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GIVEN the scarcity of capital in Pakistan’s nascent start-up ecosystem and the shyness of local angel investors to invest in home-grown ventures, the government has decided to step in for supporting disruptive Pakistani start-ups.
The Planning Commission has initiated a start-up package worth Rs2.3 billion, of which Rs1.1bn would be used for investing in start-ups from all sectors, including information technology, textiles, medical technologies, biotechnology, etc.
The government also provided incentives to tech start-ups in the previous budget, including a three-year income tax break, exemption from sales tax, the establishment of IT Software Park and an innovation challenge fund.
The question is: how can this Rs2.3bn fund be utilised optimally?
There can be two approaches for employing this fund. One is that the government should co-invest with local or international investors and get its money back with a certain interest rate at the time of company’s exit; or at best, the government should get its share back at the time of exit.
The underlying rationale behind this argument is that since governments are usually inefficient and waste taxpayer money, they should not get their hands dirty. Moreover, since governments are not self-interested profit-making entities, people inside the government are usually less accountable for any losses done.
Therefore, the government should park the funds with some experienced venture capital (VC) companies that can then utilise them and then pay back the government. This would benefit both public and private sectors.
Since there is already a scarcity of capital in Pakistan and start-ups are in abundant supply, the price of getting that capital is high
But there is a contradiction: why should the government subsidise local investors, especially when they are not willing to invest on their own?
Second, how would the government make sure that these local investors are ready to invest in Round A, B, and subsequent rounds after the initial seed stage investment, which should be one of the primary objectives of this fund?
Third, as it happens, government intervention fuels crony capitalism. The ones who have the right connections get the funds while others struggle. So, how would the government make sure the right funds are distributed to the right people?
The second approach is that the government should invest directly in start-ups, which would be selected based on certain indicators such as traction gained, revenue, growth rate, etc. The rationale behind this argument is that Pakistani seed investors have a predatory nature.
Since there is already a scarcity of capital in Pakistan and start-ups are in abundant supply, so the price of getting that capital is high. Except for one or two seed investors, the term sheets which they offer are much skewed, virtually taking away the control of entrepreneurs and making them employees of their own companies. This kills the essence of entrepreneurship.
So, the purpose behind the government-backed VC fund directly investing in companies is to fill the wide hole of early-stage risk capital which is appropriately priced and give founders a long enough runway to build out their business and gain sufficient traction to get series A funding.
This argument makes sense as the basic purpose of this fund is to kick-start the innovation-investment-exit cycle. Secondly, losing a higher percentage of equity right at the time of seed funding also kills the chances of the start-up for getting series A funding from foreign investors as well as global expansion.
Foreign investors seek initial term sheets which, if poorly negotiated, have a detrimental effect on further negotiations and the start-up founders are left with no option other than to hand over the management rights even at round A funding.
One of the best examples in support of this approach is of Yozma, which was the venture capital fund created by the Israeli government in 1993. Yozma used to invest directly in start-ups. It has been one of the most successful government-backed venture capital funds in the world which initially invested $100 million in start-ups. The fund had a worth of around $1.4bn in 2002. The start-ups in which it invested raised $10bn from venture capitalists and received $17bn in merger and acquisition deals.
Thirdly, most members of the local angel investor community, since they are also newbies in the field of venture capital, are inexperienced in how to mentor start-ups, which is one of the primary requirements by founders.
The government, on the other hand, can hire experienced mentors from abroad who have first-hand experience of creating and managing start-ups in the developing markets. What Pakistani founders just need is confidence, the right push to go through their initial stages and some good mentors who have experience in go to market strategy and building early product adoption.
The example of Careem (Middle East’s only unicorn), Viptella which was sold to Cisco for $610m, and other US-based companies which were founded by Pakistani founders or co-founders and had highly successful exits or have high valuations are already there.
However, the Yozma programme also allocated a portion of its fund for co-investing in start-ups with international investors as well. The right approach lies in learning from other countries’ experience, keep in view the indigenous conditions of Pakistan, have funds allocated for both options of co-investing and direct investing, and then scale according to their respective performance.
The primary purpose of this fund should be to attract foreign investment by creating a self-sustaining entrepreneurial ecosystem in Pakistan. The government funds are always in scarcity, so they need to be utilised properly to create a dynamo effect.
For example, the government should fund those start-ups which have a global market potential, are based on high-tech proprietary technology which cannot be replicated easily, and preferably have multiple streams of products.
In Israel, the problem in 1993 was that they had R&D capabilities, but they did not know how to market those technologies.
So, what the fund actually did was to help those companies in their go-to market strategies, linked them with international customers and helped them out in quick global expansion. A similar approach needs to be adopted in Pakistan.
Published in Dawn, The Business and Finance Weekly, May 14th, 2018
