Crowdfunding vs. Traditional VC Funding Within The Nigerian Startup Ecosystem

Most Nigerian startups, as with other startups generally face the challenge of accessing capital to fund and grow their businesses. In the past, startups have had to opt for traditional methods such as venture capital funding, and bank loans. However, more recently, the use of alternative methods like equity crowdfunding is starting to gain more popularity. Consequently, startups now have more fundraising options available to them than ever before.

Overview of Venture Capital and Crowdfunding

Venture capitalists are investment firms or groups of investors who financially support growing startups in exchange for equity. Sometimes, they provide technical and managerial expertise. Their investments are allocated to small companies with growth potentials or companies with great growth track records. Usually, investors in venture capital funds are financial firms, pension funds, university endowments, high net worth individuals among others. 

Equity crowdfunding involves raising money through the public in exchange for equity. Through this process, the crowd gets to invest in an early-stage private company. Consequently, they become shareholders and stand to profit if the company does well. Importantly, equity crowdfunding has helped democratize the investment process by allowing a large pool of investors to invest in startups. The main idea of this is to raise the required capital by receiving small contributions from the public. Crowdfunding usually takes place online via crowdfunding platforms such as GoFundMe, Kickstarter, Fundable, Crowdrise, and MicroVentures.

Pros and Cons of Crowdfunding

• Crowdfunding gives startups access to broader investment opportunities. They can promote their business to a much wider audience and get multiple small investments that can eventually add up to a large amount of capital. 
• Crowdfunding also allows founders to remain in control of their company because most of the investors do not hold majority power to sway decisions. 
• The investors in a crowdfunding round may be among the early users of the product. Hence, they provide valuable feedback on the product offered by the company. Having a stake in the business will also encourage them to promote it and talk about it with others. 
• This option also provides market validation for startups because having a large number of crowdsourced investors shows that the market approves the product. This will be advantageous when pitching for future rounds of funding.

On the flip side, 

• There is no guarantee that founders will get their businesses funded, as the public may not buy into it. This is especially true for early-stage startups which have not put their product on the market. It can be hard to predict how the public will react to their campaign on crowdfunding platforms.
• There is usually a limit to the amount raised at a time on these platforms. Hence crowdfunding seems more suitable for early/seed rounds and not for startups that want to raise large amounts of money, especially for later funding. 
• The fees charged for hosting campaigns on crowdfunding platforms can also make using this method more expensive.

Pros and Cons of VC Funding

• Startups that receive funding from VC firms can raise huge amounts of capital from a single round of funding. This is because VCs are established funding institutions with large amounts of resources. Even at early-stage, startups can raise up to millions of dollars. For example, Nigerian logistics startup, Kwik Delivery, recently raised $1.7million from VCs and other high-net-worth investors.

• The resources and connections that VCs provide also increase a startup’s chance of having good scalability. A VC can participate in multiple funding rounds for the same company, and even introduce the founders to other VC firms that can provide additional funding. 
• Aso, VCs do not only provide funds; they can also provide industry expertise and help with management, which would be very beneficial to founders. 

However, there are some downsides to VC funding. 

• There are a lot more strings attached than with crowdfunding, as VCs usually seek advantageous terms like board seats and anti-dilution protections to gain control in the business at the expense of the founders. 
• The process of raising multiple rounds of VC funding leads to dilution of the founders’ equity and can cause them to lose majority ownership in their company. In effect reducing their control and decision-making power in the business.

Regulatory Framework of Venture Capital Funding in Nigeria

When deciding on which fundraising option to choose within the context of the Nigerian startup ecosystem, the laws regulating both sources of funding also need to be considered. Venture capital in Nigeria is regulated by the Securities & Exchange Commission (SEC) which has to control the involvement and operations of corporate and individual investors in the country. The following are some of the rules governing VCs:

• Rule 555 of the SEC Rules and Regulations 2013 provides for the requirements for the application of authorization of venture capital funds with the commission. 
• Rule 556 also explains some of the functions of venture capital firms such as raising funds, targeting investment opportunities, adding value to the firms they invest in, and designing and executing exit strategies. It also provides some characteristics of the firms they invest in which include projects of high profitability and those which have no dominant competitor with monopolistic gross profit margins. 
• A venture capital fund manager has to be a company incorporated under the Companies and Allied Matters Act with a minimum paid-up capital of N20,000,000 (Twenty Million Naira). The fund manager must also be registered with the SEC. 

Nigerian law also provides some incentives for venture capitalists in the form of tax exemptions: 

• Section 4(a) of the Venture Capital (Incentives) Act 2004 provides for yearly deductions from a startup’s income tax for every equity investment made in it by a venture capital firm. This continues until five years after each investment. To qualify for this incentive, the investment made by the venture capital firm must make up at least 25% of the total funding required by the startup. The deductions are made in the following manner:
  • First-year – 30% deduction
  • Second year – 30% deduction 
  • Third year – 20% deduction
  • Fourth year – 10% deduction
  • Fifth year – 10% deduction
• Section 4(b): where the investment is disposed of (for example, in an exit or secondary buyout), the gains made by the venture capital firm will be exempt from capital gains tax according to the provisions of the section. 

Thus, Nigerian laws seek to encourage venture capital funding and make it beneficial to both startups and venture capital firms.

Nigerian Laws Regulating Crowdfunding

Generally, existing Nigerian business laws do not allow private companies to raise equity from the public as provided for in section 67 of the Investment and Securities Act and Section 22(5) of the Companies and Allied Matters Act. However, the new Rules for Crowdfunding released by the SEC in January 2021 now provide guidelines for equity crowdfunding. According to the Rules, only micro, small, and medium enterprises that have been in operation for at least 2 (Two) years can raise funds through a crowdfunding portal operated by a registered crowdfunding intermediary. There are also limits to the amount that can be raised within 12 (Twelve) months. Medium enterprises cannot raise more than N100,000,000 (Hundred Million Naira), small enterprises have the limit of N70,000,000 (Seventy Million Naira), while micro-enterprises must not raise more than N50,000,000 (Fifty Million Naira).

Also, portals that facilitate interactions between fundraisers and the investing public will have to be registered with the SEC as Crowdfunding Intermediaries. They must also have a minimum paid-up capital of N100,000,000 (Hundred Million Naira). Companies with no stated investment goals or immediate transparency of ownership are prevented from raising funds through crowdfunding portals. 

The regulations seek to protect investors as crowdfunding portals are required to conduct due diligence on prospective fundraisers, ensure every investor fills out a risk acknowledgment form, and give investors the right to withdraw from an agreement to purchase the securities by giving the portal notice 48 (Forty-eight) hours before the close of the offer. 

It is clear that these regulations are more restrictive and make crowdfunding less accessible to Nigerian startups than venture capital funding. The two-year requirement limits the number of startups that can fundraise through crowdfunding platforms as new startups of less than 2 (Two) years would not be able to take advantage of this source of funding unless they can partner with an MSME that meets the requirement of being in operation for more than 2 (Two) years. Also, the paid-up capital requirement places a high barrier to entry for prospective crowdfunding portals, which could limit the means through which startups can raise money using this method.

There are many things that Nigerian startup founders have to take into consideration when choosing which fundraising option to go with. Considerations like how much control they want to have in the business and the need for scalability will be very important. Also, the laws regulating both methods will need to be considered. For VC funding, the laws are a lot more certain and it is clear that they seek to encourage such investments. However, with crowdfunding, the regulations are still very new and uncertain, and the focus appears to be more on protecting investors than helping startups have more access to funding. Ultimately, choosing the best fundraising option does not have to be an either/or approach as both methods can be complementary. For example, Gumroad, a startup that helps creators sell their work, raised over $8,000,000 (Eight Million Dollars) from VCs in the past and, in their most recent fundraising round, went the crowdfunding route and raised $5,000,000 (Five Million Dollars). Nigerian startups can also adopt this complementary approach and take advantage of the benefits of both methods of fundraising.