Newcomer investors flood Nigeria venture capital market

Olubunmi Abayomi-Olukunle and Adekunle Adewale, partners at Nigeria-based venture capital and private equity advisory law firm, Balogun Harold, have observed a steady increase in the number of Africa-focused venture capital funds, corporate VC, accelerators, private equity firms implementing growth strategies and other early-stage investors who set up shop in Nigeria in 2017.

Both (Abayomi-Olukunle and Adewale) are of the opinion that growing investor confidence and a positive economic outlook make a compelling case for a robust year ahead for Venture Capital-led Mergers and Acquisitions in Africa’s largest economy.

Their insightful views and projections for 2018 are outlined below by BusinessDay’s Private equity and Fundraising editor, Lolade Akinmurele.

It Can Only Get Better

And It Will.

The early-stage/venture capital market in Nigeria is still largely, a buyer’s market and we suspect that this trend will persist through 2018.

However, there are two important factors that are driving a market shift on the sell-side.

Tech founders are now more familiar with the VC model and with the commercial expectations of VC investors.

The resulting alignment of interest is critical and good for the market because it means deals should close faster and exits can be pursued more vigorously.

However, this increasing familiarity is also driving new questions around whether or not VC is a good fit for the market. Tech founders still have significant concerns around losing control of their companies or been unduly pressured by VC investors.

In a number of cases, such suspicion has led to deal fractures and in some cases, driven founders to consider more strategic investments.

Increasingly, tech founders are asking to see more value-add and not just ‘cash’.

The other trend driving a market shift is the steady increase in the number of Africa-focused venture capital funds, corporate VC, accelerators, private equity firms implementing growth strategies and other early-stage investors who set up shop in Nigeria in 2017.

We find that newcomer investors tend to offer more flexible control and economic terms.

This strategy will inevitably intensify competition for earlystage deals in 2018. Keeping good relationships within the ecosystem is now more important than ever as word spreads very fast about greedy VCs. Inevitably, incumbents will have to rethink prevalent deal origination and investment strategies to remain competitive in a market that is increasingly flush with early-stage capital.

Market trends are also shifting from the traditional sectors like software outsourcing, e-commerce, fintech, micro-lending and edutech to sectors like entertainment, renewable energy, agriculture, digital media & marketing technology, consumer goods and travel. Significant opportunities are also opening up with late-stage companies, with very experienced founders and strong cash histories, as these companies warm up to VC investments, cutting USD5-10million cheques.

This is a solid area for deal origination at the moment. We find that there is vast potential in non-tech companies, with strong cash flows, looking to use VC financing to ‘go tech’ and scale their businesses.

Fintech is of particular interest.

We expect that the intense competition driven by lowering transaction fees should make pooling resources, by way of mergers or strategic acquisition offers from banks or foreign payment companies, a viable growth strategy for fintech in 2018.

Although, the Nigerian venture capital market is still behind newer venture capital markets, like India, (especially, in terms of global VC presence, available exit opportunities and sophistication of the governing legal framework), the Nigerian venture capital market is fast evolving and holds a lot of promise for investors who take time to understand the peculiar risks and structure around these risks with support from competent counsel.

Relative to any period before now, it has never been this easy for technology founders to access financial support and far more founders are now pioneering far more disruptive ideas across different sectors.

Contrary to what we have seen in some foreign legal media outlets, the five legal frameworks applicable locally are largely favourable to VC investment, to a large extent.

VCs and other early-stage investors looking at investing in Nigerian companies can expect to secure legal rights which are standard for similar investments in more developed venture capital markets.

Typical protective terms which include tranching, preferential equity terms, veto rights, anti-dilution protection, forced liquidation, redemption and transferability of shares are recognised and ordinarily enforceable under Nigerian corporate law.

In 2017, we were privileged to advice on a number of early-stage deals, ranging from seed investments to Series A investments and also helped set up a number of venture capital funds looking to attract institutional limited partners, which are based in Nigeria.

We reflect on that experience and now share a mix of expectations, reflections, feedback and deal insights.

The paperwork still matters

A good number of the early-stage investments in Nigeria’s technology space are never ‘closed’ in a sense that guarantees the rights of investors and ensures that those rights are enforceable.

More often than not, an early-stage investor will merely sign a term sheet but omit to execute definitive agreements. In other scenarios, parties actually proceed to execute the definitive agreements but fail to observe standard closing procedures.

Failure to ‘close the deal’, remains largely an investor risk, especially existing investors, because there is no certainty as of now, on the enforceability of the rights of an investor who invests solely on the basis of a term sheet or fails to follow through with key closing procedures.

The situation is also bad for the existing investors because, existing investors will most likely be negotiating from a weaker position in a follow-on round.

For follow-on investors, issues around prior financing and the enforceability of prior existing rights, is a key diligence point and follow-on investors must have a clear view of where there economic and control rights lie or how these rights interact vis-a-vis the rights of an undocumented investor from the outset.

There are also significant implications for tech founders as failure to close a deal may unduly complicate, delay or abort follow-on financing. As a general rule, investors who are keen on a particular target should ensure that term-sheets are drafted with sufficient detail and certainty to provide a soft landing in the event that a dispute as to enforceability arises.

100k will block USD 3m

Tech founders, who have set their minds on raising VC financing must structure specifically for VC financing from the outset.

We find that a number of structures in place are ill-prepared for the realities of venture capital investment.

This can complicate later-stage financing in many ways.

One of such complications which we have seen is where existing investors in a Nigerian company, object to flipping their shares for the shares of a holding company in a follow-on investment.

We find that a number of the local early-stage investors tend to follow a long term, strategic pattern to investing. This strategy will often coincide with, even the standard financial investment strategies of VCs. The key concerns for existing investors are usually around tax liability in a foreign jurisdiction, unfamiliarity with legal framework of an offshore jurisdiction and avoidable reporting obligations.

In practice, the more sophisticated investors in the prospective portfolio company will, on this account, attempt to block a follow-on investmentwhich has offshore incorporation provisioning or other seemingly unfavourable provisions.

Situations like these can be particularly frustrating and fatal for founders especially when one considers that Nigerian corporate law allows any shareholder to bring an action to restrain a company by way of injunction or declaration from carrying out any act or omission that will affect the shareholder’s individual rights as a shareholder.

VC is relatively predictable and continuing chain of events. By the time a tech company raises a Series B financing, there are already other investors at the table who have received a set of rights in Series A or Series Seeds financing and these rights will need to be taken into account when negotiating the terms of Series B.

The scenario plays out with subsequent series. In sum, it is very possible for founders alongside their counsel to envisage and accurately plan for the eventualities of VC financing, from the beginning.

Founders, who simply register a company without any thought around financing issues and shareholder strategy, will definitely battle avoidable financing and shareholder issues later on. Whilst DIY approaches may be useful for certain types of businesses, one area of law that is still not ready for DIY is investment and securities law. Other than the fact that this is a fairly complex area of law, every deal/company is different and often calls for a different approach and strategy.

Diligence is still the mother of good fortune

Depending on the stage where a business is, there may not be too many data points available initially, from a diligence perspective. However, one data point that isn’t an easy variable is regulation.

Technology reacts with the law in unprecedented ways and regulation as a diligence focus in Nigeria can be particularly complicated by a number of local factors, which include the fact that (a) a good number of laws are not actively enforced and can therefore easily fall through the cracks (b) the country operates a federal system where the legislative power of the federal government and the state often coincide, resulting in intergovernmental litigation and uncertainty as to the applicable framework in some cases. (c) there is competition for regulatory relevance, a trend which will often trigger over-regulation.

We find evidence of due diligence failures on the point of regulation, especially with early-stage investors. Granted that, prior to external financing, many early-stage companies may not be able to bear the cost ofregulatory compliance in terms of the time and money required and bearing in mind that offshore holding structures are of limited use in mitigating regulatory and or compliance risk, each investor in a round and their counsel must sufficiently diligence regulatory issues well enough (regardless of the stage of the portfolio company or the perceived sophistication of a lead investor in a financing round) and ahead of time, to accurately understand the exposure, if any and to put a portfolio company on the path of compliance, post-financing up on till exit.