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Q3 2022 - (released November 2022)

SA's quarterly Private Equity & Venture Capital magazine

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No Country for Entrepreneurs 

by Michael Avery

The impact of Venture Capital cannot be measured by comparing its size with other asset classes like private equity or the larger Association for Savings and Investment South Africa (ASISA) membership numbers, which run into the trillions. 

At the end of 2021, the South African VC asset class had R8,13bn invested in 1021 active deals. While this has increased substantially, compared with the figures at the end of 2020 where R6,87bn was invested in 841 active deals, according to the latest SAVCA Venture Capital survey, the true value of the asset class is its role in supporting the innovation economy. 

This is foundational economics. Innovation is fundamental to the growth in any economy. But for innovation to flourish, there needs to be funding. And the Venture Capital asset class in South Africa is fundamental to that growth. 

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Stephan Lamprecht, founder of VS Nova, long-time researcher and compiler of the VC survey and advisor to the industry, points out that what we've seen over the last couple of years is that, despite an economy under pressure, the VC asset class has shown relatively robust growth, albeit from a small base. 

“I think what's becoming clearer as well is that the role of venture capital is not just limited to funding, but also in keeping skills in South Africa,” explains Lamprecht, “because by funding local opportunities, those entrepreneurs are employing people that are able to develop those products and services in South Africa. So the impact is fundamental; it's significant.” 

The numbers in this report reiterate the fact that the VC industry is growing year- on-year, with more early-stage businesses receiving funding and strategic guidance from VC fund managers. 

Investment activity, by value of deals, decreased slightly from record levels reported in 2020, amounting to R1,31bn in 2021 (down from R1,39bn the previous year). While we continue to see healthy fundraising, this could lead to more money chasing fewer deals and driving valuations higher. Great news for founders but less so for investors. 

There was an 11.4 percent increase in the number of deals, with 129 entities receiving VC investment in 2021, up from 122 in 2020. 

The report shows that a significant proportion of all deals (62.3%) were less than R5m in value, with 56.2 percent of all active deals being seed or start-up stage businesses, which has been a consistent feature of the SAVCA asset class, as recorded in previous surveys. This is encouraging because these early-stage investments are the acorns that grow into mighty oaks. 

The survey found that fewer fund managers invested in 2021, with various fund managers focused on supporting existing portfolios. 

Zooming out to the continental picture, African start-ups attracted a record US$3.5bn (R63bn) in venture capital investment in the first half of this year, bucking a global decline in deal-making linked to worldwide economic turmoil, according to data released by industry group, the African Private Equity and Venture Capital Association (AVCA). 

The funding, raised by 300 different companies, represents growth of 133 percent compared with the same period last year. 

If one assumes similar growth in the second half, that would take the total invested in African startups in 2022 to $7bn (R126bn), which shows that South Africa, based on the 2021 figures, accounts for less than one percent of continent-wide VC activity, surely a figure far too low for such a large and sophisticated economy. 

As Lamprecht explains, one of the major constraints remains the continued imposition of exchange controls which are anachronistic in a modern open economy: “Basically, what it comes down to is that when you want to scale globally, you will want to raise funding in that market. So, for example, it's very clear in South Africa that our advantage is our cost base in terms of having local access to skills. We have very good skills locally, and those people are paid in South African rands; that's fine. But if you want to set up in the US, in Europe, or even China, to tap into those markets, you need to set up people and processes in those countries. To be able to do that means that you need to have funding that is based in those territories, not funding that is South African – simply because we don't have those quantums available in South Africa. And from an exchange control point of view, the physical barrier or impediment of moving money across borders is significant. If I need to pay a salary for my developer, who is currently sitting in Amsterdam, I first have to get Reserve Bank approval to do that; I can't operate. So that creates operational challenges for companies. The repatriation of that money and associated tax issues contributes to uncertainty.” 

From an entrepreneur's point of view, the impact that exchange control is having on South Africa’s local entrepreneurial ecosystem is shocking. 

Lamprecht believes that the bottom line now is that if you have a business with global market appeal, with a product or that kind of intellectual property that you want to commercialise, you have to set that up offshore in order to minimise dealing with Reserve Bank approvals linked to exchange controls. 

There has been some leniency from the Reserve Bank and from the tax authorities, but it is not practical. 

“We're talking about companies that are taking six to 18 months to get approvals, and yet we're talking about start-up entrepreneurs, people that need to focus and keep their eye on the ball. With limited resources, they still have to navigate red tape, trying to hunt down government officials to get stamps of approval. It's ridiculous. From that point of view, we really are shooting ourselves in the foot.”

 

Clearly, some work is ongoing in the form of lobbying Treasury to change the system. Judging by the approach taken to Section 12J, where some people were taking advantage, the impact had stimulated much needed additional capital flows into the class, but the baby was thrown out with the bathwater. It seems VC is not very high up on Treasury’s priority list.

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When we talk about priorities from a taxation point of view – mining, minerals, financial services, that's clearly where the priority lies. Treasury seems to think that entrepreneurs are based in a basement in Cape Town somewhere, and that's why it's been on the back burner to a large extent. 

“And the easy thing that you hear from the regulators is ‘show us the data, show us the impact’. But a lot of the implications of our regulatory constraints unfold over many years. I spoke to an entrepreneur earlier this week. It's a well-known company that's in the financial services space, and they received Reserve Bank approval for a part of their transaction almost eight years ago. The implications of that approval are only now unfolding for them, at a time when they are trying to get their next round of investment. So, to go to the authorities with these business cases is very difficult because you are not always aware of how these things are going to unfold in the future, and what's going to be the impact for the start-ups themselves.” 

A short survey was distributed amongst a few start-up entrepreneurs during the Case Studies research project, using the networks of Endeavour, Silicon Cape and SiMODiSA. 

Out of a sample of 52 respondents, 81 percent moved their business offshore to raise investment from international investors. 85 percent of the sample ended up having to set up an offshore company. Two thirds of the 52 respondents were required by their investors to set up an offshore company, with almost 70 percent reporting that setting up the offshore company was a prerequisite of the investor prior to concluding the transaction. 

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49 of the 52 respondents ended up setting up an offshore company as indicated above. The US was the preferred choice for setting up a new company (34.7 percent of those with offshore companies), followed closely by the UK and Ireland (30.6%). The state of Delaware in the US was the prominent legal jurisdiction for those targeting the US. Mauritius was the preferred choice for non-South African jurisdiction on the African continent. 

55.8 percent of respondents reported the need to physically relocate some of the company’s staff to the offshore company, with only 7.7 percent reporting having to move the founders and entire staff compliment to the offshore location. 26.9 percent of respondents reported not having to move anyone to the offshore company. 

32 of the respondents had employees or founders move to the offshore company, amounting to a total of 169 individuals. 122 of those individuals and their families formally emigrated. 

When asked what the number one reason was to relocate away from South Africa, 32.7 percent cited the ability to attract foreign investment as the primary reason, followed by 23.1 percent selecting the limitations of Exchange Control as the primary reason. 

Relaxing exchange controls, easing the movement of intellectual property, and making it easy to set up a foreign base for the local operations were cited as the main reasons for reconsidering the move abroad. 

32.7 percent of respondents would relocate back to South Africa if Exchange Controls were scrapped. 25 percent would relocate if they were able to keep the IP offshore without any future actions, including taxing from the SA government. 

Clearly, this is no country for entrepreneurs, but that could change with the stroke of a pen.