African startups flock to debt as equity funding drops

Startups across Africa pushed deeper into the debt market with over $1.1 billion raised from debt as of 30 November, according to data from Africa: The Big Deal. Experts say this indicates that investors are making greater efforts to protect themselves, given that debt is “senior” to equity and repayable.

The $1.1 billion debt raised by African startups accounted for over 35 percent of the total $2.6 billion funding raised by startups in Africa in 2023. Equity funding was the highest at $1.5 billion, representing 60 percent of the total funding raised. The Big Deal noted that the equity raise is less encouraging with the 2023 tall to date representing only 40 percent of its 2022 and 2021 level at $3.7 billion.

Debt, on the other hand, has seen a significant growth in 2023 as the $1.1 billion raised as of November surpasses the $676 million and $257 million raised in 2022 and 2021 respectively.

“For every $1 of equity announced, 70¢ in debt was raised in 2023 versus 19¢ in 2022 and 7¢ in 2021. While debt numbers might have been underreported in the past (either not announced or rolled in with equity numbers), this evolution points to a trend in startups on the continent using debt to finance their growth, especially through large deals: with almost $700 million of debt raised this year so far, MTN-Halan, Sun King, and M-Kopa,” the report noted.

The Big Deal monitors funding from $100,000 and above. A similar report from Partech in January found that debt funding in African startups rose to $1.5 billion across 71 deals in 2022 and $767 million in 2021.

Debt funding refers to raising capital by borrowing money from external sources, with a promise to repay the principal amount along with interest within a defined timeframe. While equity financing involves selling ownership stakes in the company, debt financing doesn’t dilute the ownership of existing shareholders. Instead, startups are obligated to repay the borrowed amount to the lender, irrespective of the company’s success or failure.

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There are different reasons startups may be turning to debt financing. One of them is the need to retain ownership of the company. Debt financing allows startups to secure funding without relinquishing ownership to external investors. Control is particularly important for founders who want to maintain their vision and execute their business strategies without interference.

“I believe that debt funding when structured well, allows the startup some breathing space to scale at their own pace and still meet up with their obligations,” said Johnson Ajani, a financial expert and Head of Electronic Banking at Haggai Mortgage Bank Limited. “This diversification of funding sources helps just like a bank takes on liabilities in the form of customers’ deposits for business purposes.”

Debt funding, unlike equity, enables startups to gradually deploy their initial resources without a long-term impact on the company model. Strategic use of debt can extend startups’ runway and help them make the most of their position. It also allows startups to work more closely with lenders and vendors willing to extend or accept credit to help the startup reach its launch point.

The report by Partech showed that debt financing deals in African startups have increased nearly six-fold since 2018, and the 85 unique debt investors last year alone represented at least a two-fold increase.

Henry Azubuike Ojuor, Founder in Residence and Director of Programs, Startupbootcamp, sees equity funding as very expensive particularly for startups on the African continent. In advanced countries with macroeconomic indices that are on track with assets and infrastructure at optimal level, startups that go for equity do not have as much difficulties.

“In Africa or third world countries, it is a bit harder. When people want to play the venture game it is tricky because ventures put in money to enable you to grow rapidly. That is how you unlock the value that is attractive to venture capital,” Ojuor said. “Personally, in 90 percent of cases where founders say I want to raise money, debt is a better approach.”

Despite the attractiveness of debt funding, some experts believe that it poses significant risks for startups in Africa. However, it offers many investors the protection of not being exposed to the risks should the company fail. This could explain why more investors are taking this route. One expert who prefers anonymity told BusinessDay that the debt terms may come with a kicker where it can be converted to equity if the business shows earning potential.

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“Debt funding is crucial for startup growth. But, it is limited and costly for African startups,” said Jasiel Martin-Odoom, African investment lead at Accion Venture Lab. “Before seeking debt, prioritise positive cash flow; update underwriting to match current interest environment; and if possible, seek denominated debt.”

Ajani said for a startup, it is a sin not to borrow as long as it is for productivity. Debt financing at a fixed interest payment helps startups increase the volume of businesses they take on.

However, Nigerian startups considering debt funding from local investors should be cautious of the constant upward adjustments in the interest rate regime in the country, according to Ajani. The startups signing the deals must scrutinise the terms and conditions of the debt deal. He says the best option is static interest loans instead of those in which interest rates change with every adjustment in MPR.

There are other macroeconomic factors such as foreign exchange fluctuations and this particularly affects loans that are in foreign currency. Fluctuations can impact the cost of servicing debt and overall financial stability. Another macroeconomic factor is frequent regulatory changes which affects the overall business environment. For instance, the recent delisting of all PSSPs, super agents and switches from the bank NIP transfer list by the Nigerian-Interbank Supplementary System.

“While this is not in itself a wrong policy, the fact that some startups were allowed on that platform in the first instance, and that could have encouraged other players, makes it a big regulatory risk. This is the same as the frequent demolishing of buildings for various reasons after the government allowed those structures to be erected in the first place,” Ajani said.

Ajani also believes that survival or sustainability is critical for startups in Nigeria going for debt funding.in doing this, startups must ensure that even if they acquire debts, their business model and structure will be able to sustain the repayments when due. So, careful consideration of the projected cash flow, purpose of debt and potential revenue to be realised must be done.

Ojuor says Startupbootcamp now tells its founders to go for loans because it is easy to go for debt and they can help with the location where the loan is gotten from. Many banks in Europe, for example, have negative interest and some give loans at meagre interest rates.