Crowdfunding Finance in Nigeria and the Need for Legal and Regulatory Framework

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Crowdfunding Finance in Nigeria and the Need for Legal and Regulatory Framework

By Correspondent

Olisa Agbakoba Legal (OAL) was recently instructed to advise a client on the possibility of raising capital by way of crowdfunding. Coincidentally, I had taken a short course on this relatively new financing model and was excited to advise on the practicality of such a transaction in Nigeria. Crowdfunding is alternative financing by which small businesses, corporate organizations and individuals can raise money from the general public through an online portal called a Crowdfunding Portal. The theory behind this is that if a large number of people, referred to as the “crowd”, each provide monetary contributions, then it is possible to raise substantial sums of money, without the need to go to traditional lending sources. Thus, Crowdfunding provides an alternative financing model, which is fast being used in Europe, the US and Asia to raise capital for various financial and non-financial projects. There are today some 1000 Crowdfunding portals worldwide supporting a multi-billion dollar industry. Global Crowdfunding experienced accelerated growth in 2014 to reach $16.2 billion in the United States (US). In 2015 the industry raised over $34.4 billion. The Crowdfunding market is made up of various funding models such as consumer lending, debt and equity financing for small and medium sized enterprises and donations for philanthropic causes. Funds raised by way of Crowdfunding ensure that small businesses have the credit to grow their business, which in turn creates jobs and stimulates economic growth. There are three broad platforms for Crowdfunding; philanthropic and promotional that allow individuals and charities raise money for philanthropic causes and artist promotions through online donation portals.  The second and third platforms are for investment, these provide for both debt and equity online transactions, referred to as Equity-based Crowdfunding and Loan-based Crowdfunding.  A brief discussion of these two investment platforms will demonstrate how they work. Equity-based CrowdfundingEquity Crowdfunding allows people to invest in an early stage unlisted company in exchange for shares in that company. A shareholder has partial ownership of the investee company and stands to profit should the company do well. The opposite is also true; so if the company fails investors can lose some, or all of their investment. The benefits of using an equity crowdfunding platform for raising capital are;
  1. access to quick capital
  2. the investee company is able to set its own valuation and
iii.            the platform generates good PR for the company.From an investor’s point of view, it creates an opportunity for diverse investments allowing the risk to be spread across a diversified portfolio of assets. Returns on the equity crowdfunding platform are potentially more than those on the loan crowdfunding platforms and often the returns are more than those from public equity capital markets.Of course, there are latent risks for the company, which border on legal and regulatory risks which are based on the absence of structured legal and regulatory framework to provide investor and consumer safeguards. Investments in crowdfunding are high risk as levels of due diligence may be unclear and most investors in the crowd may have no experience and are just ”˜following the crowd’ to coin a phrase. Again, because these investments are mostly in small private businesses, there are no exit strategies for investors within a specified period. In some countries, the companies’ legislations are not flexible enough to accommodate crowdfunding and issues may arise pertaining to minority shareholder protection, pre-emptive rights, management issues, insolvency etc. Major issues that equity crowdfunding platforms have had to address are structural in nature. How can an investee company control the crowd on the crowdfunding platform, when the platform is open to numerous investors? This also proposes a challenge in the legal structure of the crowdfunding arrangement. In the UK two major competing platforms namely; CrowdCube and Seedrs have structured their platforms to deal with the legal structure of crowdfunding. In the CrowdCube model, the crowd invests directly into the company which in return issues new shares to investors, whereas in the Seedrs model a nominee company collects the funds and issues shares in itself to the investors; the nominee company then invests in the company requesting finance, which in turn issues shares to the nominee company. Both models have their advantages and disadvantages. The CrowdCube model’s advantages are that the shareholders are not consolidated under a nominee company, each investor is a shareholder but with very little minority protection rights. The potential disadvantages are that the platform could end up with hundreds of shareholders that would entail a lot of administrative work on the part of the company. Again, shares may lack adequate anti-dilution protection. The Seedrs model has the advantage that the structure may be more attractive for venture capital participation as the nominee company represents numerous shareholders. The Nominee would therefore take decisions for the investors giving the crowd more bargaining power; however, this could be a disadvantage to the company. The innovation of crowdfunding has alerted venture capitalists to the reality of this alternative finance model, which makes funds readily available before venture capital funds decide to invest. In the UK, venture and growth stage companies are increasingly finding success with equity crowdfunding, perhaps capitalising on the confidence inspired among investors as crowdfunding becomes more mainstream and subject to Financial Conduct Authority (FCA) regulation and scrutiny. A recent paper by Wilson and Testoni titled ”˜Improving the Role of Equity Crowdfunding in Europe’s Capital Markets,’ suggests equity crowdfunding may be significantly riskier than business angels or venture capital finance, due to a “lack of adequate pre-investment screening and due diligence, weaker investment contracts and poorer post-investment support and monitoring”. Loan-based CrowdfundingLoan-based or lending crowdfunding also called Peer to Peer-lending (P2P) is where individuals lend money online to a company or project in return for repayment of the loan or interest on their investment. Due to the increase of loan-based crowdfunding in the UK, the regulation of the consumer credit market has been transferred to the Financial Conduct Authority that now regulates loan-based crowdfunding platforms.  This form of crowdfunding has developed as an alternative to bank lending. Since the P2P lending companies offering these services operate entirely online, they can run with lower overheads and provide the service more cheaply than traditional financial institutions. As a result, lenders often earn higher returns compared to savings and investment products offered by banks, while borrowers can borrow money at lower interest rates, even after the P2P lending company has taken a fee for providing the matchmaking platform and credit checking the borrower. Legal & Regulatory Framework For Equity-Based Crowdfunding In NigeriaIn many countries like Nigeria, soliciting finance from the general public without legal authorization is considered illegal. Crowdfunding arrangements that require people to contribute money to a company in exchange for shares in that company comes under the securities laws in Nigeria, comprised of the Investment and Securities Act, 2007 and Securities and Exchange Commission Rules 2013 (SEC Rules). However, there is no specific crowdfunding legislation in Nigeria. Only recently, the United States’ Securities and Exchange Commission adopted rules to permit companies offer and sell securities through crowdfunding. The new SEC rules and proposed amendments to the Securities Act are designed to assist small companies with capital formation and provide investors with additional protection. In the UK, the FCA introduced new rules that apply to the distribution of “non-readily realizable securities”; these are shares or debt securities in new or existing businesses that are not listed on a regulated stock market. Since these securities are termed unlisted they carry significant risks. The 2014 FCA rules contain market restrictions allowing only high net worth investors to partake in equity based crowdfunding. Such investors are to take regulated advice and those that opt to invest in this type of security must confirm that they will invest no more than 10 percent of their net assets on any platform. These new rules were implemented to protect investors and ensure that consumers have access to clear information, which allows them to assess the risks as well as providing them with consumer protection. Nigeria has seen a tremendous rise in the use of online platforms; we have seen the success of online shopping portals, and more recently online gambling. Although Crowdfunding has not taken deep root in Nigeria, there is a certainty that it will and when it does, we must ensure that we have the enabling legal and regulatory framework to support this massive innovation. Equity Crowdfunding may prove to be an expedient way to raise capital for our struggling small businesses known as SMEs. These entities find it difficult to raise startup capital because they are perceived as high risk to banks due to the fact that they have little or no track history of borrowing, inadequate or no security for the bank to fall back on in the event that they are unable to liquidate their debts and poor legal framework. If properly legislated and regulated, equity crowdfunding could very well serve as a finance option for our teeming small businesses. At the same time, it would provide a new security class and deepen our capital markets, where such securities are listed on the capital markets. SEC regulates all securities offered for sale by public companies in Nigeria and as at the time of this article there are no provisions relating to crowdfunding in the SEC rules. What is interesting is that SEC is partnering with the Ontario Stock Exchange to develop a framework and rules on crowdfunding for Nigerian capital markets. As welcoming as this news may appear, it may not be a simple task bearing in mind the fact that Nigeria’s financial sector has not been successfully coordinated to accommodate new innovations such as crowdfunding. Some issues would need to be considered in structuring a crowdfunding transaction. Bearing in mind that there are three main parties to the transaction; the Company raising funds, the investors and the online platform, a suitable legal vehicle would have to be employed as the investee company. The vehicle used for crowdfunding in both the UK and the US is the limited liability company, since it is a legal entity recognized by law and where the liability of  its members are limited to the amount unpaid on the authorized share capital. However, in the UK, equity crowdfunding platforms operated under a combination of exemptions and exclusions from the regulated activities regime. The Companies and Allied Matters Act, 2004 (“CAMA”) regulates the formation and operation of all types of companies and enterprises in Nigeria. However, to meet the objectives of crowdfunding for small businesses it would be expedient for such small business to register as a private company under CAMA. A review of some of the restrictive provisions of CAMA dealing with transfer of shares, invitations to the public to subscribe for shares etc, for private companies may need to be made more flexible or there may be need for special provisions for public companies applying to register on a crowdfunding platform. The provision of CAMA restricting the number of members of a private company to 50 could be an advantage in that it would ensure crowd control and may encourage high net worth investors, thereby establishing a class of self-certified sophisticated investors that would have sufficient knowledge to understand the risks associated with such an investment. In conclusion, Crowdfunding may very well be the answer to funding SMEs in Nigeria and there can be no better time than the present to review all legal and regulatory framework required to invigorate our capital markets and financial services sector. It has been recommended that a centralized body akin to the Financial Conduct Authority be created to administer the financial sector. In the UK, the FCA protects consumers and financial markets by enhancing the integrity of the UK financial system while also promoting competition. The FCA aims to support and empower a healthy and successful financial system, where firms can thrive and consumers can place their trust in transparent and open markets. It also makes sure that firms stick to the rules and take appropriate measures to prevent them from being used as a channel for financial crime. The recommended review of the SEC rules should enable investors to finance crowdfunding projects, subject to certain thresholds to be determined on a case-by-case basis. Companies seeking to raise funds should also be required to disclose information about their company and the securities on offer. There should also be an enabling legal framework for intermediaries that may be involved in facilitating crowdfunding transactions. The new rules should prohibit online portals from offering investment advice, soliciting sales or offers to buy securities and any information that would be considered to mislead or misrepresent prospective investors. Establishing the legal and regulatory framework for crowdfunding is a pragmatic move for SEC, which should involve a holistic review of our securities laws, company legislation and other related legislation. The ongoing study should not be restricted to the Ontario Stock Exchange but should be broadened to include the UK that has similar laws as Nigeria.The next step will be for SEC to adopt a robust plan to ensure that crowdfunding in Nigeria becomes a reality. Bisi Akodu is a Partner at Olisa Agbakoba Legal (OAL) and heads the Corporate/Commercial & Public Sector Group. She is a member of the Capital Markets Solicitors Association, a member of the CBNFSS 2020 Legal Implementation Team and a member of the Lagos Chamber of Commerce & Industry Committee on Commerce & Taxation.

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