A new report by Briter Bridges, a data insight firm, has revealed that startups in Africa have raised more than $2bn in debt funding in the last ten years, as equity funding has declined significantly in the same period.
The report, titled ‘Debt financing in Africa’s innovative ecosystem’, analysed the trends and patterns of debt funding in the African startup ecosystem, and compared them with equity funding, which is the most common form of financing for startups.
The report found that debt funding accounted for about 10 percent of the total funding raised by startups in Africa in the last decade, and more than three-quarters of it went to the big four markets: Nigeria, Kenya, Egypt, and South Africa.
The report also found that debt funding has increased its share of the total funding volume from four percent in 2019 to 26 percent in H1 2023, while equity funding has dropped from $2.6bn in 2022 to $1.4bn in 2023.
The report attributed the rise of debt funding to several factors, such as the need for startups to bridge their funding gap, the availability of innovative debt products, and the suitability of debt for certain business models.
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A preference for asset-heavy businesses
The report showed that debt funding was mostly flowing to businesses that had collateral, such as assets, revenues, or loan books, that could secure their repayment. Nearly 75 percent of debt funding went to asset-heavy businesses in sectors such as cleantech, mobility, agriculture, and logistics.
Cleantech companies, which provide solutions for renewable energy, waste management, and environmental protection, received nearly half of all disclosed debt funding, followed by fintech companies, which received around 20 percent.
The report explained that most of the debt funding for fintech companies went into digital lending products, where startups could use their existing loan books as collateral. Digital lending is a fast-growing segment of the fintech sector in Africa, as it provides access to credit for individuals and businesses who are underserved by traditional financial institutions.
The report also showed that debt funding was becoming more accessible for early-stage startups, as nearly a quarter of all debt deals done were between $1m and $5m. The report credited this to innovations such as convertible notes and revenue-based financing, which offer more flexible and favourable terms for startups than conventional loans.
A challenge for the ecosystem
The report highlighted that debt funding was playing a positive role in Africa’s startup ecosystem, as it offered an alternative and complementary source of financing for startups, especially in times of uncertainty and volatility.
However, the report also raised some questions and challenges around the role of debt financing and when it should be sought. The report cautioned that debt financing was not suitable for all startups, as it could pose risks such as over-indebtedness, loss of control, and misalignment of incentives.
The report advised startups to carefully assess their business model, growth stage, cash flow, and risk appetite before opting for debt financing, and to seek professional advice and guidance from experts and mentors.
The report also called for more transparency and data on debt funding in the African startup ecosystem, as it noted that many debt deals were not disclosed or reported, making it difficult to track and measure the impact of debt financing.
The report concluded that debt financing was a valuable and viable option for startups in Africa, but it also required more awareness, education, and regulation to ensure its responsible and sustainable use.
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Risks of debt financing for startups
Startups can raise funds through debt financing, which involves borrowing money from lenders, investors, or banks, among the dangers associated with debt financing for startups are:
Repayment risk, which requires the borrowed funds to be repaid within a predetermined time frame, typically with interest. This may negatively impact the startup’s profitability and cash flow, particularly if it doesn’t make enough money to pay off its debt. The lender may pursue legal action, seize the business’s assets, or even compel the startup to close its doors if it is unable to pay back the debt.
Also, covenant risk which startups are frequently subjected to through debt financing must be met. Financial ratios, performance metrics, reporting specifications, or limitations on the startup’s operations are a few examples of these covenants. The lender has the right to increase interest rates, demand prompt repayment, or discontinue the funding if the company breaches any of the covenants.
Since the startup must set aside a percentage of its earnings and assets to pay down the debt, debt financing may restrict the company’s capacity to explore other ventures or investments. Since debt raises the startup’s risk profile and lowers its equity value, it might also make it less appealing to possible equity investors.
If the loan has features that are similar to equity, such warrants or options, or if it is convertible into equity, debt funding may also dilute the startup’s stock. This implies that the lender has the option to either purchase startup shares at a reduced price or convert the loan into shares at a fixed price or ratio. The current shareholders and business founders may have less ownership and control as a result.
For startups, debt funding might be a good and practical choice, but it also comes with dangers that need to be carefully considered and managed. Before choosing to use debt financing, startups should consider the advantages and disadvantages of the option and consult with experts and mentors for professional advice and direction.