By: DAMILOLA BAMISILE
Over the last few years, Nigeria and indeed the whole world has seen an exponential increase in entrepreneurial activities. Without a doubt, these entrepreneurs have caused a shift in the traditional way of doing things as they have ushered the world into seamless methods; into new ways of doing anything and everything. Consequently, society has taken a rapid pace of advancement.
Most billion-dollar companies started as an idea, a light-bulb flash in the minds of ordinary people. These ideas then translated into products that resolved collective problems of the society in sustainable and efficient ways. Interestingly, funding is a driving force in converting ideas into reality and no matter how great an idea is, it may simply go to the grave in the absence of resources to nurture it.
For some startup founders, the popular ‘chase the vision, the money will follow you’ dogma comes alive when a set of people decide to cast their faith in the growth of the new invention or business by investing in the company to propel growth in exchange for a stake in the ownership structure of the business. This intervention typically comes in the form of venture capital.
Thus, venture capital is simply a type of financing where investors provide funds to startups or growing businesses with long-term growth potential in exchange for equity participation in the business.
VENTURE CAPITAL COMPARED WITH OTHER SOURCES OF FINANCE
Private Equity and Venture Capital
Private equity is an umbrella term used to describe a class or group of investment ventures aimed at privately-held/unlisted companies. Simply put, this type of financing is structured towards private companies as against publicly traded companies. Private equity may be broadly divided into Venture Capital and Leveraged buyouts.
Venture capital is a branch of private equity that focuses on investing in growing companies at their earliest operational stage while leveraged buy-outs are more concerned with taking controlling interests in mature businesses.
Although the common denominator between all private equity is that the funds are invested in private companies, venture capital differs in the following ways:
- Established Company vs. Start-ups: Private equity firms pool resources in order to invest in and acquire parts or all of an established company ownership structure while venture capital firms invest in a company during its earliest stages of operation.
It is essentially a case of proven concept vs. rapid growth. While private equity funds are majorly concerned with a mature and established company (even if they are struggling), venture capital looks at a new and developing company with high growth prospects.
Venture capital provides a new business with funding in order to increase the company’s capacity to make profits. More often than not, it is venture capital funding that gives new businesses the means to attract other private equity fund and investment banking services.
- Industry: Private equity funds are generally committed to investing in any private industry with prospects. Venture Capitalists on the other hand are more inclined towards the technology sector: to kick-start innovations in fintech, biotechnology etc.
- Risk Level and Payout Ratios: It is trite that the higher the risk in an investment, the higher the expected returns. High risk translates to high returns and thus given the high level of risks associated with start-ups, venture capitalists typically record a higher rate of return than other private equity funds. This high return on investment ratio helps a venture capitalist to balance losses made from failed investments in other start-ups.
Debt Capital and Venture Capital
The overall capital structure of most companies comprises a combination of debt capital and equity (or solely equity) deployed in financing the operations and growth of the business.
Debt capital refers to the part of a company’s finances derived from bank loans, overdraft facilities, bond or debenture issues etc. while equity may come in the form of ordinary shares or preference shares etc.
Venture capital forms part of equity because investors take up shares in exchange for the funds provided. That is, they become shareholders of the company.
It is generally accepted that debt is a cheaper source of finance due to the fact that it reduces tax liability and does not alter the equity capital of a company. Debt financing, unlike venture capital and other equity, does not give the providers of funds a stake in the ownership of the company or participation in the management of the company. Thus, once a debt liability is settled, the burden ceases to hang over the company. Venture capital, on the other hand, grants access to the venture capitalist to actively contribute to the growth of the company through equity participation.
For startups, it is generally difficult to derive funds from borrowings (debt). This is because loans are less accessible to startups due to factors such as inconsistent cash-flows, low credit rating, the potential risk of failure, and unavailability of collateral assets.
Start-ups are therefore more inclined towards equity financing and this invariably makes venture capital a startup-friendly financing option.
STAGES OF VENTURE CAPITAL FUNDING
Venture capital funding typically starts when a start-up submits a proposal or business plan to a venture capital firm and the firm, in turn, conducts thorough due diligence into the company’s business, operating history, founders and management and the products they offer. This due diligence then informs the firm on their decision to either invest or not invest.
When a venture capital firm decides to invest, it may then decide to release funding to the start-up at different rounds (as described below). Finally, the investor may decide to exit the company after a period of time by initiating an Initial Public Offer (IPO) or by a Merger or acquisition.
The four major rounds in funding start-ups are:
- SEED FUNDING: This can be likened to a physical planting of a tree. Like a physical seed, the seed funding round of investments is the first official investment that a start-up raises. Seed funding would thus come in handy to a company that is at the Research and Development stages. With seed funding, a start-up is then availed with resources to hit the ground running.
- SERIES A: Once a start-up has established a track record coupled with a significant customer/user base, it may now proceed to raise ‘Series A’ funding which provides the company with access to a larger market and user base. Although several groups of investors participate in this round of funding, it is mostly dominated by venture capitalists. One major consideration for investors at this stage is whether the company has great ideas and has equally developed a substantial strategy to turn the ideas into a profitable business. Thus, in order to attract investors, start-ups must commit to developing business models that project long-term benefits.
- SERIES B: The focus of investors at this stage is helping to bring start-ups past the development stage. Startups are basically being made to leverage their substantially developed product offerings and user base to further drive growth in the business. At this funding stage, more venture capital firms (particularly ones that specialize in later-stage investing) would begin to pick interest in the company.
- SERIES C: At this round, more private equity investors are attracted because a company at this stage is well established with strong & consistent revenue flows, a strong user base as well as a steady growth rate and thus less risky than a company at an early funding round. Although it is generally possible to proceed to Series D or even Series E, most companies typically end the private equity rounds at this stage before proceeding to an Initial Public Offering (IPO).
EXAMPLE OF SUCCESSFUL VENTURE CAPITAL FUNDING
The idea of Uber came to founders Garrett Camp and Travis Kalanick in 2008 when they attended a conference in Paris and could not get a cab. They then began to work on the idea of having a cab-hailing network to make transportation affordable and stress-free. This idea birthed the UberCab which was valued at $5.4 million in 2010. Interestingly, Uber was valued at $79 billion when the company went public in May 2019.
One of the first venture capitalist to invest in Uber was “First Round Capital” owned by Rob Hayes who invested $510,000 and the value of the investment today is $2.5billion. Another venture fund of $50,000 (now valued at $248.3 million) was invested by David Cohen through his venture capital firm “Bullet Time Ventures”.
Interesting, Universal Music invested the sum of $107,148 in Uber and sold the investment a year later for $863,000. The investment is now said to be valued at $532 million.
The above examples serve to show that ‘striking gold in venture capital is not only the result of investment acumen and business connections but also one of timing’. Venture capitalist must this be well versed in the timings of exiting a company.
INVESTING IN START-UPS: FACTORS CONSIDERED BY VENTURE CAPITALISTS
Before investing in startups, venture capital firms must carry out a thorough and detailed due diligence in order to properly estimate the viability of their proposed investment. In doing this, some of the primary factors to be considered by venture capitalists are:
- Large potential market: Here, the investor simply considers the target customers to whom the company directs its products and the overall expansion potentials available to the company’s market. This helps the venture capitalists to identify the sales potential of the company.
- Long-term growth prospect: One driving factor for most venture capitalists is their ability to find startups with high chances of becoming big, large corporations later on. Since startups are high-risk investments, it is invariably true that venture capitalists are concerned about startups whose prospects for growth offset the potential risk for failure.
- Quality of the product: The venture capitalists must consider whether the product or service offers a solution to a real problem. Invariably, any product or service that offers a solution to any real and identified problem is bound to succeed, other things being equal. The venture capitalist must also look at the timing of the product and whether it is being launched into the market at the right time as good timing will positively influence the market’s response to the product.
- The Founder and the people: After all factors have been duly considered, it is imperative for venture capitalists to examine the team behind a startup. The founder(s) of a startup holds a defining stake in the future of the company as they make the primary decisions that affect the company. Thus, the venture capitalists must consider the technical expertise of the founders as well as their experience level before investing
VENTURE CAPITAL IN NIGERIA
Regulation of Venture Capital in Nigeria
Venture capital is primarily regulated by the Securities & Exchange Commission (SEC) and the role of the Securities and Exchange Commission to venture capital in Nigeria hinges on the Commission’s primary duty to regulate the involvement and operations of individual and corporate investors in Nigeria.
The Securities and Exchange Commission Rules and Regulations (SEC Rules) 2007 make special provisions for the authorization of venture capital fund with the commission. (See Rules 282-283).
In addition to the SEC Rules, an additional rule (Rule 249D) was issued and made effective on the 28th February 2013 to regulate the activities of private equity firms with a minimum commitment of (one) 1 billion naira investment funds.
Rule 249D restricts private equity firms from soliciting funds from the general public but may privately source funds from qualified investors and further restricts a private equity firm from investing more than 30% of its fund assets in a single investment. The rule also mandates private equity fund managers to render quarterly returns of the fund to the SEC.
Rule 249D (3) expressly provides thus:
“A private equity fund shall not:
Solicit funds from the general public but shall privately source funds from qualified investors alone
Invest more than 30% of the Funds assets in a single investment.”
Sources and Management of Venture Capital funds
Venture capital is a private equity strategy and such cannot solicit funds from the general public. Unlike other private equity funds that invest their personal funds, venture capital typically derives its fund from external sources.
Most funds are sourced from institutional investors such as insurance companies, pension funds or development financial institutions. Funds may also be sourced from individuals with high net worth.
The venture capital fund is usually managed by a Venture Capital Fund Manager. This Manager must be a company incorporated under the Companies and Allied Matters Act with a minimum of N20,000,000.00 (Twenty Million Naira) paid-up capital. The Fund Manager must also be registered with the Securities and Exchange Commission.
Tax Incentives Available To Venture Capitalists:
- Venture Capital (Incentives) Act:
Generally, the law seeks to encourage investments through tax reliefs in order to ensure that people are motivated towards investments in certain areas of the economy. The Venture Capital (Incentives) Act, Cap V2, Laws of the Federation of Nigeria, 2004 contains incentives geared towards encouraging venture capitalists in Nigeria. Section 4(a) of the Venture Capital (Incentives) Act, Cap V2, Laws of the Federation of Nigeria, 2004 provides thus:
“The following incentives shall accrue to venture investments-
(a) an equity investment by venture capital in a venture project company shall for purposes of capital allowance under the Companies Income Tax Act be treated as follows-
- for the first year deduct 30 per cent;
- for the second year deduct 30 per cent;
- for the third year deduct 20 per cent;
- for the fourth year deduct 10 per cent
- for the fifth year deduct 10 per cent”
Section 4(c) further provides thus:
“The withholding tax payable on dividend declared by the Federal Inland Revenue Service in a Venture project company shall be reduced by 50 per cent of the prevailing rate of withholding tax in respect of dividend received by a Participant in the Risk Fund and venture project company within the first five years”
- Foreign Exchange (Monitoring and Miscellaneous) Act:
Foreign venture capital firms that bring in capital through authorized dealers (usually licensed commercial banks) and obtain a Certificate of Capital Importation are entitled to unconditional and unrestricted repatriation of profits, dividends and/or interests as guaranteed under Section 15(4) of the Foreign Exchange (Monitoring and Miscellaneous) Act which provides thus:
“Foreign currency imported into Nigeria and invested in any enterprise pursuant to Subsection (1) of this section shall be guaranteed unconditional transferability of funds through an Authorized Dealer in freely convertible currency relating to
dividends or profits (net of taxes) attributable to the investment;
payments in respect of loan servicing where a foreign loan has been obtained;
the remittance of proceeds (net of all taxes) and other obligations in the event of sale or liquidation of the enterprise or any interest attributable to the investment.”
Lastly, investors from countries that have a double taxation treaty with Nigeria will enjoy a withholding tax reduction of up to 7.5% as against the standard rate of 10%. This means that any foreign venture capital firm will ensure a reduction in tax paid on the dividends received.
Although there are several options available to new businesses in sourcing funds; some of which include raising capital from family and friends, crowd-funding etc, venture capital has over the years, proven to be the most viable financing strategy for startups.
Venture capital is unique in its commitment to seeing the growth of the company over a period of 5-10 years before exiting by selling its shares. Venture capitalists do not only provide money to run a new business, they also offer mentoring and other technical expertise from their well of experience. It is thus conclusive to say that venture capital is the future of entrepreneurs.