Diseconomies of Scale & First Mover Disadvantage

The Plight of Infrastructure-Building Startups in Africa

When Tony Chen (then MD of Kinyungu Ventures), Osaruman Osamuyi (Founder, The Subtext) and I started working on what would become Chasing Outliers: Why Context Matters for Early-stage Investing in Africa, the mission was fairly straightforward. Tony had launched Kinyungu Ventures as an evolution of his angel investing activity. As preparation for launching the fund, he wanted to learn from investing best practices on the continent, conducting practical research to gather large amounts of insight quickly and efficiently.

Around the same time, I was entering my third year of digging into topics related to African tech and innovation, resulting in a report on the role of tech hubs in African startup ecosystems for the International Trade Centre (ITC) and an exploration of shared ownership models for the Open Society Initiative for West Africa (OSIWA). Fortunately, Josiah Mugambi had the foresight to connect us. We’d grabbed coffee while I was in Nairobi for the OSIWA research, and he mentioned Tony—another Chicago-based, hyphenated American working on African tech. Soon after, Osarumen joined the team through a fortuitous introduction from journalist and community catalyst Andile Masuku. Anyway, the whole thing started because Tony wanted to become a good investor by learning from other investors. But where we landed was quite far from where we expected to, which is, well…life.

Source: Chasing Outliers

So, where did we land? By talking to more than a hundred founders, investors, and LPs, we distilled some compelling, structural insights about VC in Africa. Rather than focusing on investing best practices and characteristics of startup success (although this was part of the mix too), we surfaced some fundamental mismatches between generalized, but fundamental characteristics of African markets and their consumers, and fundamental principles of “Silicon Valley style” VC. This piece isn’t a full-on reflection on Chasing Outliers and what resonates nearly five years later. But there is an element of the core argument that’s popped up in more recent conversations about digital commerce and fintech for my retired podcast, The Trajectory Africa, I’ve decided to revisit.

During the early-ish part of the research process, an investor told me that African startups were “heavier” than expected because they held more assets than a tech company normally would. That insight stayed with me as one of my first glimpses into the infrastructure-building reality of African startups. Post Chasing Outliers, this theme resurfaced in my pod chat with Abraham Augustine, Ecosystem and Marketing Manager at Norrsken, about the limits of digitalization when infrastructure is missing. It emerged yet again with Jean-Claude Homawoo, Co-founder and CEO of Lori, as he described how African startups vertically integrate to solve the problems around the problems they’d originally intended to address. To re-quote Jean-Claude:

If your business plan says you’re going to sell croissants, usually three months in, what you realize is that you also need to make the flour, pump the water and start a salt factory and so on. [You] have to do everything that precedes providing and delivering your business plan. And sometimes the weight of taking on all of that can break your company. All of a sudden [A] doesn’t work the way you said it was going to, and investors are looking at you, [asking] why is A not working like it was supposed to. And you’re looking at them like, because I’m doing B, C, D, E, F, and G and I’m not an expert in any of them.

Building Distribution Infrastructure to Create Trust in Fintech
Where does all of this infrastructure building show up? In fintech, for starters. Niche neobanking, or delivering financial products and services to distinct customer segments like young people, SMEs, and individual producers (e.g. content creators), is one of the five fintech opportunities I described in my last piece about fintech. A core question that lingers about building customer relationships is to what extent technology can replace or enable analog trust. To this point, Samora Kariuki wrote an instructive piece on neobank strategy that ranked Moniepoint as a top-performer. In a follow-up conversation, he explained that its dominance boiled down to two ways that the company delivered trust: 1) establishing physical touchpoints; and 2) delivering reliable service. These observations also refer back to critical points he’d made in this conversation about the cost of financial services infrastructure. He explained that although agents weren’t the most (cost) efficient solution, they were more viable than unprofitable brick and mortar bank branches. Similarly, what makes Rank’s (formerly Moni Africa) model so compelling is how it builds on well-known community savings and lending group structures (e.g. ajo, esusu, stokvels, tontines) to derisk lending.

The Cost of Last Mile Distribution in Digital Commerce
Of course, there’s nothing new about agents as people-powered financial infrastructure if you’re familiar with mobile money. But how does the math change when you’re distributing physical products instead of digital ones? Extrapolating from what I’ve learned about digital commerce so far, I’d suggest that it’s difficult to run a profitable business distributing staples. Commodities are zero-to-low margin products, so absorbing the cost of building last-mile distribution channels coordinated by technology (even if efficiency is increasing and costs are dropping) can be challenging. It’s also difficult to compete with efficient, informal distributors who are leveraging longstanding supply chain relationships and don’t have added technology costs. The demise of Copia suggests a more nuanced reality, though, because it matters where those products are being distributed. Abraham suggests that although Copia sold branded products (a bit more on this below), low consumer density in its rural and peri-urban markets rendered its operations less efficient and more costly.

With Chari, an-e-commerce and fintech app for retailers in Francophone Africa, the B2B e-commerce part of the business doesn’t drive profitability. Instead, it’s evolved into an engine for acquiring merchants to distribute financial products. Once Chari builds trust with shopkeepers by giving them financial tools (debit cards and accounts) to restock their stores, they become distribution points for telecommunications and financial services. In short, founders have adopted different strategies to navigate the difficulty of running “pure play” digital commerce businesses. They’ve improved their business models by selling staples at higher prices, prioritizing higher-margin packaged goods, and delivering financial services.

Infrastructure, Diseconomies of Scale, and First Mover Disadvantage
At this point, it’s probably clear why some infrastructure investments are necessary and what problems they cause for startups. Chasing Outliers frames these challenges in a way that articulates the paradox underlying the core problem. African startups may suffer from “diseconomies of scale”—when unit economics worsen as companies grow due to increasing infrastructure costs. Here’s how an investor defined the term:

Our lack of infrastructure, our infrastructure deficit, the failure of leadership over the last 50 years since independence, has created a situation where we don’t have an environment that allows you to scale effectively. We have what I call a diseconomy of scale, so when we need to go from two outlets, or whatever your business is, to 10, your unit economics are worse, because you need to hire more people. You actually have worse unit economics as you scale because it has become so expensive to check all that stuff and because we just don’t have the infrastructure in place.

This is the challenge of vertical integration. To deliver a product or service, a venture often has to first build the infrastructure or fix the supply chains required to do so. It’s also why these diseconomies of scale exist: companies have to absorb more and more infrastructure costs as they grow. Because they can’t always find partners to provide inputs that are sufficiently high-quality, they build functions internally, e.g., starting a salt factory to make croissants.

Source: Kinyungu Ventures

I’ll recall here again that the five fintech opportunities I described in a previous piece—trade-boosting credit, cross-border payments, consumer payments (infrastructure), neobanking, and asset-based financing—are infrastructure-building plays. Similarly, Chasing Outliers showed us that some investors reframed the problem of infrastructure-building as an opportunity. From their point of view, the foundations of African economies needed to be built using technology, so that critical goods and services could be delivered. Here’s how it’s described in the research:

Many investors see massive, profitable opportunities in creating the backbones of African economies through investing in building blocks such as human capital, financial services, infrastructure (e.g., power and roads), and real assets, such as real estate and manufacturing. This investment also involves using technology to make it cheaper and easier to reach customers by defragmenting and organizing markets, reducing customer acquisition and distribution costs, and increasing efficiency.

By fixing supply chains in, for example, health, education, and logistics, tech-enabled startups reduce friction and create the infrastructure for the digital economy. By doing this, these companies pave the way for inclusive economic growth that melds profit and impact, creates jobs, and increases household wealth. Investors understand that delivering basic products and services that fix market failures in largely uncontested markets is a lucrative and effective opportunity.

Source: Chasing Outliers

Nonetheless, there’s another risk associated with this approach, called “first-mover disadvantage.” As with diseconomies of scale, first-mover disadvantage accrues when sector pioneers invest in building or fixing infrastructure, educating consumers, and influencing policy, etc. Here’s how one investor described the market building process in Chasing Outliers:

I think some really simple language is what I personally like to call first-mover disadvantage…because the companies that start out have to build so much of the ecosystem around them, which later-stage players can then take advantage of. For example, the first solar home system company M-KOPA had to educate all their customers on how to use mobile money, sometimes having to hire or recruit agents or recruit on behalf of the mobile network operator. And then the next companies that come in, they benefit from that infrastructure or that behavior change. Often, it’s payments, it’s financial inclusion, it’s behavior change, it’s agreements with government, it’s recognition on the policy side that your business model is viable and should be included in that country’s strategic thinking.

Note: Today, M-KOPA is an asset-financing business focused on smartphones. This fantastic piece by Andile Masuku tackles difficult questions about how likely it is for companies to become unicorns by delivering public goods that governments haven’t, and who gets to spend a decade-worth of patient capital to discover a business in data-driven credit instead of solar home systems.

Along similar lines, Leta Co-founder and CEO Nick Joshi was describing first-mover disadvantage when he named the burden born by the first generation of logistics startups who “paid school fees” for the next generation. They, not unlike Konga and Jumia in digital commerce, educated key players such as truck owners who were disinterested in technology. But if you happen to be a rare first mover that becomes an incumbent, you might have the resources to outmuscle a disruptive competitor when you want to explore new market opportunities.

Coming back to the role of technology, one part of the question is whether and to what extent it can dislodge first mover disadvantage. Firas Ahmad, Co-founder and CEO of Sarafu describes the value of technology in a way that suggests this probably isn’t the case:

The point is that yeah, the tech is there, but you have to understand what is the alternative value proposition to your tech and how does that relate to what you’re doing. And if you’re not significantly better than the easiest, most simple alternative, then you are spending a lot of time congratulating yourself for your technology, but you’re not really solving a problem.

Another element is whether or not digital technology can disrupt diseconomies of scale. In the introduction to my first piece about fintech, I recapped Abraham’s argument that the scope of digitalization is limited by incomplete infrastructure. Ultimately, you can’t digitalize what doesn’t exist, right? But the counterargument is that using digital technology is the way to circumvent infrastructure gaps. This is how Adetayo Bamiduro, CEO and Co-founder of MAX, describes the critical role technology plays in the transition to EVs:

It’s very simple. The infrastructure has to be built. And thankfully, with digital exponential technologies, we don’t necessarily have to build bridges everywhere to accelerate access, and to deliver inclusive growth and development. There are alternative infrastructures that we can build that are, for the most part, digital, and not necessarily physical. And the exciting thing about building digital infrastructure is that you can accelerate the process very quickly.

No matter what you do, if you’re trying to build bridges and roads, it still takes months and years to do that. It’s very difficult to compress time in that domain, in dealing with real world physics. But with technology, computing, with the internet, we can rapidly build products and also scale them to literally tens of millions and perhaps billions of people, quite literally overnight.

We made a similar claim in Chasing Outliers that using technology unlocks the scaling logic of software, which assumes that the marginal cost of producing another unit of digital solution is zero (or otherwise negligible). For example, automating people- and paper-intensive processes, and reducing the cost of acquiring customers and distributing to them, allows businesses to run more cheaply. Here’s the basic argument:

Companies…can overcome the diseconomies of scale (increasing rather than decreasing marginal costs as companies grow) caused by infrastructure gaps through the use of mobile infrastructure. These companies more closely adhere to technology-enabled scale logic, where the business costs less and grows more the bigger it gets. Large amounts of capital are deployed to generate revenue and build the infrastructure and network required to sustain competitive advantage.

The hitch is that fixing friction may be insufficient to sustain a moat. Organizing a local analog market such as a commodity exchange and then adding a digital layer, however, may be more difficult for larger, better-capitalized competitors to replicate. This may, in turn, contribute to the development of digital economies that create more opportunity for everyone. When a company braves first mover disadvantage to build infrastructure, educate customers, and digitize markets, subsequent generations of companies benefit.

Drawing from what founders of digital commerce and logistics startups have told me, I’d argue that technology might not be enough to disrupt diseconomies of scale when one or both of the following conditions are in place: 1) very thin margins are earned from the products (think staple commodities) for which you’re building or coordinating distribution infrastructure, i.e. last mile delivery; AND/OR 2) assets in your logistics/distribution infrastructure aren’t optimally utilized, e.g., maximum throughput in warehouses and trucks that are full coming and going.

Still, talking to fintech founders suggests there’s an opportunity to use technology to unleash the use of productive assets, whether it’s unlocking consumer credit to acquire phones and motorbikes or extending supply chain finance to producers to fulfill orders from large companies. Again from Chasing Outliers:

Similarly, all across the continent there are opportunities to provide basic products and services such as access to consumer finance that have not yet been offered but that enable pre-existing consumer behavior. Products that enable consumers to put their limited income to productive use in the ways they deem fit, as opposed to trying to change their behavior, create opportunities for investors to take advantage of.

Needless to say, I’m still working through the logic of all of this, and the next few posts will continue to fill in missing pieces of a broader argument. But it’s worth reiterating a key observation from my long read on digital commerce: companies that are battling diseconomies of scale need debt to build infrastructure. This means we need more debt (venture debt, private credit, etc.) as well as vehicles that can accept it. The last bit about vehicles is a nod toward a longer conversation about how funds are structured that won’t be explored here. But in the Chasing Outliers research, we heard about the need for longer duration funds and made an argument for considering other structures, such as permanent capital vehicles. The challenge, of course, is selling a package that LPs aren’t willing to buy. That’s a story for another day, but the journey continues…