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Why do investors continue to shortchange entrepreneurs in emerging markets?

Written by Hannah Lewis | May 11, 2017 5:29:09 PM

Consider this:

  • Only 10% of private capital investment goes to emerging markets
  • More than half of global venture capital goes to three US metro areas (New York City, Silicon Valley and Boston).

Are there simply not enough great founders in emerging markets? Our experience at Village Capital — and a new study released last week by the Global Accelerator Learning Initiative (GALI) — tells us that there’s another reason.

Read the Global Accelerator Learning Initiative report  here

Here’s what GALI found when they looked at 2,400 entrepreneurs in emerging markets:

  • They have the same or higher levels of education as entrepreneurs in “high-income” countries
  • They report higher revenues and more full-time employees as their high-income country peers
  • They have founded significantly more companies on average
  • They invest similar amount of their own money in their companies
  • They do just as well coming out of accelerator programs, even improving their ability to raise debt funding by 10 times as much as high-income country entrepreneurs

So why do these founders have a harder time raising capital?

The role of pattern recognition

GALI is a partnership between the Aspen Network of Development Entrepreneurs and Emory University. They’re on a multi-year mission to find out what works, and what doesn’t, in entrepreneur acceleration. Their first report, released in 2016, helped provide insight into Village Capital’s curriculum, and last week’s follow-up studied early stage ventures that applied to 43 acceleration programs in nine countries.

One finding that resonated with us was the disconnect between entrepreneur quality in emerging markets and investor perception — particularly when those investors are from elsewhere.

The researchers found that “cultural bias might be driving the perception of lower entrepreneurial skills”, and that investors claimed emerging market entrepreneurs lacked experience, despite evidence to the contrary. These conclusions align with a phenomenon we’ve been exploring in our work: the role of pattern recognition and in-group bias in VC.

It’s no secret: investors use patterns as a proxy for potential.

Did the founder attend a prestigious university? Is the company affiliated with highly selective business networks? Were they recommended to the investor by a trusted source in their network?

If you’re an emerging market founder and you’re not part of a well-connected elite, it can difficult to build trust and relationships with investors, advisors, and other partners. In a soon-to-be-released Village Capital study (coming June 2017), we found that more than 90% of funding for East African startups went to expat founders (most early-stage investors in East Africa are expats themselves). Meanwhile in India, 78% of startups that raised follow on investment had at least one founder who attended one of a few top universities.

Pattern recognition can also manifest in a different way: a one-size-fits-all, Silicon Valley-style approach to investing. Many investors approach VC in emerging markets through the lens of equity. Will this investment lead to a 10x return in 5 years? Are there potential acquirers in the market? This can also be a limiting factor: equity is not the best model for all entrepreneurs, and can encourage a dangerous “grow at all costs” mentality.

The GALI researchers found that when provided the credibility and networks to attract investors (through accelerator programs), emerging market ventures raised 43% more debt. Why? Because venture debt and alternative financing structures may be a more appropriate form of investment for some early stage ventures, particularly in markets with limited merger & acquisition activity.

The good news is that accelerators can play a role in breaking patterns. Accelerators can help entrepreneurs get into the right networks, and other entrepreneur support organizations, from government to non-profits, can also lift the blinders. At Village Capital, our strategy to avoid pattern recognition is to use a peer-selection model where we put the power of investment in the hands of entrepreneurs. We also offer non-equity options like debt and revenue share, depending on what entrepreneurs need.

The data is looking good for entrepreneurs in emerging markets. It’s up to investors to find ways to break the patterns.

Heather Strachan is Manager for Emerging Markets Operations and Product at Village Capital. If you’d like to learn more about Village Capital’s work in emerging markets, e-mail heather.strachan@vilcap.com.