DAVID LEWIS: Start-ups require changes in mindset and regulations

A common perception of the structure of the SA economy is that while it’s long on successful, large corporations, many of which are multinationals, it lacks vibrant competitive start-ups.

I recently attended a workshop in Sandton which, while partly confirming this perception, also called its accuracy into question. That is to say we do indeed possess a vibrant community of successful start-ups, but the picture could be far rosier. 

It was not always thus. Until relatively recently SA had the largest and fastest growing start-up sector on the continent. No longer. The start-up sectors in other African countries — notably Nigeria, Egypt and Kenya — are now growing faster than in SA.

For example, in 2021 Nigeria had five tech “unicorns” — companies with annual revenues of $1bn or more — all realised within the five preceding years, while SA had none. What we are now witnessing is that many of our highest-potential start-ups are leaving SA altogether and setting up abroad. 

The binding constraint is the obstacles that in effect prevent our start-ups from raising the capital they require. It’s not that vast amounts of capital are required, rather that we need to emulate some of the countries to our north and review the regulatory environment that constrains our entrepreneurs from raising the capital they require. 

Why, given our litany of seemingly more pressing problems, does this represent a shortcoming that should be urgently addressed? For one thing, the start-up sector addresses many of our key challenges — it’s potentially employment intensive; it challenges established businesses, thus stimulating competition; it generates new activities and exports; and its products are often directed at poorer or under-serviced consumers. 

But more than this, start-ups are not subject to the constraints currently impeding the growth of large businesses. It’s trite to say that the most binding constraints limiting economic growth are electricity and transport. Equally trite, our fiscus is severely constrained, limiting our ability to immediately address our energy and logistical problems.

Start-ups, on the other hand, are largely independent of electricity and transport. And they do not require huge amounts of financial support from the state. What they require are changes in mindset and regulations. 

The workshop referred to above was hosted by Trade and Industrial Policy Strategies, an independent nonprofit research institution established in 1996 to support economic policy development.

It was addressed by Claudia Manning, a principal at the SA SME Fund, a “fund of funds” established by the CEOs of SA’s 50 largest corporates as well as the Public Investment Corporation, with a mandate to invest in growing small and medium enterprises. It has become one of the largest institutional investors in venture capital (VC). Manning’s role includes co-leadership of the SA SME Fund’s capital raise for the new VC Fund of Funds, which achieved a first close at R800m.

Others who addressed the workshop were Shainal Sukha, MD of Sukha & Associates (S&A), a black-owned, owner-managed and independent asset consulting company that focuses on providing a dedicated, tailored and high quality service to institutional clients including retirement funds and corporates; Alison Collier, MD of Endeavor SA, a large global fund that supports and develops high-impact entrepreneurs; and David Kaplan, an academic and highly regarded innovation policy specialist. 

There were about 40 participants. The public sector was represented by, among others, the Reserve Bank, the department of trade, industry and competition, the department of science and innovation, and the Treasury. There were private-sector representatives from the start-up industry and from the financial sector. 

Conversation was robust, infused with a mutual recognition of the problems and a sense of urgency and commitment to address them. Indeed, one participant who has experience of working globally and started working in SA recently was particularly struck by the mix of public- and private-sector participants and the frank dialogue between them. 

The bottom line is that if start-ups are to grow, more investment, sourced both domestically and internationally, is required. One might have thought domestic investment would be relatively easily sourced. After all, SA has a well-developed financial sector and famously deep capital markets. Pension funds have assets of more than R4.6-trillion, one of the highest asset-to-GDP ratios in the world.

In other jurisdictions where pension funds are well established — for example, the US and UK — they invest in start-ups, albeit only small proportions of their assets. Globally, returns on investments in venture capital have often outperformed equity markets over the past few decades. But in SA, pension funds have shied away from investing in start-ups. Or, more accurately, in VC funds that invest in start-ups.

This is despite the fact that, as one of the presentations clearly demonstrated, returns from investing in start-ups in SA may well exceed the returns from conventional investments, particularly as the returns on SA equities have been subdued. Fortunately, this is changing with the launch of the new Venture Capital Fund of Funds raised by the SA SME Fund, which has secured capital from SA institutional investors for the first time.

To a large extent this was enabled by the provision of a first loss layer of capital from the SA SME Fund that provides considerable downside protection to investors without limiting their potential upside. 

More pension funds and other institutional investors such as insurance houses and endowment funds, need to come to the party. They need to review long-established practices and take a closer look at the start-up and innovation economy, both for their own returns and for the broader benefits that such investments will have for the country.

It’s in the nature of entrepreneurial start-ups that there will be failures, but those that hit the target will provide returns that will compensate for the losses incurred by the failures.

The impediments to foreign capital are more complex but could be addressed by regulatory changes that would be relatively easy to effect. It was generally understood that to grow in global markets high potential SA start-ups need to attract foreign capital. However, foreign funds are reluctant to invest directly in SA. Indeed, for the most part their mandates will prohibit investment in SA.   

The upshot is that to attract foreign investment SA start-ups need to set up an overseas holding company in a jurisdiction where foreign funders are used to doing business with VC — Holland, Singapore, the UK, the US and others. This is in itself costly and time-consuming, involving expensive lawyers and onerous regulatory hurdles.

For example, for an SA start-up to transfer its intellectual property — invariably a start-up’s most valuable asset — to its offshore holding company means confronting restrictive domestic regulatory barriers. These need to be urgently reviewed. At the same time, as some of the government people stressed there will need to be safeguards to prevent SA's IP being exported with no gain to the country. 

On the other hand, a seemingly easy hurdle to overcome is the SA Revenue Service (Sars) stipulation that provides that capital gains tax (CGT) accrues when a local start-up transfers its shares to its international holding company. CGT thus become payable before the company has significant revenue and is using any available cash to fund expansion.

Surely a simple tax directive could ensure that CGT only becomes payable when the shares in the company are actually sold and the company consequently has the financial resources to pay the tax? This exemplifies the sort of regulatory barriers that have been addressed elsewhere on the continent. 

Forgive this rather wonkish opinion piece, but I came away from this engagement with the strong sense that the impediments that currently hold back the more rapid growth of the start-up sector could be relatively easily overcome.

No-one complained about international crime syndicates; not a word was mentioned about the ravages of state capture. All that is required is a small change in mindset and a few regulatory tweaks. And this seemed to be well within the ken of the people sitting in the room. 

• Lewis, a former trade unionist, academic, policymaker, regulator and company board member, was a co-founder and director of Corruption Watch.