Thursday, February 04,
2021 / 5:30PM / Olubunmi Abayomi-Olukunle
/ Header Image Credit: EcoGraphics
Perhaps, one of the most important decisions you can make as a Nigerian founder/business owner is that decision around the type of investor from whom to raise money and the type of investment instrument that better reflects the nature of the investor's risk appetite.
Nigeria's new crowdfunding regulations ( the "Regulations") issued by the Nigerian Securities and Exchange Commission, ( the "SEC") in January 2021, presents a fairly predictable legal framework that allows Nigerian businesses to raise funding through crowdfunding portals (the/a "Portal") managed by SEC-licensed crowdfunding intermediaries. The Regulations are particularly remarkable because for the first time, the SEC is providing clarity and greater comfort to investors looking to deploy small amounts of capital through crowdfunding.
The Regulations also conform with global regulatory norms around protecting investors. Even so, it is useful for Founders to weigh the decision to crowdfund against other forms of early-stage investment available locally. In this Update, using institutional venture capital as context, we provide 6 levers to help Founders think more strategically around the decision to raise money through SEC crowdfunding.
Here are Some Key Considerations
1)How much do you need & how large is your team?
To qualify for SEC crowdfunding under the Regulations, a Fundraiser, (that is, the Founders' company) must have been operating for at least 2 (two) years. If the Fundraiser does not have up to 2 years of operating experience, it must have a technical partner or a core investor. This means that if a Fundraiser is still at the idea or pre-revenue stage, its Founders will not be able to raise capital by way of crowdfunding in Nigeria.
Not only that, the Regulations also limits the amount of money that Founders can raise within a 12-month period to N100 million. To raise N100 million, a Fundraiser would have to be a medium enterprise and have at least 50 employees and have assets worth at least N50 million, excluding land and buildings. Small and micro enterprises can only raise N70 million and N50million respectively.
These are not limitations that exists, as a matter of law, when Founders raise money from institutional venture capital firms. Venture capitalists often invest at the idea/pre-revenue stage through a thriving segment of the venture capital market that is focused primarily on early-stage companies. Looking at available data around venture capital investments in Nigeria, we find that on the average, Nigerian tech start-ups raise up to N100M in risk capital, in their first 3 (three) years of operation. In 2020, a Nigerian fintech raised up to USD1 million in pre-seed funding, less than 2 years from incorporation. Another fintech raised USD10 million, in seed funding in the same year.
These figures are important to note because, these investments are made into (a) early-stage companies which are by definition high-risk, pre-revenue and pre-profit (b) early-stage companies with between 2 and 3 founders and often without physical assets, like buildings or land.
2) Might you Need More than Cash?
With crowdfunding under the Regulations, Founders are likely only going to get cash. With institutional venture capital, Founders would typically have access to cash, technical and management expertise, access to a network of investors who would often be useful in subsequent funding rounds and for key introductions and strategic partnerships.
3) How many Shareholders are you Likely to Have? What's your cap Table going to Look Like?
Local law does not allow Nigerian companies to issue non-voting shares. This means that each shareholder who invests in a Fundraiser, will be entitled to 1 vote and Founders will have to collect the signatures of all shareholders when taking key shareholder decisions. We expect that many of the shareholders would be free riders as they are unlikely to want to incur monitoring costs. It is possible to manage these complexities in a number of ways, but this is a complexity that is avoidable and certainly not the case with institutional venture capital. In a number of jurisdictions, Founders can issue non-voting shares. Within the context of crowdfunding, non-voting shares can be very useful in providing Founders (and the board) with more control over business decisions.
4)You May get Stuck
Founders need to source for a licensed Portal on which to introduce their business to the public and to source for investments. In practice, Portals are differentiated on the basis of product offerings and capabilities around regulatory compliance. For this reason, Founders would need some level of diligence on a Portal before listing.
The Portal operators are also required, by Regulation, to conduct extensive diligence on a Fundraiser and to formally accredit a Fundraiser to offer investment instruments to investors through the Portal. Essentially, this means that your ability to raise funds is entirely dependent on a Portal. You may have to wait until SEC licenses a Crowdfunding intermediary and would have to deal with only licensed Crowdfunding Intermediaries. If you do not meet the requirements of a Portal, your access to crowdfunding might be severely limited.
5)Your Investors are Mostly Going to be Retail Investors.
To understand how retail investors can be a hurdle, think about the relative advantages a B2B e-commerce business strategy has over B2C. Also, the Regulations provide that retail investors cannot invest more than 10% of their annual income and can withdraw their investment money within 48 hours if they are no longer interested in investing or, within 7 (seven) days if that investor decides that a material adverse change has occurred. It is important to understand that these limitations have been introduced primarily to protect retail investors. However, these are not issues Founders would encounter with institutional venture capital, as Founders are likely dealing with sophisticated investors who are by design, better structured to manage the risk of failure and illiquidity that typifies many early-stage investments.
Venture capitalists may take only a minority stake, tranche their investments and are unlikely to withdraw their investments except within the context of a liquidation event. Sometimes, early-stage venture capital firms waive their rights to hold shares or demand interest payment, (after investing in a start-up), for up to 18-months or until the occurrence of priced equity round.
6) You would be "Public" from the get-go.
Fundraisers would also be subjected to a higher level of disclosure and transparency similar to that of a public company. Fundraisers need to prepare standard offering documents and make full disclosures. For instance, Founders are required to disclose information on the risks related to the liquidity of the securities, risk of dilution, risk of non-performance, restrictions on the ability of investor to cancel investment, information around promoters, directors, shareholders and their control structure.
Even though Crowdfunding Intermediaries will essentially function as a regulatory intermediator, it would be useful to structure a Fundraiser's internal compliance functions on the assumption that Fundraisers would be under the regulatory supervision of the SEC, at least to a greater degree than would be, with a similar private company raising venture capital.
Again, these limitations are not generally common with venture capital investments. The investment instruments used in early-stage venture capital financings are typically standard and the reporting requirements facing investors are usually less-burdening.
In concluding, it is important to note that the risk profile and sophistication of "the investor" is what primarily informs the approach to securities regulation. With SEC crowdfunding, investors are deemed to be less sophisticated and deserving of protection and preservation, using tax payer's monies.
In the other case, the investor is assumed to understand the nature of its investments and to be capable of protecting itself from a risk of loss. Overall, it would be inaccurate to assume that venture capital financing is ideal for all types of Fundraisers. Not all companies get to raise venture capital. It may well be the case that crowdfunding may be the better option for your business. It is often wise to seek professional counsel early-on in the fundraising process.
About the Author
Olubunmi Abayomi-Olukunle leads the venture capital transactions team at Balogun Harold and has advised on over USD100 million dollars of venture capital financing transactions facing Nigeria.
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