Dec 17, 2020
Tags: Impact Investing,
Catalytic Investing in Emerging Markets
In emerging markets, big opportunities are disguised as challenges.
We need more entrepreneurs focused on building innovative start-up ventures in these contexts. But building high growth ventures is hard. Recruiting world-class talent is hard. Raising critical funding from investors in order to scale is hard. Add in unique operating environments, increased complexity, and the perception of heightened risk in emerging markets and the prospect of building a successful company can seem downright impossible. And these feelings of doubt are justified: data shows that most start-ups in emerging markets will fail[i][ii], though this fate is hardly limited to African ventures.
But this difficult environment is precisely where Factor[e] sees incredible opportunity. According to the International Finance Corporation, 600 million jobs will be required in the next 15 years to support a growing global population, and the necessary “radical innovations [that will drive this transformation will] disproportionately often originate in small and entrepreneurial new firms.”[iii]
Our belief that combining market-driven forces with disruptive start-ups can solve the worlds global challenges drives the work that we do every day. We are a small team with a big vision. We believe that by supporting innovative technologies and business models in regions like Africa and India today, we are poised to capitalize on equally strong impact and financial returns in the years to come.
But how can a small impact investor like Factor[e] make a difference, when an estimated $7 trillion annually is required between now and 2030 to build a sustainable global economy and achieve the United Nations Sustainable Development Goals? [iv] The answer lies in our ability to catalyze an exponential multiplier of our initial investment capital into our sectors, an outcome we frequently measure through a mix of both quantitative and qualitative metrics. We know that disruptive innovation, supported by the right business model, and coupled with market and technology de-risking, leads to increasing levels of commercial investment, which drives growth (and ultimately exits), creating a virtuous cycle of repeated innovation and investment through escalating financial returns.
It is through a range of deep technical, in-market, and entrepreneurial experiences across our team that we have developed the core set of capabilities described below that collectively drives our ability to catalyze the sectors in which we invest.
- We are thesis driven which means we are exceptionally informed about our sectors, building a vision for the future that allows us to be intentional about innovations that will transform the relevant value chains.
- We act as a knowledge broker, bringing technology and business model innovations to the people and markets to which we are dedicated.
- We are venture builders, bringing hands-on individualized support, access to networks, connections to peers, rich technical and regional expertise, and a comprehensive venture platform that offers systematic operational support to portfolio companies; and
- We bring complementary dilutive and non-dilutive capital to the market by partnering with some of the most well-respected and experienced philanthropic institutions in the world, a financing mix that is often necessary to overcome the increased complexity and overall cost of building technology ventures that reinforce the core building blocks of an economy in emerging markets.
The following sections take a deeper dive into how Factor[e] measures performance quantitatively, through KPIs like survival rate, investment leverage, time between rounds, and portfolio IRR, and qualitatively, by understanding and documenting the depth of our supporting activities, as well as the experiences, perspectives and feedback from our entrepreneur collaborators, peer investors, and philanthropic partners.
Financial and operating performance
With a current portfolio of 19 seed investments across four thematic areas (energy, agriculture, mobility, and waste and water) we have assets under management of over $10 million USD. Our investees have a survival rate to date of 89%, our unrealized IRR is just under 11%[v], and our portfolio companies have secured over $178 million USD in additional capital as part of or after our initial investment, which is 17x+ the capital we invested. These figures are particularly noteworthy given the developing market context in which we invest, where the average net IRR according to the 10-Year Africa Private Equity & Venture Capital Index hovers just over 5%.[vi]
One of the biggest hurdles to startup growth in our markets is the slow pace of funding rounds. The Digest Africa reports that on average, venture-backed start-ups in Africa take 80 days to raise a pre-seed round, 414 days to raise a seed round, and another 455 days to raise a Series A.[vii] While these figures may seem promising, the results are largely driven by fintech firms. In contrast, technology firms within the energy and ag sectors have historically faced a much tougher battle when it comes to raising Series A+ funding.
These extended time horizons – and the challenge of raising growth capital – creates, as Figure 1 shows, one of several “death valleys” young companies must traverse in their journey.
Figure 1. Development lifecycle of a startup and meeting needs on the African continent
Source: AFD/Roland Berger, Etude sur L’innovation numerque en Afrique et dans les pays emergent, 2017
“Death Valley” as the chart above highlights, or what we refer to as ‘the great divide,’ is one of the most challenging obstacles for our early-stage entrepreneurs to overcome. This chasm refers to the void in funding that exists for start-ups in developing markets between pre-seed or early-seed investment (i.e., friends and family, incubators, university grants, private foundations) and commercial lower-cost sources of institutional capital (i.e., debt financing, private equity, public markets). This is where patient venture capitalists like Factor[e] are critical for the growth and development of emerging economies because we are risk-takers by design. In fact, we often invest against our theses in exceptional entrepreneurs that do not have a fully realized vision for their product or service in context. Without investment at that stage, however, it is a steep climb to product-market fit and a compelling and comprehensive story. And a persuasive and credible product-market-fit and a tight narrative for the vision for your company is a requirement to reach the promised land of true Series A financing.[viii]
Figure 2. Distinguishing Factors of Patient Capital
Source: Acumen, 2018, https://acumen.org/wp-content/uploads/Accelerating-Access-Role-of-Patient-Capital-Report.pdf
Leadership and Support
While hard to define and even harder to compare to peers or across industries and markets, we think it is important to quantitatively track, to the extent possible, the level of deep support we provide to our portfolio companies through active engagement from our Investment Principals. We believe our hands-on venture building approach is a meaningful differentiator and a core component of our portfolio’s success. Key metrics we monitor include board representation, where we have held director or observer seats in 84% of our companies, and type of investor engagement, where we have led rounds in 63% of our deals. Our principals have also worked closely with entrepreneurs to navigate 13 major strategic pivots, 7 country expansions, 9 C-suite hires, and 15 new product releases. Our team is constantly evolving how we tackle portfolio engagement and support, and we look to US venture capitalists like First Round Capital, who are “focused on being the world’s best partner for founders at the very first stages of company creation” and apply these types of best-in-class approaches to emerging markets.
Complementary to our strategic and customized Principal and director-representative support activities, is our Engage Platform, a systematic (i.e., replicable) post-investment support program led by our operations team. A recent example of the type of platform support we offer was our 2020 virtual pitch day, which saw attendance from a wide range of international philanthropic donors and commercial investors. Our investment and platform teams worked tirelessly across our pre-Series A portfolio in preparation, managing or orchestrating fundraising story workshops, pitch prep practice and feedback sessions, deck design, logo and graphics support, and multiple formal feedback loops. But the arc of our systematic support platform doesn’t end with an event like a formal pitch day; rather, it covers the full range of start-up needs, including all aspects of leadership, operations, technology de-risking, early sales traction, and fundraising, and continues until our portfolio companies have graduated into more advanced funding rounds, typically a Series A or (less often) a Series B.
Thesis Driven, Knowledge Broker, Venture Builder
As a thesis driven investor, we couple our deep domain expertise with data-driven analysis to understand the ways markets need to change to positively impact the bottom of the pyramid. We form our theses based on these insights and update them regularly to stay in front of a sector. This means we don’t just identify a theme and then invest in a range of companies that fit within that space, we formulate a hypothesis for the future of that thematic area, and deliberately invest in (or create) companies that will drive us towards that vision.
For example, in crafting our minigrid enabling ventures investment thesis we recognized that minigrids would need to play a significant role in closing the access to energy gap globally and that the minigrid sector and business model was not yet equipped to do so. Among other prongs of our investment thesis, we knew that the minigrid future required smart metering solutions, remote monitoring and controls, and software platforms to drive down the costs of designing, financing, and maintaining community-scale grids. In SparkMeter, we found a world class technology solution fit for purpose and well-matched to the smart meter component of our investment thesis.[ix]
In contrast, we searched but did not find a solution that matched the clear need for a finance marketplace for minigrids. As committed venture builders, we leveraged our entrepreneur-in-residence (EIR) program to launch Odyssey Energy Solutions. This program is a unique opportunity we have run three times with three different female entrepreneurs from around the world. Emily McAteer inaugurated this program and, along with her team, developed Odyssey Energy Solutions, an all-in-one platform to develop, finance and manage distributed energy projects at scale that has worked with over 500 developers in 30+ countries to facilitate over $350 million into mini-grid projects to date.
While our venture building is highly customized to the market needs that we want to invest in, it also requires an incredible amount of resource in order to be successful. And we recognize that not every attempt we make at it will succeed, as failure is an intrinsic aspect of the high-risk nature of the work we do.
A third core component of our investment strategy increases our success rate by leveraging our ability to broker existing technologies and business models into the markets and thematic areas that we focus on. Knowledge brokering, coined by Andrew Hargadon and Robert Sutton, refers to systematically using existing ideas as raw material for new, innovative ones. Their studies show that companies with repeated technological innovation execute a four-part approach of capturing good ideas, keeping old ideas alive, imagining new uses for old ideas, and testing promising concepts.[x]
Factor[e] has demonstrated our ability to capitalize on this well studied and understood knowledge brokering cycle of innovation through one of our more recent investments into Boston-based Clean Crop Technologies.
Clean Crop Technologies has developed a breakthrough food processing technology that today removes up to 83% of toxins from grains and nuts, 99%+ of molds and pests, and extends shelf-life of perishable foods for up to 7 days. 25% of the world’s grain food supply is lost annually in the post-harvest supply chain primarily due to spoilage caused by bacteria, yeast, molds, fungi, and mycotoxin and aflatoxin contamination. That makes Clean Crop’s solution a disruptive technology that is a perfect fit for the over 40% of global peanut supply (or 16 million tons annually) that is produced in Asia and sub-Saharan Africa whose processors represents roughly 67% of the global peanut processing market but capture less than 20% of the total global export value.
And as Clean Crop Technologies’ CEO Dan White asserts, “Clean Crop was really born out of our experience in emerging markets, and the compelling opportunities we saw in those food systems that we could solve. We knew we needed millions to go from the lab to commercialization, but very early on we ran into a big challenge in the kinds of risk most capital was comfortable with. Most funders interested in emerging markets were not comfortable with immature technology with some unknowns about how and where it will be most effective, and VCs with comfort around immature tech weren’t comfortable with a go to market plan that starts in East Africa, or Southeast Asia. Factor[e] stands apart in recognizing the commercial and impact potential at the intersection of nascent tech and fast changing markets around the world. Their network of engineering and hardware expertise, emerging market philanthropic and venture partners have enabled (and pushed) us to keep our focus on emerging market opportunities as our business matures.”
The Critical Role of Complementary Finance
Pre-commercial ventures require different types of capital including grants, equity, and debt, working together across multiple stages of investment and growth. In established economies, these needs are met through a combination of public (grants/loans) and private (equity/debt) investment. In emerging markets, philanthropies and development finance institutions have responded to build the investment ecosystem for market-based solutions which otherwise would be missing.
Grant and equity funding are not mutually exclusive by stage, in fact, they are quite complementary. Early equity helps a venture invest in core operations while forcing important actions around ownership and governance, valuation, fundraising, business model, and product-market fit. Meanwhile, grants can incentivize key customers or regions, support R&D and the first steps of technology commercialization, and allow investment in team and bridge funding rounds while avoiding excessive dilution. While complementary, it’s important to recognize that grants and patient capital in the form of equity are not interchangeable for pre-Series A companies. As Acumen highlights in a 2018 report on patient capital, “[g]rants can also be used to fund operations, therefore playing a similar role to equity. That being said, grants do not have the signaling effect of patient capital, meaning that they often do not position companies for subsequent equity raises.” This is where experienced early stage, more risk-tolerant venture capital investors come in. Patient investors like Factor[e] prepare entrepreneurs to take on more commercial funding, and signal to the market that they are primed for growth.
We know that we can best support our portfolio by working closely with globally recognized and respected philanthropic partners to bring this highly complementary capital mix of grant and equity funding to bear. To date, 79% of our investees have received grants, a sum totaling nearly $30 million in non-dilutive capital from organizations like the Shell Foundation, DOEN Foundation, Department for International Developed (DFID), now the Foreign, Commonwealth and Development Office (FCOD), and the United States Agency for International Development (USAID) as part of or after our initial investment. We partner closely with investment managers from the Shell Foundation, which has representatives for each of our core investment areas on our Advisory Board, to discuss pipeline opportunities, investment and thesis area alignment, prospective investee growth and impact potential, and collective support and funding capabilities. We work collaboratively with our partners in the Power and Food programs at the Rockefeller Foundation in an ongoing dialogue about our respective theses and strategies. And we partner closely with the action-oriented team at the DOEN Foundation, easing the collaborative funding-financing process through gaining practice working alongside each other and building trust and confidence in each other’s judgment. We recognize that blended finance can play a critical function for high-risk early-stage start-ups in emerging markets. It’s important that we collaborate on how best to support these ventures with our philanthropic partners. As Sam Parker, CEO of the Shell Foundation attests, “Factor[e] plays a critical role in bridging the gap between philanthropic and private sector investment, providing early-stage equity investment and deep technology expertise that helps our jointly supported ventures unlock later stage commercial capital.” And we have seen this type of collaboration in numerous cases both help our investees traverse ‘the great divide’ while they work to shore up key needs like team or product-market fit and likewise help companies already primed for commercial investment to scale as they build a compelling Series A story.
Impact of COVID-19
It is estimated that hundreds of thousands of small businesses around the world will not survive COVID-19. Instead of expanding and scaling, start-ups have cut costs to survive the pandemic. Fundraising from VC funds globally slowed during Q2 and Q3 of 2020, rounds and valuations for prospective deals shrunk, and investors have looked to support current portfolio companies rather than invest in new ones. The 2020 Global Startup Ecosystem Report reveals that of term sheets that were active pre-crisis, 46% have slowed down in pace of progress given the current climate and 26% were either canceled or the lead investor has stopped responding altogether. Venture capital funding dropped by 20% globally during Q1 2020.[xi] This environment has made survival for start-ups around the world even more challenging as they face both reduced consumer or market demand and more limited investor capital to get through the pandemic.
The impact of COVID-19 on Factor[e] and our portfolio is no different. We have worked closely with our entrepreneurs this year to dive into their 12 to 18-month forecasts, analyzing runway, burn rate, capital requirements, required spend against projected growth plans, and potential for new funding sources. In early Q2 of this year, we expected we would need to deploy most of our 2020 investment towards current portfolio companies versus investing in new companies, but by the end of Q3, we were pleased that this need had not come to fruition. In fact, by the end of this year we expect to have welcomed four new companies into our portfolio.
Where we have reinvested in our portfolio this year, it was to leverage co-investor interest and accelerate – rather than just stabilize – the company’s growth. Indeed, despite the difficult global environment, we have actually seen many of our portfolio companies flourish, including S4S Technologies, a food preservation company based in India, who, with Factor[e]’s support, has been able to close a critical $1.75M USD pre-Series A that will help them build out their network of rural women drying partners, expand their dehydrated product customer base, and optimize their core business systems to prepare for rapid growth in the future. The possible alternative – shrinking their operations and ambitions in order to survive – is, happily, a distant memory. We expect them to come out on the other side of the pandemic bigger and stronger than ever and primed for a robust Series A that will be larger than they could have raised before the pandemic. Sunanda Madan, Sector Lead in Agriculture for Acumen Fund India and the lead pre-Series A investor, describes both their interest in the round and Factor[e]’s catalytic role in driving S4S towards a successful close, “Acumen’s recent investment in S4S Technologies is a testament to the fact that we believe in the power of decentralized business models in agriculture as the key to improving incomes of smallholder farmers. We are very excited to partner with Factor[e] Ventures who had invested in the company at a critical time in their life cycle and enabled it to scale to a level where it was able to attract good investor interest. We were impressed with Factor[e]’s willingness to go the extra mile to work collaboratively with us, especially in such trying times, in order to ensure complete alignment of objectives, and we are looking forward to working with them to help take S4S Technologies to greater heights”.
Moving to Scale
Big challenges mean big opportunities, but we need more entrepreneurs tackling them in the emerging market context and we need more of those entrepreneurs to be successful. Success isn’t company survival (though in the context of this global pandemic we at least need that) and success isn’t growing into nice, modest size businesses. We need ventures that scale to meet the scope of the opportunities we are faced with in emerging markets. This is where Factor[e]comes in. Our track record demonstrates that the combination of our thesis-driven, venture building approach increases the probability of our entrepreneurs building and scaling a successful startup. And the more successful startups we have in emerging markets, the more commercial capital will be mobilized.
But we can never get complacent in the work we do, and we are not satisfied. Proud as we are of what our investees have accomplished, we are just scratching the surface of the opportunities in front of us and the work that needs to be done. Ultimately, we need more here – more investment and non-dilutive capital for early-stage companies, more world class, superhero entrepreneurs tackling these opportunities, and more proven businesses that reach a scale that puts a dent in these enormous needs.
2020 has brought overwhelming challenges globally but we believe that profound solutions can be borne out of this hardship. And institutions like Factor[e] will be here to help developing markets capitalize on the innovations that will drive us towards a sustainable global future.
[i] Consider that 54% of start-ups failed in Africa between 2010 and 2018. The failure rate in entrepreneurship hubs like Nigeria, Kenya and South Africa was 61%, 58% and 54%, respectively.
[ii] Jha, Nayantara. “The Better Africa Report: Five Out Of Every Ten Startups Failed In Africa In The Last Ten Years.” March 2020, Weetracker, https://weetracker.com/2020/03/12/the-better-africa-report-startups-failed-in-africa/#mepr_jump.
[iii] International Finance Corporation, Input Paper for the G-20 Sustainable Finance Study Group, 2018, “Private Equity and Venture Capital’s Role in Catalyzing Sustainable Investment”.
[v] Unrealized portfolio IRR based on conversion of all debt and valuations from the most recent priced rounds.
[vi] Africa Private Equity and Venture Capital, Index and Benchmark Statistics, Dec 31, 2018, Cambridge Associates and AVCA, https://www.avca-africa.org/research-publications/data-reports/?cat=Benchmarks.
[vii] “Here’s how long it takes African startups to raise funding”. Digest Africa, August 2019, https://digestafrica.com/african-startups-raise-funding.
[viii] Reaching the Series A “promised land,” of course, merely positions you to take a run at the next stage of scaled growth, a feat we generally leave to larger, later-stage investors to support.
[ix] More specifically, we defined the need for a ‘prosumer’ level, high functionality, but reasonably priced metering solution that could operate effectively in low telecom network coverage settings and integrate with mobile money.
[x] Hargadon, Andrew and Sutton, Robert. “Building an Innovation Factory.” Harvard Business Review, 2000, https://hbr.org/2000/05/building-an-innovation-factory-2.
[xi] Startup Genome & Global Entrepreneurship Network, 2020, “The Global Startup Ecosystem Report GSER 2020”.
Featured image credit: Arpit Rastogi (unsplash)