Legal Considerations for Nigerian Business Start-Ups – Part 2: Financing

Source: Adobe Spark

In Part 1 of the series, I discussed the two (2) business forms that are registrable in Nigeria – companies and business names. Having considered the factors discussed in the first Part, a business aspirant would need to consider how to raise the funds for the new start-up, a decision that could also have an impact on the form of business so chosen – this is the focus of this article.

Please note that this article is not intended to be a comprehensive discussion on the points discussed, as these are very wide areas – even a full textbook will not do justice to the depth and breadth of these issues. The aim of this article is to touch on some of the basic points that I think everyone should have at their fingertips when considering business financing, especially first-time entrepreneurs. The same principles should also be helpful to people who have already started their business and are contemplating other sources of finance.

The three (3) likely (and most common) sources of financing for a business start-up are:

  1. personal financing;
  2. equity financing; and
  3. debt financing.

The funds used by a business aspirant would usually fall into one or more of these categories. These sources of financing are not mutually exclusive; a business venture can be funded from one of them as well as a combination of some or all and sometimes, it may be a requirement to have one available in order for you to obtain the other. The decision as to which source(s) should be used is not only commercial, but also personal.

It is also possible to source financing from the government (government funding) but this option is not as common and available as the three mentioned above, because government funding is usually available only in certain specified (and often limited and restricted) circumstances. As such, this article will not cover this source of funding.

Personal Financing

Source: Adobe Spark

This source of financing is self-explanatory, as it simply means sourcing for funds using one’s own finances. Such funds could be obtained from personal savings, income from other investments or businesses, monetary gifts/prizes/awards, etc.

Any funds intended to be invested in a future business that come with no strings attached can be categorised as personal. It should be noted that borrowing from friends or family or even third parties interest-free, cannot be categorised as personal financing because there is an obligation to pay back the sums so borrowed, regardless of the informal nature of such loan – this source of financing is debt.

Equity Financing

Equity financing involves the investment of funds into a business by an investor (who may or may not be the business aspirant) in return for a stake in that business; because of having such stake in the business, the investor shares in the gains (and losses) of the business on such terms as may be agreed between the parties. Where the business aspirant invests equity by himself/herself (a sole proprietorship), s/he enjoys the profits and suffers the losses alone i.e. 100 per cent. stake.

In the context of a company, such stake will typically take the form of “shares”, whereas in the context of a business name with at least two (2) parties involved (e.g. a simple partnership or firm), such stake may be described as “proportions” or even shares as well – there is no fixed terminology in relation to entities that are not companies. Profits in a company are typically described and distributed as “dividends” and there are strict rules under law (contained in the Companies and Allied Matters Act) that regulate the distribution of dividends – similar rules do not apply as far as business names (and unregistered business forms) are concerned.

For example, if X needs N1,000,000 to finance the business and decides to do this by way of 100% equity, X could approach Y for an equity contribution. If Y contributes N400,000 i.e. 40% by way of equity and X injects the balance of N600,000 i.e. 60% into the business, then Y would have a 40% stake in the business unless otherwise agreed. If the equity was injected into a company, X and Y would both be shareholders of the company with 60% and 40% ownership of the share capital of the company respectively. If the cash was injected into a business name or a simple partnership, X and Y would own the business (and be liable as well) in 60% and 40% proportions respectively, unless otherwise agreed.

When considering equity financing from another person, certain issues also need to be considered such as:

  • whether the other investor will be involved in the active management of the business and if yes, to what extent i.e. involvement in all decisions, certain decisions or no decisions at all;
  • what the other investor’s expectations are in terms of voting power, profit and loss sharing, frequency of income (dividends/profits), etc.;
  • whether the investor intends to stay in the business for a short, medium or long term and the terms on which such investor would be willing to exit the business if/when the time comes; and
  • the possibility of bringing additional investors on board, should the need arise, etc.

Source: Adobe Spark

It is worth noting that it is possible for investors to own a certain proportion of a business based on their capital contribution but be entitled to a share in the profits/losses of the business in different proportions. So, whereas, from the example above Y has contributed only 40% to the business, it is possible for X and Y to agree that Y will be entitled to 90% of the business profits and X would be entitled to 10% of the business profits, but both parties would share the losses in the business equally. It is also possible for shares to have different rights attached to them e.g. one category of shares gets paid profits/dividends before others, another category may have stronger voting weight, etc. Thus, in the context of equity financing, equity does not necessarily equate with equality – it ultimately boils down to bargaining strength, risk appetite and risk allocation.

Another interesting point worth noting (briefly at least), is the possibility of having a nominee arrangement in place, which is a method that can be used to circumvent the need for a second person to join in the formation of a company. In practice, this works by X appointing Y as its nominee (in a separate document between X and Y) then Y will hold shares in the company as a nominee (for X obviously) – so, on the surface, the shareholders in the company will be X and Y but they understand between themselves that Y does not really own the shares.

Debt Financing

This type of financing involves the use of funds obtained by way of debt i.e. borrowed money. In other words, if X obtains money from Y with the understanding that X will repay that money (in whole or in part) to Y, this is debt financing. Although bank loan or a loan from friends, family, etc. is usually the first type of debt that pops up in one’s mind, this is not strictly speaking, the only type of debt financing available – there are bonds as well.

I will briefly mention touch on bonds and loans. Bonds will only be mentioned in passing (for information purposes only), while loans will be dealt with in greater detail in Part 3, which will be dedicated to discussing the important parts of a loan document.

Bonds

In simplest terms, a bond is like an IOU. It is issued by a business (X) called an “issuer”, to other parties called “bondholders” as an acknowledgment of debt owed by X to the bondholders. For example, if X would like to raise N1,000,000 for its business by way of bonds, it would effectively try to raise this amount by seeking contributions (called “subscriptions”) from other people and those who eventually contribute money to X will be issued bonds – in return, the bondholders would expect to be repaid their money over time. Such repayments may be made with or without interest, on a regular basis (the terms vary from transaction to transaction).

From this oversimplified explanation of how a bond works, it is understandable that X would need to do a lot of ground work and produce information to potential investors in order for them to be convinced that it is a good deal, as well as show some form of track record/history of business activity in order to build trust.  At the end of the life of the bond (e.g. if X issued the bonds for a period of five (5) years) (called “maturity”), the bonds will be redeemed by X at which point, all bondholders should have been paid back what they contributed as expected.

Bonds may be issued by both corporate and government entities. It should be noted that the bond market is heavily regulated as it is a capital market activity and only corporate entities (i.e. governments and certain categories of companies) can issue bonds to the public – business names or other unregistered business forms cannot issue bonds. It suffices to assume that a first-time business aspirant will not be considering bonds as a source of financing in view of the heavy cost implications as well as the usual need for some track record/history in order to convince potential bondholders to subscribe to the bonds.

Source: Adobe Spark

Loans

Most adults should be familiar with the concept of loans, as everyone at some point in their life would have participated in a loan arrangement (as lender or borrower), whether formally or informally so I see no point in flogging an explanation. However, I would like to briefly touch on three (3) types of loans, which a business aspirant would most likely need if debt financing is contemplated – the first two discussed below can be arranged with non-bank entities but the final one can only be arranged with a bank or some other deposit-taking financial institution, by its nature.

  1. Term loans / term facilities: these are loans that are typically repaid during the course of a fixed time period. Usually, once amounts under such loans are repaid, they cannot be borrowed again i.e. once you have repaid an amount, the debt is reduced by such amount. For example, if X has a N1,000,000 term facility with Y and X borrows the whole amount, if X repays N700,000, X would not be able to (re-)borrow that N700,000 (or any part of it) again. This is the most common type of loan – e.g. car loans and regular personal loans from banks.
  2. Revolving loans / revolving credit facilities: these are loans that permit the borrower to withdraw, repay and redraw the same funds again (somewhat cyclical) until the facility expires. Businesses usually use such financing to cater for operating/recurrent expenses and as a form of short term finance – especially when there is an expectation/anticipation of funds coming from another source. The idea is that you have this facility available and it can be recycled. For example, if X has a N1,000,000 revolving credit facility with Y, it means that if X needs only N700,000 while the facility is available, X can withdraw just that amount and then repay it – if X repays the whole amount, N1,000,000 will be available for X to withdraw again and likewise, if X repays only N200,000, the total amount available will be topped up to N500,000 for X to redraw (N300,000 balance from the initial N1,000,000 plus the repaid N200,000). Of course, this is an oversimplification as there will be mechanics built into the loan documentation dealing with things like interest, fees, penalties, suspension of withdrawal, etc. So, with a revolving facility, X can borrow to pay employees’ salaries before the end of the month, expecting that X would be able to repay the loan when X’s customers pay X at the end of the month.
  3. Overdrafts: an overdraft facility is a form of credit from a bank to a customer, which allows the customer to keep withdrawing from his/her account even if the account balance is zero or the funds in it are not sufficient to meet the amount that the customer wishes to withdraw i.e. the account ends up having a negative balance. As with every loan, the size of the overdraft available to a customer will vary, so will the terms. Although this may not seem like a wise means to finance a business in totality, it has its purposes and can come in handy especially in case of emergency. One can have an overdraft facility (charge-free) and not use it at all, but it is comforting to know that it is there on standby should it be needed.

Interrelationship between Source of Funds and Business Forms

Personal Financing

(unregistered forms, business names and companies)

Personal funds are suitable for any new business as the principle of “my money, my choice, my risk” can be applied with ease.

If you can fund your business from personal funds without input from another person and still have the ability to meet your other financial needs, that is good for you because you can truly own YOUR business and have all the autonomy and independence that may not necessarily be available with equity or debt finance.

Equity Financing

Unregistered forms and business names

This will only usually be contemplated when considering two (2) or more people coming together to form the business. In this context, although the business partners could fund the business completely from personal funds, their injection of such funds into the business would be by way of equity because they would each have a stake in the business by their investment (in cash or in kind).

It is also much easier and less formal for profits to be shared between the investors – likewise the losses. An area of concern, however, is the issue of personal liability. The owners of the business will generally remain personally liable and in such situations, it is not that simple to run away from the business and leave it to fend for itself (compared to a company) – if the business cannot pay its bills, the owners would need to pay from their pockets.

In addition, as such business forms (if registered) will be public record (because of registration with CAC), if an investor wants secrecy, this can be easily achieved by non-registration.

When equity financing is used, the need for independence and autonomy would need to be considered, as the other investor(s) may be interested in having a say in certain (if not all) things concerning the business – it is no longer “my money, my choice, my risk”.

Source: Adobe Spark

Companies

Investment in the share capital of a company is by way of equity finance. Each shareholder will own agreed proportions in the company, with certain rights attached to such ownership – some of these rights are even protected by law and any agreement between the parties to try to take such rights away will not be permitted by law. The law also prescribes strict rules on the distribution of dividends, so profit-sharing may not be as automatic/simple as if it was a business name/partnership/firm.

If the company is incorporated as a limited liability company, then the shareholders are only liable to pay the value of their shares into the company. If the company cannot pay its bills, the shareholders are not liable to pay them on behalf of the company. Conversely, if the company is incorporated as an unlimited company, then the liability of the members will be unlimited.

Because shares are categorised as assets capable of being owned, transferred, sold, etc. by law, it is generally easier for a party to leave the business or bring additional investors on board by way of share sales, transfers, allotments, etc. in accordance with the terms of the company’s articles of association or any shareholder’ agreement in place.

As the identity of the shareholders in Nigerian companies is public information, a secret investor would need to consider more complicated structures to keep such identity secret e.g. through trust or nominee arrangements, but these come with added legal issues in the event of a dispute about ownership.

Sometimes, people are compensated for their services by way of shares in the company so it will not be uncommon for Mr X (an emoji specialist) to be offered shares in Emoji Nigeria Limited in return for him to develop extraordinary emojis (the company’s main business) – in return, he will share in the profits by way of dividends (of course). Issues then arise if Mr X decides to quit his job at the company – do the documents allow him to quit but retain his shares? Can he say he no longer wants shares and would like to be paid cash monthly instead? Can he sell his shares to a random person? Can the company re-negotiate the terms of his employment if it becomes more profitable without any useful input from Mr X?  These are some of the risks with equity financing.

The point about independence and autonomy mentioned above will also apply – there is a chance that some (if not all) shareholders may want to be represented on the board of directors. How much independence and autonomy is the business aspirant willing to forfeit, if this is the case.

Debt Financing

(unregistered forms, business names and companies)

Debt finance is usually considered as a last resort and an opportunity to access more funds than one may be able to raise personally or through equity alone. Before taking on debt, the business would most likely need to show that it will be able to repay the borrowed amount otherwise it would struggle to obtain this type of finance – hence the need for credit support through collateral, guarantees, letters of credit, etc.

In certain circumstances, a lender might insist on a certain level of equity being injected into the business before they would be willing to even provide debt finance – this is usually because such lender would need to be comfortable that the owners of the business have some “skin in the game” and usually such equity contribution amounts will need to be tied up in a designated account also controlled by the lender. The lender will most likely take that account as collateral as well.

Debt finance is not cheap – there may be interest payable at exorbitant rates as well as other fees, penalties, etc. Sometimes, businesses find themselves borrowing from X in order to pay a debt owed to Y, to avoid a default scenario. There is also the issue of over-collaterisation, which is quite common. In this scenario, the lender takes collateral over the borrower’s assets, which are worth more in value than the amount borrowed e.g. for a loan of N200,000, the lender might take collateral over a plot of land worth way more than that amount.

With debt finance also, lenders expect to have some sort of control over how the business is run (but from a distance) and may often require updates and certain information that may be an administrative burden to the business e.g. regular management accounts, letters from auditors, etc. The loan document may even state that the ownership of the company cannot change without the lender’s prior approval.

Where collateral would need to be provided in support of debt finance, care also needs to be taken to ensure that this would not impede the operation of the business e.g. if the bank wants to take collateral over a business’ warehouse, the business owner needs to ensure that the loan documents do not require the bank’s permission before the business can open and shut the warehouse if such warehouse is used daily. In other words, the loan documentation should not only be reasonable, but also practical in recognition of commercial realities – this is where legal drafting expertise becomes very important.

Finally, although some banks are happy to lend to business names, they prefer lending to companies because companies have legal personality (as discussed in Part 1). In addition, a company is separate from its owners, so it is much easier to treat transactions as purely business and not personal (compared to when dealing with business names or unregistered forms, where the owners remain personally liable). The banks can also have the best of both worlds with companies by obtaining personal security / guarantees from the owner(s) of the business. It is also easier to conduct due diligence on a company because of the public records and registers available at CAC – so, a bank can easily check and verify whether a company’s collateral is free and can be taken as security by the bank, whether the company has complied with its statutory and regulatory filings, who the owners and officers of the company are, etc.

Conclusion

(Phew!) I appreciate that this post was somewhat long, but I hope that you got to the end and it was worth your time. When considering how to fund a business from the outset, the types of financing available should ordinarily have an impact on the business form that a business aspirant chooses to adopt. If the wrong form is chosen at the outset, the good news is that it can always be changed but that will have timing implications and possibly involve negotiations and discussions that could have been undertaken much earlier in the process.

Source: Adobe Spark

There are no hard-and-fast rules as to what source of financing one should use for their business; this decision invariably depends on personal financial reality, commercial and legal needs as well as the needs of the business. The key takeaway here should be a reminder that personal funds can only get you so far and if/when you get as far as such point, there are alternatives that can be explored (including partnering with another person that has already started or is looking to/interested in starting the same type of business).

If you are wondering why a lawyer would care about sources of financing a business and whether it is reaaaalllly that important, my simple response would be: “What happened to Etisalat Nigeria?” The death of Etisalat Nigeria and the birth of 9Mobile is a lesson that anyone considering financing a business needs to understand. I will be more than happy to do a case study (from a legal perspective) if anyone would like to read it.

 

Some useful links:

https://www.investopedia.com/terms/b/bond.asp

http://www.nse.com.ng/products/debt-instruments/bonds

https://www.thebalance.com/types-of-equity-financing-for-small-business-393181

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2 comments

  1. Marilyn Okowa-Daramola

    Very insightful!!! 👏👏👏

    Like

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