The background for the publication of the proposed crowdfunding rules is that as the startup scene in Nigeria has continued to grow, so too has the demand for funds to enable entrepreneurs and innovators to implement their ideas. The private equity industry has been the most significant contributor of funds to startups in recent times, seeing as most startups are private limited liability companies and have limited options when it comes to raising funds from the public.
Crowdfunding is one of those options which has increasingly gained popularity recently, beginning with foreign platforms such as Kickstarter and Indiegogo and extending to indigenous ones such as Naijafund and FundAnEnterprise, among others. Till now, crowdfunding has largely been unregulated, with the exception of the anti-fraud laws which guard all contracts.
To keep the industry in check and protect investors, the SEC; on the 29th of March, published its proposed Crowdfunding Rules for public consideration and feedback. This article is an evaluation of its contents and implications for all stakeholders.
Scope and Application
The first question is exactly which entities and investment programs are covered by the proposed rules. The proposed regulations make that clear in Section 4, vis: “Every platform that facilitates interaction between fundraisers and the investing public (crowd) for the purpose of any investment-based crowdfunding…”
When read together with Section 2 which stipulates that all crowdfunding must be done through a registered crowdfunding portal, the above quoted provision establishes two things: First, the Rules are intended to apply only to investment crowdfunding, to the exclusion of reward-based crowdfunding and donation crowdfunding (please see this article for explanation of those terms). Secondly, the Rules apply to all Nigerian crowdfunding platforms insofar as the platform is operated or based in Nigeria (even partly) or actively promotes its offers to Nigerians.
Analysis of Relevant Provisions
To analyse the provisions of the proposed rules properly, they will be grouped under relevant headings. It should be noted that the terms “issuer”, “startup”, and “company” are used interchangeably.
Establishment and Registration of Crowdfunding Platforms
- Entities Permitted to Operate a Crowdfunding Platform – Crowdfunding platforms must be operated by only by organizations registered with the Commission as an Exchange, Dealer, Broker, Broker/Dealer or Alternative Trading Facility as prescribed under the Investment and Securities Act and the SEC Rules and Regulations, although there is a stipulation for entities to be registered as a “Restricted Dealer” to carry out crowdfunding activities exclusively.
- Discretionary Power to Register – The SEC will have the power to determine whether to approve any application for registration, taking into consideration the technical ability of the organization, the competence and character of the officials as well as risk-carrying capacity.
- Minimum Paid-Up Capital and Insurance – Evidence of required minimum paid up capital of N100,000,000 (One Hundred Million Naira) and current fidelity insurance bond valued at a minimum of 20% of the paid-up capital as stipulated by the Commission’s Rules and Regulations.
Corporate Governance and Responsibilities of Crowdfunding Portals
- Due Diligence – The Rules mandates platforms to investigate prospective issuers by conducting background checks to ensure that the issuer’s board of directors, officers and controlling shareholder(s) are fit and proper persons or entities; verify the business model and comply with all KYC(Know Your Customer), AML(Anti-Money Laundering) and CFT (Combating the Financing of Terrorism) regulations.
- Transparency – All platforms must display certain information prominently on their website, including but not limited to:
- Information relating to issuers hosted on the platform.
- Investor education materials and appropriate risk disclosures.
- Information on how the platform facilitates the investor’s investment including having a forum to permit discussions about offerings hosted on its platform.
- A general risk warning on participating in funding through the platform.
- Information about complaints handling or dispute resolution and its procedures.
- The fees, charges and other expenses that it may impose on an issuer or investor.
- Appointment of Trust Account Custodian – The funds raised in each funding round must be deposited into a separate trust account which would be maintained by a financial institution approved by the SEC to act in that capacity.
- Avoidance of Conflict of Interest – Platforms must not host any funding round in which the platform, its officers, directors or their proxies own or control more than 5% of the startup.
- Transaction Fees Limit – The total fees payable to parties to a crowdfunding issue must not exceed 2% of the total funds raised.
- Record Keeping and Data Protection – Crowdfunding platforms must keep extensive records of all their activities for a period of at least 7 years and such records will be subject to reasonable periodic or special examination by officials of the SEC. They must also take steps to keep information pertaining to investors secure, install backup facilities and be insured appropriately.
Obligations of Issuing Startups
- 2 Years Operational History – Only companies which are incorporated in Nigeria and have been operating for a minimum of two years will be able to raise funds through crowdfunding.
- Maximum Capital to Be Raised: The rules would restrict the total sum which companies can raise in a 12-month period according to their size categorization:
- Medium enterprises – 100 Million Naira
- Small enterprises – 70 Million Naira
- Micro enterprises – 50 Million Naira
An exception from these limits is provided for platforms which receive the Commission’s approval to operate as digital commodities investment platform, which entails promoting agricultural investment opportunities rather than traditional equity investment.
- Non-permitted Issuers – The following entities are prohibited from raising funds through a Crowdfunding Portal:
(a) complex structures (Defined in the interpretation section as an entity without immediate transparency of ownership and/or control thereby making it difficult to immediately ascertain the beneficial owners of the entity).
(b) public listed companies and their subsidiaries.
(c) companies with no specific business plan or a blind pool (Defined in the interpretation section as a business plan which is solely for the purpose of merging with or acquiring an unidentified entity).
(d) companies that propose to use the funds raised to provide loans or invest in other
(e) such other entity as may be specified by the Commission.
- Offer Document – All companies intending to raise funds through crowdfunding must file an offering document which contains particulars of the investment proposal such as the business model, pricing and expected returns, principal risks, capital structure and ownership and any holders of more than 5% of the existing shares. It must also contain the financial information and two years audited financial statements.
The document must be made available to potential investors via the crowdfunding platform and must not be posted on any other website.
- Fundraising Thresholds – Issuers must stipulate a minimum and target amount they intend to raise. If the minimum amount is not met, all funds raised must be refunded to investors and the issuer would be estopped from attempting another fundraising round for a period 90 days. If the minimum threshold is reached but the target isn’t attained, the issuer must deliver a new plan to the investors regarding how they intend to utilize the funds and investors would then have the right to proceed or withdraw.
- Ongoing Disclosure – After a successful funding round, issuers must regularly deliver their audited financial statements to the SEC and make them available to all investors. Specifically, prompt (within 24 hours) notification must be given to investors in the event that any of the following situations occur:
- A discontinuation of the issuer’s business
- A change in the issuer’s industry
- A change of control of the issuer.
- Ban of Referral Programs – Companies are not permitted to directly or indirectly pay a commission, finders’ fee, referral fees or similar payment to any person in connection with an offering other than to the Crowdfunding Portal. This means there can be no discounts or bonuses for bringing in friends and family as is common with Nigerian investment platforms.
Investor Rights, Protection and Restrictions
- Cooling Off Period – The proposed rules stipulate that within a period of 48 hours after the date of the close of the offer, an investor may withdraw their investment. Such withdrawals must be followed by a refund of the investment sum to the investor’s account within 48 hours of the request to cancel.
- Limitation of Investment Amount – Retail investors (as differentiated from Sophisticated, High Net Worth and Institutional Investors in the SEC Regulations) are not allowed to invest more than 10% of their annual income in a calendar year. The other categories of investors are not limited in the sums they can invest, although the restrictions will be subject to review by the SEC from time to time.
- Restriction on Transfer of Investment Instrument: Investors will not be permitted to sell or transfer their investment for a period of one year except if a transfer is:
(a) to the issuer of the securities or investment instrument.
(b) to an institutional investor.
(c) part of an offer for sale registered with the Commission.
Review and Recommendations
Overall, the proposed rules represent a job well done on the part of the SEC. The regulations touch on all the essential areas and are forward thinking in how they approach the dicey issue of balancing the interests of startups and investors, to engender innovation and entrepreneurship while safeguarding the funds of everyday Nigerians.
Specifically, the restrictions on referral programs is welcome as it will staunch the pervasive pyramid-scheme marketing that forms part of many investment “opportunities”. This way, the profiteering incentive to convince people to invest in any company is eliminated, thus paving the way for more honest and objective analysis. Even though this might dampen the effectiveness of word-of-mouth marketing that many startups rely on, the trade-off is worth it insofar as it better protects the majority of everyday investors who may not be fully financially literate.
Nonetheless, there are a few points which require more attention to improve the proposed rules even further:
- Clarification of TargetAmounts – The proposed rules stipulate that there will be a minimum amount and a target amount which companies will aim to reach in a fund-raising round. That is good and in line with best practices in other jurisdictions. It is important, however, for the rules to clarify what happens when a company reaches its target amount – does the fundraising stop immediately or would the company have the opportunity to capitalize on the soaring demand by initiating “stretch goals” which would involve making a new offer document detailing how they intend to utilize the new target sum?
Beyond giving businesses the opportunity to raise more funds, that clarity is also important with respect to what would happen if an investor withdraws their investment during the 48-hour period. Assuming the fundraising terminated as soon as the minimum sum was attained, would such a withdrawal have the effect of voiding the fundraising round and mandating the company to wait for 90 days before attempting again?
- Restriction on Transfer of Shares – This provision, presumably inserted for the purpose of maintaining the stability of the issuing company, restricts investors severely, especially the retail investors who might need to convert their holdings into cash for various reasons. If the Commission believes it is best to maintain that provision, it must be listed as one of the terms which must be disclosed and prominently displayed on crowdfunding platforms to ensure that investors understand the implications and plan accordingly.
- Effective Corporate Governance – The activities and decisions made by the board of directors in any company form a crucial part of its success or failure, to ensure that crowdfunded companies are in the best position to survive and deliver returns to investors, the Rules must include stipulations as to the composition of the board of directors, especially the secretary of the company.
The extant position, according to the Companies and Allied Matters Act, is that private companies are only required to have a secretary, without the requirements as to the person’s expertise as in a public company. However, since a crowdfunding round necessarily involves the input of public company, it stands to reason that such companies be held to the higher standard of having a legal practitioner or experienced chartered secretary to act in that position, as a way of ensuring better regulatory compliance and general adherence to corporate governance best practices.
The proposed rules represent a major step forward for the technology industry in Nigeria, as current economic conditions shut the door on many traditional avenues for raising funds. The provisions are well designed to protect investors and ensure maximal transparency while affording startups the latitude to innovate and expand.
Even when compared to the regulations of other, more established countries, the Rules are very comprehensive and cover almost all the essential aspects of crowdfunding. With a few amendments drawn from the suggestions sure to be sent it by various industry stakeholders, the Rules; when passed, will certainly have a major positive effect on Nigeria’s investment climate.
P.S. The proposed crowdfunding rules can be downloaded here – https://sec.gov.ng/exposure-of-proposed-crowdfunding-rules/.