Is debt financing ideal for African startups in a funding winter?

Navigating the complex world of fundraising with strategic precision is one thing that keeps African founders awake at night. While equity funding has traditionally been the go-to choice, recent trends reveal a significant surge in venture funding through debt financing. This shift in approach has captured the attention of African startups, with an impressive doubling in debt funding raised in 2021.

In 2022, the landscape witnessed an impressive 71 deals, with startups successfully securing a staggering $1.5 billion from 85 unique debt investors. Debt financing has swiftly evolved into a formidable alternative for capital acquisition to entrepreneurs seeking fresh avenues to drive growth and expansion.

Why are African startups embracing debt funding

The appeal of debt financing lies in its ability to provide startups with much-needed funding while circumventing the equity conundrum. As the market reset took its toll on equity funding, African startups encountered challenges in raising capital through traditional means. Equity funding's scarcity necessitated a search for viable alternatives, leading to the prominence of debt financing.

Debt financing became attractive to startups seeking to cover expenses, acquire valuable assets, and embark on ambitious expansions. In contrast to equity funding, which requires relinquishing ownership and control, debt financing allows startups to access capital without compromising on their vision. It presents a more cost-effective option, eliminating the need for equity dilution.

“Equity is expensive because the assumption is that the value of the equity will rise faster than the cost of interest,” says Oo Nwoye, founder of TechCircle. “So, if you sell $1 million of your company today, in one year it will be worth $2 million; that means you have taken a loan worth 100% interest. However, debt will be a 25% interest within the same period. Debt is also for short-term capital, hence it is a risky proposition if you do not have a clear direction as to what you're doing.”

While debt financing opens doors to capital opportunities, experts say that startups must be mindful of meeting specific lender criteria. These qualifications vary from one lender to another and may include factors such as revenue growth, operational stability, and creditworthiness.

Which African countries and sectors raise more debt?

As the global venture capital downturn unexpectedly impacted the African tech ecosystem in the latter half of 2022, many stakeholders found themselves grappling with uncertainties. However, in a remarkable response to the challenging funding climate, African startups turned to an alternative path: debt financing. Representing 24% of the total $6.5 billion raised during this period, debt financing emerged as a strategic means for startups to weather the funding winter.

Amidst macroeconomic challenges and currency instability, the volume of debt financing doubled, witnessing an impressive 106% year-over-year growth. This surprising surge in debt raised questions about how African startups were adapting and leveraging alternative funding models to sustain their growth and operations.

Kenya leads the charge

Among the countries that embraced debt financing, Kenya stood out as the clear leader, raising an impressive $608 million. Egypt followed closely with $356 million, while Nigeria secured $252 million. South Africa, despite being one of the continent's tech powerhouses, appeared at the 6th position with $77 million in debt financing. The distribution of debt across these countries indicates the growing attractiveness of debt as a funding option in various African markets.

Fintech and Cleantech at the Forefront

Within the spectrum of debt financing recipients, fintech and cleantech emerged as the primary beneficiaries. Fintech startups secured a substantial $691 million, highlighting the continued demand for innovative financial services in the region. Cleantech, driven by the increasing focus on sustainability and environmental concerns, attracted $605 million in debt financing. e-commerce rounded out the top three sectors, securing $184.5 million in debt funding.

Is debt financing ideal for African startups?

Analyzing the global inflation scenario is essential to understand the viability of venture debt as a funding option for African startups. In 2022, inflation surged to 8.75%, the highest since 1996, prompting central banks to raise interest rates to combat the inflation surge. However, higher interest rates also mean increased borrowing costs, potentially dampening the demand for debt financing.

Moreover, Africa's Big Four economies faced currency depreciation, posing a significant concern. The Nigerian Naira depreciated by 10.2% in 2022, with a projected 20% fall expected in 2023. Kenya's shilling experienced a 9% devaluation, the largest drop in 7 years. Egypt's Pound also suffered a 13% decline earlier this year, adding to the more than 60% loss in value observed in 2022. South Africa's Rand depreciated by 9% in 2022.

These currency devaluations have broad implications for the economies of these four African nations. Given the combined impact of rising inflation and currency devaluation, careful analysis is necessary before African startups consider debt financing as a suitable funding alternative.

Peter Oriaifo, a Principal at Oui Capital, says he sees debt as a ”tool available to cashflow-positive businesses”, he argues that “if you need venture debt as a startup it likely means you have deviated from a quintessential software business model”. He further explains that most startups that have raised venture debt in Africa are not cashflow-positive, and have opted for this type of financing in some cases, because they operate an asset heavy business model or encountered difficulty raising raise venture funding in exchange for equity.
Peter believes there’s material weakness across the board due to macroeconomics, and that with many of the venture debt facilities taken out by African startups being dollar denominated , and growth now harder to come by for most startups, he reasons that “there will be some defaults”. He adds that venture debt defaults can lead to cap table wipeouts, as debt facilities have senior preference above equity holders on a company’s capitalization table. This means that in the event of default, a venture debt provider depending on how strict their covenants are can cut off the flow of additional credit and in an aggressive move, even force liquidation.

Another thing Peter says startups should be be aware of is how the mere presence of venture debt can dampen follow-on investment appetite, “If debt isn’t being drawn down through earned cashflows, upstream investors may grow weary that their newly invested funds will not necessarily be spent on growth, but funding venture debt.” He concludes that venture debt can prove disastrous for both founders and investors if poorly managed, and though not a proponent of this method of financing, he makes the case that founders and their equity investors need to go into the process “eyes wide open” should they choose to purse this alternative means of financing.

Findings from a 2022 research paper by Tellimer exploring the resilience of various Fintech business models amidst macro headwinds, shows that fintech products like POS financing (e.g., buy now, pay later), consumer and SME financing and cryptocurrencies are deemed to be the most vulnerable in the face of challenges. Conversely, the paper highlights other fintech products that are anticipated to exhibit higher resilience, offering valuable insights for the industry during these uncertain times.

How African founders can navigate debt financing

• Be Cash flow positive before going for Debt Financing. According to Peter Oriaifor, if a company isn't cash flow positive, you are merely just servicing debt from VC money raised and it can quickly begin to look like a game of musical chairs, you raise new money to pay old venture debt, raise new venture debt to pay old debt.
• Credit startups should ensure a new underwriting to reflect the rising interests.
• Raise in local currency which protects you from currency risk. Ayobami Teriba, a Venture Analyst at Founders Factory Africa advises that to mitigate foreign exchange risk for startups who raise USD debts, startups can seek local financiers willing to extend loans in Naira against international debt collateral, allowing them to manage the ROI and currency fluctuations effectively.
• Raise convertible debts, which is a flexible funding option. It allows startups to raise debt now and convert it into equity later when conditions are favorable. This approach helps startups manage financial risks while providing potential upside for investors.
• Partner with finance companies to underwrite consumer facing loans and then make commission by selling underwriting data.

Debt financing offers a promising path for African startups seeking growth capital without diluting equity. However, prudent financial planning, careful consideration of inflation and currency dynamics, and maintaining a cash flow positive position are essential for startups to navigate this funding landscape successfully. As the African tech ecosystem evolves, innovative financing models will continue to shape the future of the continent's entrepreneurial landscape.