Can African startups scale using VC subsidies?

I was born, bred and buttered in Kampala, the capital city of Uganda. Like any other poorly planned city, we have insane morning and evening traffic jams. Although not as legendary as Lagos’, it’s just as frustrating. To beat the traffic, I turn to Safeboda, a ride-hailing app.

Safeboda is arguably Uganda’s most prominent startup, and in Nigeria, it has made inroads in Ibadan, a southwestern city in Oyo state.
 

Not only is it convenient crisscrossing through traffic on a Safeboda, but it also has some of the lowest prices per trip. To sweeten the deal, Safeboda has been running promotions for a few months now where users get free trips sporadically. Ugandans have been excited and have taken to social media to share their joy. 

This is not an experience reserved for Safeboda users only. In Nigeria, if you have taken a Bolt or Uber trip in the past, you might have enjoyed the trip, and the price shown was so low that it surprised you. Again, if you’re a regular shopper on Jumia or Konga, you might have purchased a heavily discounted product or gotten free delivery on a food order.

How can these startups afford to give away freebies when the cardinal rule of doing business is to make profits? Are these startups even making money? The straightforward answer is that someone else is covering the difference if you’re not paying full price.

Ranjan Roy, the author of the Read Margins newsletter, explains this perfectly in the context of food delivery. Doordash, a US company, delivers $24 pizzas at $16, losing $8 because they pay full price to get the pizza from the pizzeria.

Globally, this phenomenon is cleverly known as the Millennial Lifestyle Subsidy. As more millennials (people born between 1981-1996) and Generation Z (people born between 1997-2012) enter the workplace, they have turned to apps to navigate adulthood. To watch movies, they turn to Netflix. For trips, Uber or Bolt does the trick. Do you need food? Gokada and Jumia are just a tap away on your phone. What about your laundry and other chores? Edenlife is there for you.

But sometimes, these apps charge low prices or even run offers that would make their accountants baulk. To do this, they rely on funding from venture capital (VC) firms. Remember our Doordash pizza delivery story? It had just raised a $400 million Series F. If you’re going to lose money, you must have reserves to keep on running. VC firms do not intentionally provide funds for startups to lose money off each transaction, but it is all part of a long-term growth strategy.

But how sustainable is this model where startups rely on VC funding to offer services below break-even prices? And can it work for African startups? We’ll dig into these questions but first, let’s look at VCs and their relationships with startups. 

What are VC firms?

Venture capital is a form of private equity that finances startups with long-term growth potential. In return, the VCs get an equity stake in that startup.

Harvard Business School professor, Georges Doriot, is known as the Father of Venture Capital. In 1946, he started the American Research and Development Corporation (ARDC) and raised a $3.5 million fund to invest in companies that built businesses from the technologies developed in WWII. One of the early companies they invested in used x-ray technology to treat cancer. In 1955, this company went public, and the $200,000 Doriot invested turned into $1.8 million, a 9x return.

This is the VC model at its core.

A startup founder pitches their startup, let's call it Deep Dive Technologies Ltd, to VCs. The VCs do their due diligence. At the end of this process, everything checks out, and the VCs table an offer—a $2 million investment for a 25% stake. This means that the startup is now valued at $8 million. With this new funding, Deep Dive Technologies moves from 1,000 users to 50,000 over five years. As a result, revenue increases from $500k to $5 million a year. With this growth, the startup’s valuation grows to $100 million.

The 25% stake that the VCs own in the company will now be worth $25 million, equal to a 12.5x return on investment ($25 million divided by $2 million). The VCs can turn this stake into liquid cash when Deep Dive Technologies gets acquired or becomes a public company. Or the VCs could also sell their stake to new investors that come on board in the later financing rounds. This is called an exit.

But the VC industry is incredibly high-stakes, where failure is more common than success. The strike-out ratio, the proportion of companies that fail relative to those that succeed is driven by the 80/20 rule. Essentially, 80% of returns come from less than 20% of a firm's investments. And the big wins that deliver at least 20x returns make up only 2% of investments. But the successful investments offer outsized returns that are usually enough for a VC firm to have overall returns of 3-5x for its investors per year.

We now understand why VCs invest in startups, and that is to make returns on their investment. Now we’ve laid the foundation to dive deep into how startups use the money raised from VCs to hit their growth targets. 

Why do startups raise money?

As Y Combinator founder Paul Graham put it, “startups are designed to grow fast", which separates startups from other companies.

That’s why it shouldn’t surprise those familiar with the tech ecosystem to see startups sacrificing profitability for a few years. They focus on gaining new users in different markets or building new services during this time. For example, Amazon had its first profitable year in 2004, a decade after it was founded. It made a net profit of $35 million from revenues of $5.26 billion. For an entire decade, Amazon pursued growth over profitability, and it is now the largest e-commerce company in the world. Last year, Amazon had 152 million users with profits of about $33 billion, slightly less than Meta’s $39 billion.

This is where those “freebies” I was referring to come in.

Amazon was famously known for its low prices in its first two decades as it battled brick-and-mortar giant Barnes and Noble for market share. Netflix did the same to sway users from Blockbuster, the leading offline movie retailer. It even scrapped late fees, which were a key source of revenue for Blockbuster. Uber, Airbnb, Safeboda and Bolt have also used made similar moves.

This strategy is known as penetration pricing, and it’s pretty simple. A startup launches a new product or service and offers it to users at such a low price that the startup either loses money on each sale or makes thin margins. The goal is to attract as many customers as possible rather than make a profit.

When penetration pricing is executed efficiently, it can lead to swift market penetration before the competitors can react.

So, it shouldn’t be surprising to see startups adopt incentive structures to drive mass-market adoption. When startups take VC money, they are on a ticking clock to prove they can deliver massive and outsized returns to their investors. Strategies to execute this typically look like low-cost pricing that should entice consumers away from incumbents so they can start to see the startup’s products as a more viable alternative. While the likes of Amazon and (maybe) Uber might have proven this to be true, this approach to customer acquisition might not always be the right play. 

As long as it can deliver returns, most investors hope it can be sustainable.

But, sustainable funding of customer acquisition requires a market that the startup can penetrate with customers willing to pay. If there’s no market or users that can afford to pay for the service, penetration pricing will be futile. 

At Stears, we have covered the African consumer market extensively. Many founders point to the region’s 601 million internet users when discussing Africa's consumer market. But we have to look at the ability of these users to pay for a product or service.

World Data Labs says the daily global total spend is $200 billion. African consumers account for 7% ($14 billion), yet Africa has 18% of the worldwide population. The daily per capita spend of African consumers stands at $9.78 and is projected to grow to $10.4 in 2025. Our daily per capita spend is the lowest of any region worldwide and will remain so for a long time. 

But to paint a more accurate picture, let's focus on the spending power of millennials, which are the target market of most startups on the continent because they are digitally literate.

The World Data Labs groups millennials into two subsets; the early Gen Z and late millennials (15-30) and the early millennials (30-45). The early Gen Z and late millennials have a total spend of $3.9 billion, and a daily per capita spend of  $10.1, which is higher than the African average. But consumers in this group are either still in school or have been working for less than a decade. So, assuming their income will increase over time as they cement their positions in the job markets is plausible. The early millennials have a total spend of just $3.1 billion but a daily per capita spend of $12.5. Combined, both groups have a total spend of $7 billion, half of Africa’s total spend, and a daily per capita spend of $11.

Why is this data necessary? It shows us how small the market is for African startups. Despite the population of millennials being 631 million (45% of the African population), they spend so little on average. Remember, the whole point of penetration pricing is to acquire new customers and increase market share. There must be a market.

So as Michael, the Stears Head of Intelligence explained, the data shows that African countries don't yet have the consumer class required to support the products that startups offer. This throws up questions about whether penetration pricing is sustainable enough to drive market adoption, especially when startups rely on the funding they get from VCs to execute this.

Given the small consumer class, it will be difficult for a single startup to rake billions of dollars in revenue off millions of users while operating in a single country. It is not feasible even for a country with a significant population like Nigeria. About 40% of the Nigerian population (82.9 million) live below the poverty line, according to Nigeria’s National Bureau of Statistics (NBS) 2018 report.

So it is reasonable for the startups to expand geographically to offer services to Africa’s 631 million millennials rather than just a few in a single country.

It is common for Nigerian startups to announce the expansion to new markets, usually Ghana, Kenya, South Africa, and Egypt, after a funding round. Some Nigerian startups would rather open up shop in Lagos and then expand internationally than nationally in Nigeria because there is not much of a market outside Lagos.

Even when we look at Africa’s most valuable startups, most operate in multiple African countries. According to WeeTracker, only 9 African companies have ever reached unicorn territory, a valuation of $1 billion. Flutterwave, the most valuable of them all at $3 billion, operates in 33 African countries. Interswitch, the Nigerian fintech, operates in 23 countries, while Jumia, Africa’s e-commerce giant, is in 11 countries.

It is almost essential for a startup to build for Africa, rather than a single country, for it to be sustainable for VCs to fund its user acquisition costs. This is to optimise for larger markets.

Another critical characteristic of the African consumer class is price sensitivity, making penetration pricing so tricky to pull off in this region. Eventually, startups will need to move out of their user acquisition phases as they shift towards profitability. At some point, the price the startup charges its customers should reflect the cost of providing that service. Just ask Glovo, which used to offer loss-making free deliveries when it started operations in Nigeria but has since eliminated them.

This is why it’s typical for African startups building out of Africa to not just focus on a B2C play but go down the B2B route as a hedge. For example, Nigeria’s Evolve Credit, a lending marketplace, built Configure. This software helps other lending businesses, microfinance players and non-bank providers to deploy credit products in days instead of months. So Evolve Credit sells products to other companies instead of consumers.

The B2B business model is driving the valuations of companies like Paystack, which facilitates payments for over 60,000 businesses and was acquired by Stripe in a record-breaking $200m deal in 2020.

Of course, companies can also do both: offer a B2B model, and a B2C model. The startup can lower prices for its B2C model (user acquisition tool), and use its B2B model to cross-subsidise it as the startup scales. This can also be sustainable.

In conclusion, the VC model makes it pretty standard for startups to make their products cheap or free to drive market adoption and raise the prices once the alternatives have been phased out.

While African startups have access to large piles of cash, they can try this method. But, with the current price sensitivity of African users, this strategy is unlikely to work out for consumer-facing businesses on the continent.