Introduction
It is a notorious fact that most business ideas never make it to the market, mostly because of lack of funds. The inability to get the needed funds to kickstart a business or to sustain it is the biggest challenge for most entrepreneurs in Nigeria and across the world. While the availability of funds does not guarantee a successful business venture, the absence of funds will certainly get the business nowhere.
In this article, we discuss some of the financing options available to start-ups in Nigeria, highlighting the pros and cons of each and the factors a start-up should consider before exploring any of them. This is essential because choosing the right source of capital is a decision that will influence a company for a lifetime.
Financing Model Options for Start-ups in Nigeria
Before delving into the subject, it is necessary to clarify the meaning of the term, "start-up" within the context of this article. There is a lot of misconception about what a start-up entails. Some believe that a person, who is selling shoes in his small kiosk in Balogun Market in Lagos is a start-up, as he is just starting out and desires growth. Some also believe that Globus Bank, fully licensed in 2019 as a commercial bank in Nigeria, also qualifies as a start-up because of its newness in the market. However, neither that person nor Globus Bank can be regarded as a start-up as they do not possess the essential characteristics of a start-up.
A start-up is a young company founded by one or more entrepreneurs to develop a unique product or service and bring it to the market, with the intention to grow large and become a unicorn. That shoe seller in Balogun market does not qualify as a start-up, as he does not have a unique business model designed to solve a problem. Also, Globus bank is not a start-up because prior to its existence, it was already 'big'. The capitalisation requirement of N25,000,000,000 (Twenty-Five Billion Naira) for every commercial bank in Nigeria is a huge sum, which takes Globus bank and every other bank outside the purview of start-ups. Thus, for an entity to be regarded as a start-up, it must be young, registered as a company, have a product or service designed to solve a particular problem, and possess an intention to grow and expand. Notable examples of start-ups in Nigeria are Piggyvest, Kuda, Flutterwave, etc.
The following are some of the financing models available for start-ups in Nigeria.
- DEBT FINANCING
This option involves a start-up company borrowing money to finance its operations, to be paid back at a future date with interest. It is a time-bound activity where the company as a borrower needs to repay the loan or the principal amount borrowed along with interest at the end of the agreed period. Debt financing comes in various forms, but in whatever form it is, it always involves borrowing money, with or without collateral, and an agreement to pay back at a later day with interest.
Debt financing for start-ups can take various forms, which include:
- Bank Loans: This is the most common type of
debt financing. This involves approaching banks in Nigeria to give
loans to fund the business of the start-up. The factors usually
considered by banks before agreeing to offer the loan include the
company's ability to repay the loan, the planned use of the
funds, the creditworthiness of the company, among other factors.
Their finding will determine the interest rate to be charged, the
amount to be loaned out to the start-up company and the duration of
the loan.
There are potential benefits a start-up company stands to gain from the option of debt financing generally and bank loans specifically. Among many are the fact that not only are bank loans easily accessible but also, the option preserves the ownership of the company and prevents the dilution of its equity. In other words, provided the principal sum and interests on the loan are paid by the start-up company as and when due, the company's ownership and all its assets remain intact and the lender (the bank) has no say in how the start-up should manage its business. Another advantage of this financing model is that there are no tax liabilities on the interests paid on the loan as they are seen as part of deductible expenses.
Notwithstanding the above benefits, this option may be at a huge cost to a start-up, whose only possession is an excellent business plan with no asset or any track record of success. For this reason, it may be difficult for commercial banks to loan the required amount of capital to a start-up company. Also, banks typically require collateral (assets) from the borrower as security for the loan to be advanced and usually charge high-interest rates, which can be as high as 25% of the loan amount and this may eventually create a huge financial liability for the company, impacting strongly on its growth in the long run. For a start-up, these requirements may be too much to bear, thus making this option less favourable. Furthermore, in the event of failure of the business, there is a high risk of bankruptcy and adverse impacts on credit ratings.
However, Microfinance banks (MFBs), which are financial institutions that provide small loans to small scale enterprises, can help to cushion the costs of obtaining loans from commercial banks.
- Government Loans: The Government of Nigeria,
in an effort to strengthen the growth of small and medium
enterprise businesses in Nigeria often comes up with loan plans for
some of these businesses. Some of the advantages of government
loans include the absence of collateral and little or no interest
rates when compared with bank loans.
However, obtaining this type of loan usually comes with a lot of bureaucratic bottlenecks and the amount obtained in the end may be inconsequential to facilitating the growth of the business of the company. Thus, as much a start-up is enjoined to explore this option, hopes should not be raised to prevent a disappointment.
- EQUITY FINANCING
This is another viable option a start-up company can explore in raising the needed capital to finance its business. Equity financing refers to raising funds by selling shareholding interests in the company to investors. The major difference between equity financing and debt financing is that for equity financing, the investor is given shares in the company as consideration and thus becomes a member of the company, while in debt financing, the consideration received by the lender is the payment of interest on the principal amount loaned to the company.
Some forms of equity financing start-ups can explore include the following:
- Venture Capital: This is a form of equity
financing which concentrates on investing in the early stages of a
company's life. There are companies and firms known as Venture
Capitalists (VC), which specialise in this form of financing. They
seek out and scrutinise start-ups with bright business ideas and
invest in the finances of the company in return for equity
ownership. When they are sought, they are very hard to convince as
their primary aim is to invest in early-stage companies with the
highest potential for rapid growth.
An advantage of VC is that they always invest a large pool of capital, contributing largely to the finances of the company, providing a good ground for growth. Another benefit of this option is the provision of mentorship and guidance to the start-up, provided it is contained in the agreement between the start-up and the VC. VCs that invest a lot in a start-up tend to be more hands-on in the affairs of the start-up. They often nominate board member(s) to sit at board meetings and make impactful decisions to the benefit of the start-up.
A notable disadvantage of this form of equity financing, which is also common in other forms of equity financing, is that it often leads to the dilution of ownership and operational control. That is, VCs, when they do invest in a business, tend to invest a lot. Consequently, they acquire more equity in the start-up than other types of investors.
- Angel Investors: These are high net worth and
wealthy individuals, often entrepreneurs themselves, who invest in
business start-ups they believe have potential in return for equity
stakes in the company. Angel investors typically invest in an
industry they are familiar with and have experience working in. One
key advantage of this form of financing is the fact that the
'angel investor' like the name suggests, not only makes
large financial investment in a business but they can also provide
very valuable guidance for the business. However, the challenge
here is finding them. Most times, it can be as difficult as trying
to light a fire under water and when they are found, they usually
demand a lot of equity stake in the company, thus giving them
controlling powers in the company.
- Crowdfunding Platforms: This form of equity
financing allows the public to invest in the company in small
amounts and the contributions from the public are summed up to
reach a target total. A major advantage of this equity financing
option, which a company can explore is that besides raising funds,
crowdfunding ventures have also proved to be a valuable way to
gather public opinion and create publicity for a start-up or its
product especially as the process involves the use of social media
platforms.
The use of crowdfunding as a source of equity financing is highly regulated by the Securities and Exchange Commission ("SEC").1 The SEC has made guidelines detailing the process, procedure and requirements for crowdfunding. It is important for start-ups considering this option to be aware of the limit of the amount that can be raised via this platform. The SEC guidelines state that the maximum amount which may be raised shall not exceed ₦100 million by a medium enterprise, ₦70 million ($180,000) for small enterprises and ₦50 million ($128,000) for micro-enterprises.
- MEZZANINE FINANCING
This type of financing combines both debt and equity financing. It occurs where a lender provides a company with a loan. So long as payments are made on the loan, the company will retain full control over the business and the loan will be treated like any other loan. However, if the business takes a downturn and the company cannot repay the loan, the lender can then convert the loan into equity interest, effectively seizing a portion of the company and establishing a claim to any future profits generated by the business.
A start-up can go for this option with some money lending institutions. This type of loan is made available for a short period of time and usually only require minimal or no collateral. The risk involved in this option is the likelihood of the equity of the company being diluted in the event of failure to meet the loan obligation.
CONCLUSION
Beyond the options that are highlighted above, there are many underlining legal issues and considerations which if a start-up is not careful and diligent about, may end up trading the future assets and profits of the company without knowing. It is thus imperative that throughout this process, a start-up ensures that it has a sound transactional lawyer representing its interest, and perusing the necessary documents before any deal is closed with a potential investor.
Footnote
1. The SEC Guidelines for Crowdfunding available at https://nairametrics.com/wp-content/uploads/2021/01/Jan-2021-Executed-Rules-1.pdf
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
