When MFS Africa announced a $100 million raise in October 2021, its CEO and Founder, Dare Okoudjou, laid a strong case for debt financing. Although the financial and payments services company raised debt for the first time, Dare firmly asserted that it was the right call and encouraged others to take the same route. “We believe again, as the ecosystem matures, more companies will also do a combination of debt and equity,” he noted.

A few years earlier, in 2018, Michael Wilkerson, the founder and CEO of Tugende, the Ugandan asset financing company, was among the first few founders to signal long term commitment to raising debt financing. In an interview with Digest Africa, Michael noted that the only reason Tugende raises equity financing is to anchor further debt. As a result, his company has essentially funded its growth through debt - both convertible and straight - including the $5 million secured in 2018 from the Development Finance Corporation, then called The Overseas Private Investment Corporation (OPIC). The company has raised a total of $34 million in both debt and equity.

When innovative companies are starting, they are extremely risky and unpredictable, making them unappealing to most forms of financing, except venture capital. But, as they mature, other financing options open up, especially from traditional lenders. This trajectory implies that for alternative forms of financing for these companies to emerge, venture capital must take root first.

According to various accounts, Silicon Valley as we know it today traces its roots to the 1970s. The decade saw the emergence of venture-backed companies such as Apple -  founded in 1976 - and today's storied venture capital firms Sequoia Capital (an early investor in Apple) and Kleiner Perkins (an early investor in Genentech). Both Sequoia and Kleiner were founded in 1972.

It wasn't until ten years after the founding of these firms that alternative forms of financing targeting venture-backed companies emerged. Silicon Valley Bank, founded in 1983, is the most recognizable. The bank's primary strategy was collecting deposits from venture-backed companies before expanding into banking and financing venture capitalists themselves and added services to allow the bank to keep clients as they matured from their startup phase. It eventually expanded to include debt financing for these businesses and their founders.

As venture-backed companies mature, their financing needs to become numerous and extend beyond the expertise of the venture capitalists. This has spawned a new financing niche, called Venture Debt - only focused on lending to or structuring alternative financing needs suited to venture-backed companies. Many well-known technology companies have taken debt in their growth journeys, including Facebook, whose financing came from venture debt provider TriplePoint Capital.

According to Kruze Consulting’s 2019 industry survey, venture debt providers lend about $10 billion per year. Compared to venture capital, it is a small slice of the broader market for private tech financing as it is less than 10% of the U.S. venture capital funding, a figure that stood at $156.2 billion in 2020, per PitchBook data. But as more startups mature and choose to stay private longer and the need for financiers to be more startup and founder-friendly, interest in debt financing is growing. This interest extends beyond the U.S. into emerging markets like India, Southeast Asia, and Africa.

Over the last decade, venture debt has been in the mainstream in India and hit $800 million in 2020. A figure that is approximately 8% of the country's total venture funding in 2020, growing from a base of between 4% to 5% of total venture funding in previous years. This almost puts India at par with the U.S. numbers, where debt financing stood at 10% of total venture funding in 2019. Some of India's earlier debt came from lenders such as SVB's Indian arm, which opened its office in the country in 2008 as SVB India Finance and operated for seven years before getting bought out by Singapore's Temasek.

However, for Southeast Asia, venture debt comprises only 1-3% of overall venture funding, But the region is also younger than both India and the United States. More importantly, Southeast Asia is registering exciting developments. For example, the Singapore government identified venture debt financing as a critical driver to boost the local startup ecosystem, launching a S$500 million Venture Debt Programme in 2016 to encourage qualified lenders to provide venture debt to technology startups.

In 2019, Genesis Alternative Ventures, a Singapore based venture debt fund, also launched its venture lending business to Southeast Asia based startups. In April 2021, Genesis announced closing an $80 million debt fund anchored by family office Sassoon Investment Corp with other investors, including Japan's Aozora Bank, Korea Development Bank and Hong Kong multi-asset investment firm Silverhorn Group, the firm said.

For Africa, there are no exact figures around how much venture debt the market attracted over the past five years when venture capital started taking off. However, given the growing number of announcements, including from Moove, Trella, MFS Africa, TradeDepot and others, it is fair to anecdotally state that the venture debt market is ripe for serious consideration. The observation also backs this assertion that Africa's venture capital funding has been steadily rising, with this year's figure projected to hit the $5 billion mark, more than the previous three years combined.

In 2021, Africa recorded five new unicorns - private technology companies valued at over $1 billion. These are; Flutterwave, Andela, Wave, Opay and Chipper Cash. Because the African startup ecosystem hit an inflexion point this year, this should signal anticipation for further financing needs.

As these companies grow and become more predictable, they are bound to need debt financing to finance strategic acquisitions, anchor growth and expansion, or avoid issuing equity unnecessarily. However, small, fast-growing startups will also need funding to extend the runway and avoid down rounds or finance capital expenses during expansion.

There are already indicators of key lenders targeting Africa. For example, in October 2021, Lendable, an emerging markets lender, announced its intention to raise a $100 million fund targeting African and Asian fintech companies. Daniel Goldfarb, the co-founder of Lendable, noted that "we have had an amazing response to this fund and have brought on board an impressive slate of leading impact investors and DFIs who back our approach".  Before announcing this fund, Lendable had already made numerous investments in African companies, including participating in MFS Africa's $100 million funding round with $30 million in debt.

Other observations include SVB Capital, the investment arm of U.S. high-tech commercial bank Silicon Valley Bank which led Chipper Cash's $100 million Series C round—signalling the bank's foray into Africa. Although SVB Capital participated in the equity round, it is a matter of time until  SVB leverages its venture debt expertise.

This research establishes a thesis around a strategy that can take advantage of the opportunity to offer debt, and other alternative financing needs to growth stage African startups. We explore what debt financing in the African context should look like and which companies are best suited for it and recommend how traditional lenders, including commercial and investment banks, can get into the doorway.

History of Debt Financing for Startups

The 1970s and 1980s saw the rise of the modern venture industry, as pioneering venture firms such as Sequoia Capital and Kleiner Perkins built records and experience with successful investments like Apple and Genentech, demonstrating the potential of venture funding. But even with the promise of venture capital, growth-stage startups were still capital-constrained with, for example, the 1985 L.P. commitments being only $3.8 billion.

As a result, entrepreneurs and investors sought alternative forms of financing, turning to the high-tech equipment leasing industry to meet the capital needs of startups, primarily in semiconductors, databases and computing. Known as venture leasing, it would augment equity financing resulting in a more efficient capital structure, lowering the cost of funding.

This financing reluctance was fed by the notion that startups failed at an alarmingly high rate - which is still true today. However, these high-tech leasing companies still looked at the creditworthiness of the entrepreneur, and without a financial track record showing up to three years of profitability, they would only finance up to 50% of the equipment. So a more feasible alternative had to be devised - leading to the idea of venture debt from lenders willing to shoulder risks that high-tech leasing companies weren't ready to.

Over the years, facilitated by the dot-com boom, venture leasing gradually turned into venture lending as more technology companies obtained high valuations. As a result, lenders entered the market offering propositions that the traditional banks could not provide while providing a non-dilutive form of funding for startups.

Venture debt is an overarching term used for loans tailored to the needs and the risks associated with venture-backed companies. These loans target companies that have raised equity from venture capital firms or similar institutional sources instead of capital raised from "friends and family." It is highly suitable for high-growth startups (typically Series B and beyond) that do not have the collateral required by traditional banks.

Most of the credit available to businesses is underwritten based on cash flow. The second most popular option is short-term advances against liquid assets, such as accounts receivable and inventory. These asset-based loans focus more on the collateral as the source of repayment instead of cash flow. Unfortunately, neither approach works for startups that are pre-product or recently began generating revenue.

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Today, the industry has evolved to a point where sophisticated financiers like SVB and Lighter Capital offer pre-venture backed startups access to capital. But, of course, this largely depends on the type of investors that the company is likely to attract. The typical venture debt borrower is a fast-growing company that has raised money from reputable venture capital firms, or similar institutional sources, with a defined strategy to raise further capital. Ideally, most pre-venture companies, particularly at pre-seed or seed stages, do not match this description.

But, as the venture industry is maturing, the pre-venture stage is also getting institutionalized, with accelerators such as Y Combinator and others offering a stamp of credibility. In 2019, SVB and Lighter Capital jointly announced their decision to provide tech startups yet to receive venture funding with access to debt capital and bank services. Per the arrangement, Lighter Capital, a revenue-based finance provider for startups, provides the financing while SVB comes in with the banking services.

While the exact structure of a venture debt loan can vary, there are two critical variables in venture debt term sheets: the length of time during which advances can be made and the length of time before the borrower has to begin making principal payments to amortize the debt. The debt is typically structured as a three to five-year term loan with interest payments and warrants. Warrants are security that gives the holder the right (but not the obligation) to purchase company stock at a specified price within a specific period.

The exact size is based on the equity raised in the most recent round. Instead of focusing on historical cash flow or working capital assets as the source of repayment, venture debt emphasizes the borrower's ability to raise additional capital to fund growth and repay the debt. It is attractive because it minimizes the dilution of the founders and early investors.

In Africa, debt financing has historically been standard in renewable energy. Since 2017, according to Crunchbase data, the sector's combined debt financing amounted to 47% of all the disclosed debt funding raised by startups on the continent. This is understandable as renewable energy companies require a lot of capital expenditure to finance their products and services for their customers. DayStar Power, M-Kopa and Zola Electric are among the continent's most funded renewable energy companies. Zola Electric has raised $157.5 million in debt funding, while M-Kopa has raised $107 million. On the other hand, Daystar has raised at least $55 million in debt financing since the start of 2019.

Most of the debt financing to these renewable energy companies comes from DFIs such as FMO, IFC, CDC Group, and Norfund. It is worth noting that the role of DFIs in financing startups across Africa is very ubiquitous. They offer debt, invest directly for equity, and in other cases, they are the anchor L.P.s for most V.C. fund managers targeting Africa. However, their participation in debt financing for renewable energy is born out of the observation that the industry is capital heavy and risky.

As a result, only a few instances of debt financing to renewable energy companies feature commercial banks. Instead, specialized players such as SunFunder have complemented the DFIs, structuring and advancing loan facilities to these renewable energy companies. One such was Stanbic Bank which led a $55 million local currency equivalent debt facility for M-Kopa during their $80 million debt raise in 2017. There are also crowd lenders like Trine and Lendahand that have become essential debt sources, relied on by companies that can't absorb the big DFI tickets or meet the criteria stated by the DFIs.

Source: Future Africa and Crunchbase

This kind of structure is unlike what we have seen in markets like the U.S., where institutions and banks are set up with the primary objective of banking startups and later on layering debt facilities on top. In other cases, such as with Genesis, TriplePoint Capital and Lighter Capital, players have been established to explore the opportunity of advancing debt funding to venture-backed companies. However, it is rare for players to cut across the value chain, as we have witnessed with the renewable energy industry.

The renewable energy industry initially attracted debt against physical assets such as solar panels. The assumption was that these assets could quickly be repossessed to pay back the loans, which turned out challenging, especially converting them into cash in case of a default. But, because they had layered asset financing on top of their offering, it only became more attractive to value them based on receivables. This is done by considering historical repayment and default rates combined with the forward-looking ability of the company to continue collecting the debt and containing the default rates. This is not easy to establish, especially for newer players.

We are, however, seeing the same renewable energy model replicated with fintechs with Moove, a company that offers car financing, raising both equity and debt, and others expected to follow suit. In Moove's case, the debt is advanced against an easily repossessed asset compared to solar. Cars can be easily monitored, repossessed, and quickly turned into cash or transferred to another driver.

Beyond fintechs financing physical assets, debt is also infiltrating lending startups and those looking to invest in expansion by acquisition. In theory, these should be the darlings for lenders. Partly because their lending cycles are likely shorter than for the off-grid energy or others like Moove that physical finance assets, which typically take 24 months or more. And because having data from at least one lending cycle is crucial for borrowing, these fintechs can quickly generate data from their first cycle. Though, most of these companies must spend off their balance sheets to develop this first cycle data.

Debt Financing in the African Context

In 1968, Arthur Rock, an unknown investor, backed executives from Fairchild Semiconductor to start a new company, which would become known as Intel. This transaction essentially became the model for the way businesses were built in Silicon Valley. While companies in other places looked to banks to fund their enterprises, in Silicon Valley, technology entrepreneurs looked to these small venture capitalists - many of whom were engineers themselves.

The early success of this model led to a process that became self-fulfilling. Engineers became entrepreneurs and built successful businesses, then became investors using the returns from their ventures and attracting more engineers to the region to continue the cycle. This model is largely how most new companies in Silicon Valley and the West are funded. The model emphasizes aggressive venture funding in technology-enabled companies. On rare occasions, venture-backed companies consider alternative forms of financing such as debt.

Although this Silicon Valley model is practical for high growth and asset-light startups and industries, slapping venture funding on every problem, sector, or business model is not feasible and is far from universally applicable. Moreover, markets such as Africa are radically different from the West and therefore may require unique financial innovations to get around the structural, behavioural and digital challenges. It does not take keen observation to acknowledge that the Silicon Valley venture financing model does not have the full context of Africa’s wicked problems where founders solve intertwined problems in a very fragmented continent.

African startups often have to build out supporting infrastructure to the core business or new markets that serve people for whom no products existed or existing products were neither affordable nor accessible. A look at how the renewable energy industry in Africa has been financed gives an idea of how this may play out in other areas. Similarly, in Southeast Asia and India, where technology companies have relied heavily on venture capital to get off the ground, scaling has required them to invest significantly in offline approaches. An example here is the proliferation of the O2O (Online to offline) phenomenon, where companies have to entice consumers within a digital environment to make purchases of goods or services from physical businesses.

In India, in 2019, Amazon - the poster child of e-commerce - decided to go offline to create an integrated shopping experience for consumers across e-commerce and brick-and-mortar stores as part of a strategy to take on Reliance and Walmart-owned Flipkart, which we're planning a similar push across the country. Companies like Amazon or Walmart-owned Flipkart have more than enough resources to invest in capital heavy growth and expansion initiatives. But, this is not the case for fast-growing startups that, for example, are looking to establish a vast network of warehouses, dark kitchens or micro fulfilment centres. And, equity capital is not sufficient to fund these investments without unsustainably diluting the founders and early investors.

Infrastructural challenges - both digital and physical - become even more pronounced for growth stage African startups. As Christensen, Dillian and Ojomo wrote in The Prosperity Paradox, market-creating innovations are what Africa mainly needs. However, these same innovations require expensive digital and physical infrastructure investments to deliver V.C. multiples.

Take M-Kopa's mandate to provide affordable and renewable access to low-income masses who at the same time have no access to credit because they are unbanked. Or Twiga Food which simplifies the supply chain between fresh food producers, FMCG manufacturers and retailers through a B2B e-commerce platform. Twiga Foods must invest in a network of warehouses attracting a heavy capital expense as it expands. On the other hand, M-KOPA must structure the pricing of their products in a way that can spread out the cost over time. For M-Kopa and Twiga Foods to fulfil their mandates, substantial capital investments are necessary, which equity funding can not sustain.

Why Opt for Debt Financing?

In pursuit of growth, venture-backed startups must sacrifice capital and profitability in the short term. This gets even more pronounced for companies in industries where investment in supporting digital and physical infrastructure is necessary and, as a result, are required to raise capital constantly. Because venture debt is often raised alongside or soon after an equity round, startups can accommodate different debt terms depending on the stage, business model, or growth rate.

Early-stage startups that successfully raise do so against the promise that existing investors can support the companies through "inside rounds" when execution does not occur precisely as planned, or key milestones require more time than anticipated. For later-stage companies, the debt is premised more on the company's growth and product development record. Thus, venture debt for later-stage companies typically has more stringent revenue or performance covenants, and loan availability is tranched to performance or fundraising milestones.

In both cases, creditworthiness and bargaining power are generally highest during or immediately after closing an equity round. The amount of debt is usually calibrated to the size of the equity round and the company's current and projected cash-burn rate. But, verifying a company's valuation is also more accessible during this period since the venture capital investors have completed considerable due diligence with the most updated corporate information available. Therefore, it is recommended that a company considers raising debt alongside their equity round or immediately after.

Below, we give an in-depth breakdown of the key reasons a company may opt for debt financing.

• Avoid unnecessary dilution; retain control.

Securing equity investment, whilst free from interest and capital repayments, requires the founder to give up some portion of control of the startup. Popular accelerator, Y-Combinator, gives a standard deal of $125,000 for a 7% stake when you consider that most startups give up around 20% equity at the Seed stage and another 20% during the Series A round, founders may own less than 20% of the company by Series C.

Source: Index Ventures

Usually, in Africa at Series C, companies start the aggressive international expansion with capital requirements. Raising further equity funding also becomes tricky as it leads to further dilution. Simply put, equity is the most expensive form of growth capital due to its highly dilutive nature. Equity financing usually comes with its own standard set of terms and conditions, including participation rights in future rounds and sometimes board seats to the lead investors.

Yet, when paired with equity, debt can play a crucial role in aiding the company's expansion. While the equity funding goes towards the operational expenses, the company channels the debt to finance essential capital investments. This is a popular approach that most asset financing and lending companies leverage where they use the equity to anchor the debt. In the end, they avoid going through unnecessary dilution and still achieve their growth targets.

Consider Company A that wants to raise $150 million Series C to expand into 15 additional markets across Africa to achieve its growth milestones. The company successfully raises $115 million from V.C.s at a $500 million valuation for 23% equity. What should the company do about the remainder? It can raise an additional $35 million from the same or other investors at the same valuation of $500 million and give up an extra 7% in equity. Or, it can secure $35 million in venture debt with a 10% warrant coverage which equals $3.5 million worth of company stock or 0.7% in equity.

• Extend runway

Typically, startups raise on cycles of between 12 to 24 months. The funding raised is supposed to finance operations and capital expenses to the next milestone, a point at which they will be in a position to seek further funding at a higher valuation. However, more often than not, startups are bound to miss their target milestones.

What happens, for example, when a startup misses the expected 12 months milestones? Because it is unprofitable, it will run out of cash. Or raise on unfriendly terms, including a down round. A down round is when the pre-money valuation of a fundraising round is lower than the post-money valuation of the previous round. Down rounds could result from a failure to meet investors' targets, a tightening competitive environment, or a generally deteriorating economic environment caused by factors out of the startup's control - such as the pandemic and its aftermath.

Venture debt serves various purposes but among the most common is the need to extend the runway to achieve the company's next important milestone. So the companies have an extra 3 to 6 months of cushion in case of milestone or fundraising delays without increasing dilution. The second option could be for companies on the cusp of becoming cash-flow positive. In this case, rather than seek equity financing, which will dilute existing shareholders, the company leverages venture debt to propel it to the finishing line.

• Financing expensive capital expenses

By late stage, Series C and beyond, the company's potential has been validated and starts to look like conventional peers. Moreover, at this point, financiers have increased confidence that it can fulfil debt obligations, including paying the interest and establishing a firm valuation upon which any warrants can be exercised—making late-stage startups the ideal candidate for any venture debt issuer.

Across Africa, one particular area where late-stage companies may leverage debt is in scaling capital expenses such as in last-mile delivery. In a race to further cut down the time it takes for products to get to the end customer, delivery companies such as Egypt's Rabbit are required to invest in warehouses or micro-fulfilment centres. Others invest in dark kitchens, which are highly efficient production units - without a storefront - optimized for delivery.

But, for Rabbit, which raised $11 million in pre-seed in November 2021, further growth necessitates making expensive capital investments. Unless they eventually outsource it to a third party. Otherwise, seeking equity and debt for future capital raises makes sense. The equity finances the company's operations while the debt finances the warehouses and micro-fulfilment centres.

Beyond the traditional structure of venture debt, other forms of debt can serve the same function of financing expensive capital expenses that eat away at equity capital. This includes approaching commercial banks like Decagon with Sterling Bank or simply issuing a bond. In all cases, the company leverages the same narrative of steady growth and revenue predictability, informing the lender on thei