or advisory services, gambling, tobacco, firearms, ammunition, or liquor.
A minimum of 80% of the expenditure must be made for the acquisition of assets held at the year nd of assessment/acquiring shares from a qualifying company. VCCs are required to build a portfolio of investments from the acquisition of qualifying shares from qualifying companies. Other limitations and restrictions apply in the regulatory efforts to ensure legality, compliance, and transparency of VC transactions.
Funding sources for VCCs in South Africa
Typically, VC funds are obtained from a range of investor types. These include corporate entities, individuals with high net worth, family offices, fund managers, private sector fund managers, third-party institutional funds via professional investors in charge of the management of these funds, other fund managers, and domestic development financial institutions. Some VC funds invest in other funds.
Challenges and prospects in early-stage venture capital in South Africa
Investors considering an investment in VCCs in South Africa are wise for considering the prospects as well as challenges for early-stage venture capital in the country. South African researchers saw the potential for the current rise in SA VC coming as far back as 2013, just two years before the market began to show signs of emergence. This led to an academic investigation of the challenges and prospects of early-stage venture capital in the country resulting in a research-based publication of the study and its conclusions. The purpose of the study was to identify the factors for other countries and markets concerning their importance in the SA market. The study included private equity and VC find managers, government institutions, university research coordinators, and intermediates to conduct online surveys for broad opinion representation as we'll as in-depth responses.
One of the goals was to obtain detailed information for analysis of measures that could enhance early-stage venture capital development in South Africa. Challenges identified included the lack of tax incentives, government funding to the VC sector, and attracting outside investors. The study ended with a conclusion based on gathered and confirmed facts supported by data and recommendations for increasing the attractiveness of SA VC to investors. To fuel economic growth, recommendations included support for early-stage VC development through increased government involvement and regulation, government and private funding increases encouraged through tax and other incentives, assistance, and mentoring for new entrepreneurs and managers via incubation, increase in angel investors, and a more formal structure for pooling funds from angels.
The evolution of venture capital in South Africa
We included the 2013 research project to show the progress that early-stage VC has made in South Africa. The study outlined the challenges faced for early-stage venture capital during this point in time. We use the information they collected and verified to show that many of the problems and challenges identified by the study's conclusion provided sound recommendations for South African stakeholders to consider. We can look back from 2013 to the present to see that the study launched a chain of reactions by those with an interest in promoting and supporting the emerging VC market in SA. The changes that were made in the social and political environment in response to recommendations have made a noticeable change to open up the pathways for venture capital markets to thrive in the country. While native support from individuals and institutions is a part of the solution, along with efforts to increase the attractiveness to outside investors from foreign entities and individuals.
The venture capital market in South Africa is taking a more solid presence in the country in its emergence with the hope and likelihood of a flourishing market in the niche. An average of 30% return on investment annually from investment in South African venture capital along with exceptional tax incentives have combined with other factors to catch the eye of investors from around the world. The potential for earning more on investments is higher in South Africa than in the United States and Europe. Measures taken to create a fertile environment for the growth of venture capital including political and government support, an influx of technology, the rise of new tech startups for homegrown technology advancement, and modernization of the country are all factors that support the emergence of the market. Although South Africa still has a long way to go in the development of its regulatory system regarding VCCs, it's making impressive progress. The overarching model embraces the practices and structures of those currently in force in the United States with a few modifications. This increases the confidence of investors throughout the world. The outlook is sunny for the continued growth of the venture capital market as the economy in South Africa continues to strengthen.
Written by Allen Lee
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