Wishing to be the next Bill Gates or Ellon Musk is very simple. But actually making it a reality is something else entirely — as startups are slowly finding out. The last five years saw the establishment of thousands of startup companies in Ethiopia, but only a few managed to succeed. The majority of startups are still struggling to secure finance for their projects, as FP reports.
Despite many strides made and embracing the importance of foreign investment in Ethiopia’s fast-expanding economy, doing business remains a challenge. From bureaucratic hurdles to lack of access to capital, entrepreneurs remain in limbo, with dreams lost and as many look elsewhere for the potential of their business.
Very few are able to buck this trend. However, Ezedin Kamil, who invented 35 innovations and developed 8 android applications, is an exception. Still, in the last year of his high school education, he has been able to achieve his goal at the age of 17. He has built a successful IT startup by the time he was 14, three years ago. He struggled a lot – a road less traveled for a teenager with no road map to success for such an enterprise – he seems to be an exception.
He was able to win a funding contest organized by USAID, which helped him secure finance of USD8,000. “Using this money, I have built a three-wheeled vehicle that can work using solar power and electricity,” he said. Ezedin has capitalized on a problem that was being faced by families, friends, and everyone in my surroundings and has built a very successful start-up company now, besides creating job opportunities for other innovators. But had not been without support from USAID, it would have taken more years to sell what he has invented. This is because of the low appetite to finance startups in Ethiopia.
For long, the country’s job creation policy prioritized small and medium enterprises engaged in manufacturing and service sectors, which it considers as a high yield segment of the economy while giving less emphasis to the IT industry, which is a source of living for entrepreneurs like Ezedin. The same is true for financial institutions, which tend to employ a collateral-based financing model.
Over the last three decades, the financing sector expanded at high speed. More than 17 banks and 40 microfinance institutions were established and more are being established currently. While 6,511 bank branches were opened, the total outstanding credit of the banking system (including corporate bonds) surpassed one trillion Birr.
Yet even though 99.6 percent of private banks and 20.3 percent of state-owned banks’ loans target the private sector, the share of startups has been almost nil. It is even worse for those involved in the IT sector. Commercial banks are making a significant amount of profit from large businesses and are not actively looking to diversify their incomes.
“They are comfortable in investing in traditional and profit guaranteed alternatives such as loans, trade financing, and real estate,” says Tewodros Tassew, an IT-Consultant. “It doesn’t make business cases for the commercial banks to finance start-ups, which is very volatile, risk-prone, and unknown sectors.”
Sam Rosmarin, a Business Strategist, and an Investor say the system is not incentivized to finance startups.
“Guarantees are the key issue – banks often require 100 percent collateral for a loan, especially in the startup phase. Startups don’t have this, but there are enough property owners with collateral-seeking loans to fully utilize the available credit in the country. Therefore, why would the banks take on that extra risk?” Rosmarin asks.
“Risk-management is very weak, and this leads to lending practices relying almost entirely on collateral,” he adds.
Even microfinance institutions, established with the objective of financing small and medium enterprises in need of credit services, shy away from providing loans to IT startups due to the risky nature of their business. Almost all of the total outstanding credit of ETB 65 billion provided by microfinance institutions went to sectors other than IT.
“Investing in tech start-ups would require a new set of knowledge, expertise, and exposure from the bank/MFI side to be able to make good investment decisions, but there are a few tech start-ups focused (specialized) financers that really know and understand the sector,” says Tewodros, who believes microfinance institutions may not be in a position to have such type of expertise to be engaged in Tech start-up finance as they are more focused in the rural market and low-value investments.
Over the last two decades, IT startup businesses have been playing an irreplaceable role in boosting national economies, creating wealth throughout the world by developing innovative products and services, besides being a source of employment opportunities and instrumental in alleviating poverty.
The global startup economy has created nearly USD3 trillion in value so far, which is almost equal to the GDP of a G7 economy, according to The Global Startup Ecosystem Report 2020. Seven out of the top 10 largest companies in the world are in the IT sector— the highest concentration of any industry sector among the top global companies, the same source shows.
Although IT startups are believed to work best in developing countries that struggle to ensure the generation of sustainable wealth using innovative solutions that are able to solve societal and economic problems, almost all of the world’s most successful startups are concentrated in developed economies, including India, which transformed from being IT services outsourcing hub of the world to be a major R&D center for multinationals.
As startups become a leading player in India's economic activity with their disruptive innovations, obstacles or hindrances that make it difficult for new entrants to gradually grow faint and disappear. Founding a new startup and access to finance has become much easier than it was for the people of India.
Of 586 unicorns, a startup company with a value of over one billion dollars, established across the world in 29 countries, 21 of them were in India and 40 more of such companies have been founded overseas by people of Indian origin, according to a Research by Hurun Global published in August 2020.
With the government of India has launched projects and adopted measures for startups to run their business effectively with much easier access to funds, the Asian giant becomes the fourth biggest in terms of unicorns, behind the US, China, and the UK. With African countries willing to repeat such a success, tech start-ups in the continent USD 2.02 Billion raised in equity funding, a 74 percent annual growth, according to the Africa Tech Venture Capital Report published by Partech Africa in 2019.
The same year, neighboring Kenya and Nigeria, both nations were the lead markets in terms of total funding, securing USD149 million and USD122 million, respectively. Ethiopia was able to secure less than one million dollars, lagging behind compared to many African countries with a better ecosystem for startups. This is justified by the absence of a legal framework allowing the registration of domestic venture capital funds.
With the unavailability of business licenses to invest in venture capital, the recently approved Ethiopia’s National Entrepreneurship Strategy, also found out that this has prevented any kind of initiatives promoting venture capital and the development of business angel networks. The USD200,000 minimum capital investment for Foreign Investment is another factor hindering funding to make its way to Ethiopia. Government advisors have already advised that should be reduced and regulations allowing Financial Technology (Fintech) to emerge, though the government remains in its firm position.
Be that as it may, learning from the experiences of similar economies, Kenya managed to build one of the most developed startup ecosystems, thanks to its several strengths, including growing consumer and business market, commendable entrepreneurial talent, and strong corporate sector. This was driven by the development of strong private sector-run associations, investment from corporate Kenyan companies, funds allotted for skill development of SMEs, and investment from the government in innovation and funding.
Especially, the less involvement of the government resulted in the thriving of tech startups in Kenya, an experience which Ethiopia’s authorities should take into consideration, according to experts.
“The government should not be in the business of giving direct SME loans. Instead, they should back banks and other financial institutions, through subsidies or guarantees, so those financial institutions can extend credit to SMEs,” Rosmarin said. But Addis Alemayehu, owner of Kazana Group, a holding company, says gaining capital for an idea and prototype is not an easy journey with a mainstream banking system.
“Banks have so many options, from managing their risk by analyzing the business plan to setting getting a loan guarantee from established companies as collateral. Yet with the loss ratio of less than five percent, Ethiopian Banks never took a risk to support any crazy business idea,” said Addis, who believes Ethiopia’s financial institutions have to be bold enough to support startups.
Addis goes as far as saying the government should instruct banks to allocate a percentage of their loan portfolio to startup funding if it is serious about tackling youth unemployment. “As supporting youth business startups is the only way to achieve that goal, the National Bank can instruct Banks to take 2-5 percent of their deposit for startups and guarantee that fund back if the banks lose it,” Addis recommends. But financiers cannot solve the financial constraints faced by startups alone.
“One weakness that I see is that we have a low number of actual start-up companies at this moment who are legally registered, providing service, generating transactions, or creating jobs. A significant part of the start-up ecosystem players is filled with virtual companies that only exist on a website and mostly run as a passion project,” Tewodros underscores.
“So, we need to work on creating start-ups and ensuring that they are supported to become an actual business,” he adds.
Meanwhile, the government is drafting a new law governing startups, which legalizes the establishment of innovation funds that will finance start-ups and innovative businesses thereby encouraging the creation and strengthening of innovative business eco-system in Ethiopia. The fund must be collected from the government budget, loans designated to startups, donations, endowments, and gifts.
The bill also makes investors supporting startups eligible for tax breaks on capital gain, carry forward a loss for angel-investors, facilitation of expatriation of capital gain for foreign investors, allowing for debt investment, and selling a share below the price of any acquisition.
“The start-up act is planned to provide recognition, regulatory flexibility, financial support, and various incentives to companies that are identified as start-up and innovative businesses. This is a step in the right direction from the government,” Tewodros underscores.