4 Technology Startup Funding Sources for African Entrepreneurs

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One of the first and most important decisions that African entrepreneurs need to make when raising money is deciding what type of capital they need.
Fundraising is a crucial part of many start-ups’ journeys. While there are a few lucky entrepreneurs who can rely on funding to come from their own savings, or have wealthy friends or family members who can afford to inject capital, most business owners will need to go out of their way to raise funds from outside investors.
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In this guide, we cover four types: grant funding, debt and loans, shareholder equity, and a mezzanine mix of debt and equity. These four types of funding will apply to most entrepreneurs in Kenya, Tanzania, Uganda, Ghana, Nigeria, as well as other countries.
Grant Funding for ICT4D Projects
By grant funding we mean any source of capital that makes no financial claim on a business in return for providing the funds. This includes everything from grants offered by national and international organisations as well as foundations, to prizes and awards offered by start-up competitions, as well as donation-based crowdfunding campaigns.
The amounts that organisations grant to businesses vary widely – from thousands to millions of dollars. Most common grants, however, tend to be on the smaller side, typically under KSh 5m ($50k). This makes them most appropriate to ICT4D projects, early-stage start-ups and digital development entrepreneurs, or more established entrepreneurs seeking capital to ease cash flow constraints.
Typically, organisations making the grant will put out a call for applications, inviting interested start-ups to pitch their ideas – for example USAID grants. Applicants will need to show how their business or idea is relevant to the grant making organization. A judging panel narrows down the field to several finalists and the winner or winners are chosen from there.
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While organisations that fund grants typically do not expect any sort of financial return (i.e., a stake in the business, or a promise of repayment), they will often check on the grantees to ensure the money is being used for the intended purpose – during and after the grant has been disbursed – and ask for lessons learned during implementation. Some organisations release grant payments in stages to ensure the company is working towards its stated goals.
Advantage

  • ‘free’ money in the sense that there is no equity or interest to pay → funders have little influence in day to day operations of business

Disadvantage

  • little support besides funding – hard to grow networks or get targeted mentorship
  • long applications and long approval processes
  • post-funding reporting is sometimes extensive
  • grant makers can be inflexible in accommodating start-ups that need to pivot from one business strategy to another

Debt Financing for Startups
Debt financing is one of the most common ways to get funding. In simple terms, debt financing means an entrepreneur takes out a loan from a financial institution, which he or she promises to repay within a predetermined time period and subject to an agreed upon interest rate.
Debt funding can come from various types of funders, including banks, online and mobile lenders, peer-to-peer crowdfunding, impact investors, development finance institutions, microfinance institutions, and others.
As start-ups need to pay interest on their loans, typically in monthly installments, debt financing is best suited to more mature start-ups with stable cash flows. The amount of funding that an entrepreneur can expect to borrow depends on two factors.

  • Lender: On the organisation he or she is turning to – a bank or impact investor will be able to offer a larger loan than a microfinance organization or mobile lender platform.
  • Loan Size: The size of the loan will depend on how much debt the start-up will realistically be able to take on. Early stage start-ups with no product and no customers, for example, usually cannot (and should not) borrow much, while more established companies with proven cash flows will be able to tap into larger pools of credit.

In order to apply for a loan, start-ups will need to show a business plan and financial projections; these are meant to explain how the borrower plans to repay the debt.
When taking out a loan, borrowers typically focus on two key aspects of the financing structure: the interest rate and the tenor (the time until the entire loan must be repaid). The interest rates are seen to be correlated with the riskiness of the borrower – the less likely he or she is to pay back, the higher the interest rate a lender is going to charge, as a premium for taking on extra risk.
The rates are also determined by the central bank’s prevailing interest rates in the country. This is because government debt (bonds) are considered virtually risk-free, so the bank has no incentive to lend money to a riskier enterprise at a rate that is lower than what the government is willing to pay on its bonds.
In case of default, lenders get first claim on any assets the business has, meaning this is typically seen as a ‘safe’ financing structure from the lender’s side, when compared to equity investment.
Debt financing can come in two forms: secured and unsecured loans. Secured loans are a financing instrument in which the entrepreneur offers some asset as collateral, making the loan less risky for the lender. This could, for instance, be a car or debenture over assets that the lender will be entitled to if the borrower defaults on the loan, offsetting some of the risk for the lender and thereby reducing interest rates. Unsecured loans do not have such protections for the lender, and therefore have higher interest rates.
Advantage

  • no need to give up ownership in company

Disadvantage

  • often lenders will ask for collateral
  • interest payments can be difficult to make for cash-strapped start-ups

Equity Investments for Technology Entrepreneurs
Equity financing means an investor puts money into a start-up, in exchange for a portion of the company’s shares. This means the investor becomes a part owner of the business.
Equity investment varies in amount, depending on the entrepreneur’s needs. It includes everything from relatively small (less than KSh 5m or $50k) injections of capital from family members or angel investors, to large deals financed by private equity firms that run into millions of dollars.
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Prior to making an investment, equity investors go through a detailed screening process, commonly referred to as due diligence. At this stage, they look at the potential for a start-up to grow into a highly profitable business.
Most equity investors understand that the majority of start-ups fail; therefore, they look for growth potential rather than steady cash flows. Equity investors like to back tech start-ups because of their ability to scale with relatively low capital requirements compared to traditional brick and mortar businesses.
In order to receive equity investment, entrepreneurs will typically need to have an extensive business plan, with strong financial models showing growth projections, competitor analysis, proposed approach to marketing, and more. Equity is the riskiest type of financing for investors, as the funders stand to lose their entire investment should a company fail
Advantage

  • no interest payments to pay back
  • investors have incentive to be as helpful as possible: mentorship, advice, connections

Disadvantage

  • sometimes misaligned time horizons: start-ups building for the long term, while investors want to exit quickly
  • control mechanisms can mean entrepreneurs are less in charge of their business

Mezzanine Financing for Digital Development
Mezzanine is a hybrid instrument and refers to financing that sits between equity and debt (hence the name), and combines aspects of both types. It is popular with some investors because it shields investors from certain risk associated with pure equity investment, while still providing upside if a business becomes highly successful.
There are various types of mezzanine financing, including subordinated debt, convertible notes, and equity kickers. These are often combined into a single financing facility; the degree to which an investor is willing to be exposed to risk will dictate the amount of equity upside versus debt for which he or she will negotiate.
Convertible notes (also known as convertible debt) are quite popular in Kenya, especially for early-stage start-ups. There are several reasons why investors and entrepreneurs may want to issue convertible notes instead of debt or equity. For the investors, it provides a level of protection in case the money is used in a fraudulent way – they have the right to pursue the debt issued (typically this is at 0% rate, so they will attempt to recoup their investment).
For entrepreneurs, who expect their company’s equity to be worth more in the future, issuing a convertible note likely minimizes their share dilution. Both investors and entrepreneurs are also likely to benefit from kicking the can on valuation to a later point, when an institutional investor comes in.
While convertible notes can be difficult to understand, the key thing to keep in mind is that the amount an investor puts in as debt will be converted to equity at a later point, to be defined in the contract. The share price will determine how many shares that funding injection will be converted to.
To give a very brief example: a founder and an investor agree to a $50k convertible debt, at a discount of 20%. This means that when the company raises money in the next round, the early investor is able to purchase shares at 80% of what they are worth.
If, for instance, the shares are priced at $1 each in the next round, the investor will be able to purchase them for $0.80. That means instead of buying 50,000 at $1 each for the $50k lent in the convertible note, the early investor will actually be able to purchase 62,500 shares ($50k/$0.80).
There are other considerations and clauses that can be agreed upon, including a valuation cap. An in-depth overview of convertible notes is outside the scope of this guide, but there are plenty of online resources, books, and individuals who will be able to walk entrepreneurs through the complexities.
Advantage

  • mitigates risk for investors, meaning better funding terms than straight equity
  • can delay valuation of start-up which is imprecise in early stage companies

Disadvantage

  • entrepreneurs may need to make regular payments to funders → can be overly complex and expensive to arrange

Learn More About African Entrepreneurship
In cooperation with various financing partners Make-IT published this African Entrepreneur’s Investment Guide as a comprehensive, accessible, and informative tool that can be useful to entrepreneurs in all stages of their business. Its aim is to help Africa’s rising entrepreneurs to navigate the nebulous and sub-optimal financing landscape.
This guide aims at helping start-ups understand and navigate the variety of financing options. These include diverse mechanisms such as grants, seed funds, angel investment, impact oriented venture capital, debt, etc.
Furthermore, the guide outlines requirements, investor expectations as well as investor types in an easily accessible way, and offers practical support to entrepreneurs in asking the right questions when approaching an investor.
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