Olisa Agbakoba Legal (OAL) was recently instructed to advise a client on the possibility of raising capital by way of Crowdfunding. Interestingly I had undertaken a short course on this very interesting finance model and I was able to sink my teeth into this very challenging brief.
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. Thus, Crowdfunding provides an alternative finance model, which is taking grip in Europe, the US and Asia as fast as the platforms can be set up.
There are today some 1000 Crowdfunding portals worldwide supporting a multi-billion pound industry in the UK. Global Crowdfunding experienced accelerated growth in 2014 to reach $16.2 billion in the US. In 2015 the industry raised over $34.4 billion[1].
The purpose of Crowdfunding is to provide investment opportunities for would be investors and to provide funding for start-ups and individuals to finance or re-finance their businesses. Crowdfunding in the European market has reached a value of EUR 1 billion, this 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.
Nigeria as in other countries has a plethora of SMEs that have no or little access to finance due to stringent requirements of banks and financial institutions in terms of security or collateral. Although Crowdfunding has not taken deep root in Nigeria, there is a certainty that it will and when it does we may not have the enabling legal and regulatory framework to support this massive innovation.
There are three broad platforms for Crowdfunding, philanthropic which allows charities and individuals raise money for philanthropic causes through online donation portals. The second platform is for investment, which provides for both debt and equity online transactions. These platforms are referred to as Equity Crowdfunding and Loan Crowdfunding. A brief discussion of these two platforms will demonstrate how they work[2]
Equity-based Crowdfunding
Equity Crowdfunding allows people to invest in an early stage unlisted company (a company that is not listed on a stock market) 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 (i) access to capital (ii) 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 companies which are legal and regulatory since the legal framework in some countries is just developing. In Nigeria, there is no definite legal framework for Crowdfunding. 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. As minority shareholders, investors will have no influence in the management of the company.
Equity Crowdfunding platforms have had to address legal and structural issues such as crowd control by the investee company and the platform. This has been addressed by the two major platforms of CrowdCube[3] and Seedrs in the UK.
In the CrowdCube model the crowd invests directly into the company that in return issues new shares to the 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. 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 the 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.
In the UK funds raised from equity Crowdfunding grew by 210 per cent in 2014 and 84 million pounds was raised in capital. The innovation has alerted venture capitalists to the reality of this alternative finance model, which makes funds readily available before venture capital funds may decide to invest. In the UK venture and growth stage companies are increasingly finding success with equity Crowdfunding, perhaps capitalizing 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 entitled ‘Improving the Role of Equity Crowdfunding in Europe’s capital markets’ suggests equity Crowdfunding may be significantly riskier than business angel 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”.
In the concluding part of this article, I will be considering Loan-based Crowdfunding, and theLEGAL & REGULATORY FRAMEWORK FOR EQUITY-CROWDFUNDING IN NIGERIA.
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