The Ethiopian Government issued a proclamation in 2021 to supplement the country’s bank-based financial system with a capital market financial system. This was achieved by establishing a Capital Market Authority and subsequently setting up the Ethiopia Securities Exchange. These initiatives are designed to support the development of the national economy by mobilizing capital, promoting financial innovation, and sharing investment risks.

While these institutions are vital for a capital market system, several additional institutions are necessary on both the demand and supply side of the market if it is to function effectively. Among others, a crucial element for fostering a robust capital market financial system is the gradual development of a vibrant venture capital industry. This industry will be critical because it will address the missing link for financing creative entrepreneurs who can successfully scale their businesses and eventually list on the platform to access public funds for further growth and expansion.

Venture capital is a type of private equity financing provided to startups and small businesses with substantial growth potential. Investors, known as venture capitalists (VCs), supply the necessary capital. Key characteristics of a venture capital industry include:

• ● High Risk, High Reward: VCs invest in companies with significant growth potential but face a higher likelihood of failure compared to more established businesses.
• ● Equity Investment: VCs typically receive an ownership stake in the company in exchange for their investment.
• ● Long-Term Investment Horizon: Venture capital investments are not focused on quick returns; they generally have a 5–10-year outlook, aiming for substantial growth and eventual exit through an IPO or acquisition.
• ● Active Involvement: VCs often take an active role in the companies they invest in, providing mentorship, strategic advice, and access to their networks.

This funding is typically utilized to accelerate growth, develop products, and expand operations. In developed markets, venture capital is crucial for supporting innovative firms in sectors such as technology and biotechnology, where the potential for high returns exists alongside elevated risks. Even though Ethiopia is at a nascent stage in its development cycle and operates in a different context, venture capital can still offer substantial value when it comes to providing an alternative source of finance for emerging companies working on adaptive technologies and hold significant growth potential.

What distinguishes venture capital from other forms of financing, such as bank loans, is primarily the level of involvement and ambition. A venture capital fund is prepared to risk large sums of money on unproven ventures in exchange for considerable control and a substantial equity stake. The goal is not merely to recover the initial investment but to multiply it several times over.

In about last 40 years, venture capital-backed startup companies in the developed world have been an incubator for job creation, often in new and emerging industries that require a variety of skilled positions. Employment opportunities in these venture-funded startups not only provide jobs but also careers that drive further economic growth and innovation, creating a robust cycle of development and new opportunities. In the United States, for instance, venture investing generates billions of dollars for investors and their institutions, creating millions of jobs. Many venture-backed companies have scaled, gone public, and become household names, while simultaneously generating high-skilled jobs and trillions of dollars in benefits for the U.S. economy.

A study conducted by William Janeway at Cambridge University reveals that venture capital is linked to some of the most innovative and high-growth companies in the developed countries economy, particularly in the United States of America. Notably, venture-backed firms account for nearly half of the IPOs in the United States, despite representing only 0.5 percent of startup firms. By the end of 2019, venture-backed companies in the U.S. generated half of the total revenue and over three-quarters of market capitalization, along with significant expenditures on research and development. Although the United States is currently at a different stage of economic and social development compared to Ethiopia, the strategies employed to build their venture capital industry can provide valuable lessons for developing this industry in Ethiopia, considering local conditions.

The history of finance shows that venture capital has been part of commercial activity since its early days. However, it was around 60 years ago that venture capital financing evolved into a professional industry. Georges Doriot played a pivotal role in establishing a vibrant venture capital industry in both the United States and, to some extent, Europe during the latter half of the 20th century. Unlike companies in the growth or maturity stages of the industry life cycle, venture capital focuses on supporting startup firms that may not yet have a marketable product but possess promising ideas.

In developed countries with higher per capita incomes, the wild ideas of young entrepreneurs are typically funded initially by founders, family members, close relatives, and friends through pre-seed investments for proof of concept. Only after this stage do venture capitalists and other investors become involved, as illustrated in the following diagram.

Fig 1:    Venture Capital Funding Stages

Source: CFA Institute, Level III, Private Market Curriculum

Pre-seed funding primarily comes from founders, family members, or friends, serving as the initial source of equity capital. This funding not only helps establish a legal entity and cover other startup costs but is also crucial for assessing product feasibility and identifying market needs. During this phase, the focus is on achieving milestones such as proving the concept and developing a product prototype, typically within a short timeframe of less than a year.

Seed funding occurs when a startup has validated its idea and can demonstrate that its product prototype addresses a specific market need. At this stage, the startup may attract institutional investors and high-net-worth individuals, commonly known as angel investors, who are often entrepreneurs themselves. The capital raised through the issuance of equity, usually in the form of common shares, is utilized over an extended period to achieve product-market fit. Key milestones during this phase include developing a minimum viable product to present to potential clients and establishing a go-to-market strategy to generate initial revenue.

Following the seed funding stage, startup companies require series financing to establish a stable growth foundation.

At this point, the Growth Market platform established by the Ethiopia Securities Exchange, along with the Regulatory Sandbox from the Ethiopia Capital Market Authority, which eases compliance requirements, may significantly assist in raising the necessary capital. However, in contrast to seed financing, investors in the later stages of follow-on or series financing face lower risks, as the company is beginning to generate revenue.

The utilization of series funding differs notably from startup financing, as companies use these funds to hire staff, purchase fixed assets, build inventory, and enhance their capacity to meet initial market demand. Consequently, investor focus shifts from non-financial milestones to financial metrics, such as revenue and customer acquisition, in order to track the company’s progress toward realizing its market potential.

In addition to the Growth Market platform offered by the Ethiopia Securities Exchange, the Regulatory Sandbox provided by the Ethiopia Capital Market Authority eases compliance requirements for companies looking to list on the Exchange. Furthermore, once startup companies reach the later stages of funding, private equity firms which are currently operating in the country can  provide financing. However, the critical challenge we need to address is how to make risk capital accessible for the pre-seed and seed stages of startup companies.

Unlike in wealthier nations, many young entrepreneurs in Ethiopia may not be able to fully rely on the support of family or relatives. Even when the goodwill exists, resources could be limited to covering only a fraction of what is needed. Thus, the traditional methods used in developed countries to build a venture capital industry are not feasible at this stage of Ethiopia's economic and social development.

We must acknowledge that over the last three decades, Ethiopia's economic development has been primarily led by the public sector, relying heavily on external funding through concessional loans, grants, and various bilateral and multilateral assistance. In my view, the private sector that has emerged during this period has mainly been opportunistic and short-term oriented in its approach to the allocation of resources to alternative investment ends. Besides, the retail bank-led model has been extremely averse to financing projects without securing collateral which limits funds available for enterprising investors.

However, in the long run, a government-led development model that relies on external funding through loans and grants is unsustainable. The private sector developed in this manner cannot create significant value addition because it often adopts a rent-seeking mentality, with little incentive to shift from this low-hanging fruit business model. Businesses based on venture capital require significant value addition, which involves more complex skills, knowledge, and attitudes that foster breakthrough innovation.

For the majority of current private sector leaders, success often means maintaining close ties with public sector decision-makers and the ruling political elite. Unfortunately, the type of private sector we build in this way cannot contribute meaningfully to our nascent capital market system.

Before we explore and recommend potential strategies, it is essential for readers to understand that building a venture capital industry requires building an eco-system and making a paradigm shift in our investment culture. Venture capital is a high-risk, high-reward endeavor that requires patient capital and a long-term outlook, which contrasts with our local business culture that focuses on providing basic goods and services through easily replicable business models.

The issue we must address in this article is how to create a viable venture capital industry, ensuring that our recently established capital market system receives sustainable new company offerings over time and avoiding the pitfalls faced by many African capital markets that have marked time without significant participation in initial public offerings. Given the current size of the Ethiopian economy and the limited number of venture capitalists operating within a fragmented African market, creating a robust local venture capital industry may seem like an impossible dream. Nevertheless, there is no shortcut to making our new capital market system work for Ethiopia.

Fig 2. How to build a venture capital industry

Based on our extensive study of the venture capital industry, we have developed the above model to facilitate strategic thinking and coordinate various fragmented activities occurring across different sectors of the economy.

The core of the suggested model is to establish a venture organization through a public-private partnership. This organization is expected to have a robust governance structure and a clearly defined roadmap for execution. Founding members may include representatives from the Ministry of Innovation, Ministry of Industry, Ministry of Trade, Ministry of Justice, Ministry of Revenue, the National Bank of Ethiopia, Ethiopia Securities Exchange, Ethiopia Chamber of Commerce, Bankers’ Association, Ethiopian Lawyers’ Association, Ethiopian Economic Association, high-net-worth individuals, and science and engineering-focused universities.

Once the organization is established, it will develop membership criteria to expand its base by including other key players in the economy who can contribute to the growth of the venture capital industry. For instance, with clearly defined criteria, investment banking professionals and individuals with a proven track record of establishing highly successful businesses in technology and other growing industries—who have generated billions in revenue and employed thousands—can be invited to join as members. Until membership grows, the organization should be funded by the founding members.

In addition to coordinating the core programs outlined in the model above, the organization's key mission is to support the creation of scalable and competitive companies that contribute to the Ethiopian economy.

In conclusion, fast-tracking the development of a viable venture capital industry in Ethiopia is crucial for sustaining new company offerings in the capital market and avoiding the stagnation seen in many African capital markets. The proposed model tries to leverage two powerful resources to achieve the goal: the government’s unique position to influence and shape the growth trajectory of the new capital market and the potential of the private sector to mobilize funds for financing high-risk, high-return ventures. By creating a National Venture Capital Organization that operates through public-private partnerships, Ethiopia can foster a thriving ecosystem for venture capital.