Venture capital (VC) firms play a pivotal role in the entrepreneurial ecosystem. They fuel innovation, foster the growth of startups and drive industries. Microsoft, Apple, and Airbnb are examples of conglomerates that were financed by Kleiner Perkins, Sequoia Capital, and Sequoia Capital, respectively. But what is venture capital, and how does it work?

Private investors are always on the lookout for ways to grow their wealth through ventures they believe have long-term growth potential. However, they do this through VC firms that manage pooled investments from the investors and financial institutions.

There are two types of VC partners: general partners and limited partners. General partners finance the startup and manage the funds. They assume liability for debts incurred and other risks involved in running the business, too. Limited partners, on the other hand, are passive investors with no voting or managerial rights. They have no liability exposure beyond their investment in the business.

Identifying a worthy investment

A VC firm will identify entrepreneurs who lack capital but have ideas with a high potential to succeed. Before investing, VC firms will consider the scalability and sustainability of the business, the strength of the management team, and the appeal of the service or product. They’ll look at megatrends that, when turned into businesses, will have an impact on society 20 or 30 years into the future.

“If you look back to 1999, telecommunications was going to be a megatrend. I remember my dad with a phone, and it was such a cool thing. In the first year, I think there were only about 20,000 mobile phones in Kenya with SIM card registrations. But see,  phones are still relevant now. Now, we’re talking about 40 million. That is a megatrend. VCs will invest when those ideas are still new and fresh, and then they just grow and move with the wave,” explained Robert Ochieng, CEO and Co-Founder of Abojani Investment, a digital first-personal finance management platform for busy professionals and entrepreneurs.

 He added, “If that idea can grow, with millions or billions of people using that product, if you invest, you’re likely to make a lot of money as an investor.”

A typical venture capital financing has five key stages; the process that a startup goes through in order to receive funding.  

Pre-Seed: The founder develops the business concept, gets patents, creates a pitch deck and works on partnering agreements.

Seed: The business owner creates the product or prototype, fundraises and gets the business off the ground.

Series A: The founder researches the markets and industry, writes a business plan, and gets into marketing and advertising the business. They also begin to generate revenue and start planning to scale into new markets.

Series B: This involves expansion of consumer interest, establishing a commercially viable service or product, and scaling production, marketing and sales.

Series C: Establishing a strong customer base, building new products and markets and acquiring other companies.

After the business has received funding and is thriving, it can either be acquired by another company,  remain private and use VC funds to grow, or make an initial public offering in the Mezzanine Stage. The business owner could also make an initial public offering (sell stock shares to the public for the first time) in the Exit Stage, and investors can exit at any stage.

“VCs are keen on the promises you make. They’ll say, ‘If you hit this target, we’ll give you Stage X funding’. Therefore, you must understand the markets and industry. Stay up to date on trends, best practices and emerging technologies to make informed decisions,” advised Ochieng.

VC funding and the state of Kenyan startups

Not all businesses succeed, even when backed with funding. At least eight tech startups, which had raised close to Ksh 35 billion in investor funding collectively, folded by the close of 2023. Kenya is thought to be the next global tech hub – the Silicon Savannah. However, with such results, is this just a pipe dream?

VC funding is relatively new in Africa, and Kenya is just dipping its toes in the water, but are there lessons it could learn from Silicon Valley? Startups in Silicon Valley invest in research and development (R&D) and rely on integration with academia from universities such as Stanford and Harvard, while most Kenyan startups go it alone and don’t invest in R&D.

“When you’re busy working on the day-to-day business, there should be people who are studying the patterns in your market. One of the biggest problems is customer acquisition in Kenya, so if you have research and development, it will help you figure out the difficult things,” Ochieng shared.

Out of 10 startups, only one has a chance to succeed as some targets set by venture capitalists are unattainable, or entrepreneurs might have unrealistic expectations. However, when a startup grows and makes more profits, so does its valuation, meaning more money for VC firms.

Some business ideas might not be appealing enough to create customer loyalty. “Africa is socially driven. If you want to become as big as Equity Bank or Safaricom, figure out how to connect with people, then create more products and more branches,” said Ochieng.