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STARTUP FUNDRAISING – UNDERSTANDING THE ANTI-DILUTION PROVISION IN INVESTMENT AGREEMENTS

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By Seun Timi-Koleolu and Karo Isiorho

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In our previous article, we identified the various stages commonly adopted by Startups in raising funds. Each funding round would typically involve the issuance of shares by the Startup to investors for an injection of funds into the business. The implication of issuing fresh shares at every investment round is a possible dilution of the value of shares held by the founders and existing investors in the business.

In this article, we have set out below the mechanism that can be adopted to protect against excessive dilution.

How are shares granted to investors under Nigerian law? Under Nigerian law, shares can be granted to investors after a funding round through any of the following routes: (i) where shares have been fully allotted, either by a transfer of a portion of the shares currently held by shareholders to the investors; or by increasing the share capital and issuing fresh shares to the investors; (ii) where the share capital has not been fully allotted, by allotting the available portion to the investors; or by subdividing the share capital, increasing the number of shares in issue and decreasing the nominal value of the shares.

How does dilution occur? When shares are issued to new investors, the percentage of an existing investor or founder’s stake/shareholding in the Startup may decrease and in such an instance, a dilution of shares would be said to have occurred.

A practical example is as follows: Assuming an investor (“Investor A”) owns 100,000 shares in a Startup having 1,000,000 shares outstanding (i.e., shares held by existing shareholders) at $2 price per share, meaning Investor A has a $200,000 stake in the Startup valued at $2,000,000. He would therefore own 10% of the Startup. Where the Startup subsequently engages in a financing round and issues an additional 1,000,000 shares bringing the total outstanding shares to 2,000,000, at the same $2 value per share, Investor A would then hold a $200,000 stake in a $4,000,000 Startup and therefore his shareholding in the Startup would have been diluted to 5%.

Does Dilution reduce the value of shares held? A reduction in the percentage of shares held by an investor or founder in a Startup does not necessarily mean a reduction in the monetary value of the shares held by that investor. As a fresh injection of capital in the business may result in an increase in the valuation of the business and, therefore, an increase in the value of each share held in the business (e.g., 1 share previously worth $1 might be worth $5).

It is, however, possible for the business to be valued for less in new investment rounds so that new investors get more shares for less (“Down Round”), thereby diluting the value of shares held by existing investors.

How does dilution affect voting rights? An issue with dilution of shares is the effect it has on voting rights and controlling interests in the business (particularly for the founders). Under Nigerian company law, certain decisions require a special resolution, such as change of name, an alteration of the memorandum and articles of association, etc. must be by a special resolution passed by not less than 75% votes. Whilst decisions such as the removal of directors and appointment of auditors require at least 51% votes to be passed. Founders would typically want to maintain a sufficient number of shares in the business to enable them make key decisions for the business.

Are there provisions under Nigerian law to prevent involuntary dilution of shares? Under Nigerian company law, there are provisions that require founders to first offer their shares in the Startup to existing shareholders prior to offering such shares to new investors (this is, however subject to the Articles of Association and shareholders’ agreement). This ensures that the existing shareholders are made aware of subsequent funding rounds and can opt to invest in the business to protect their interests.

How can investors or founders contractually protect against dilution? Anti-dilution provisions are clauses included in an investment agreement or a financing document to protect founders and investors from the effect of dilution, particularly if shares are sold at a lower price during subsequent funding rounds. These provisions are capable of mitigating the effect of dilution on an existing investor or shareholder.

What are the types of Anti-dilution provisions?

There are various types of anti-dilution provisions typically included in investment agreements, some of which are discussed below.

A. Full Ratchet Provision

A full ratchet provision allows an existing investor to adjust the value of his shares purchased to the share price being offered to new investors at subsequent Down Rounds. Consequently, the existing investor may become entitled to additional shares and retain his ownership percentage in the Startup at no cost.

Using our example above, in the subsequent round of investment, let’s assume the shares being offered to new investors were offered at a lower price of $1 per share, (“Conversion Price”), where a full ratchet provision was included in Investor A’s investment agreement, his percentage holding in the Startup will not be diluted in the new round and rather than holding 100,000 shares, he would hold 200,000 shares in the Startup.

B. Weighted Average Provision

A weighted average provision allows an existing investor to adjust the value of his shares based on a formula stated in the agreement. A narrow based weighted average formula or a broad based weighted average formula may be adopted.  The broad based formula takes into account all shares previously issued by the Startup whilst the narrow based formula is limited to preferred or common shares issued.

When a weighted average formula is adopted, the existing investor would not be entitled to retain 100% of his ownership percentage in the Startup like the Full Ratchet provision above, rather the investor would be entitled to adjust his percentage holding in the Startup upwards to a percentage considered fair for both existing and new investors.

This anti-dilution provision is more common in practice because it is the compromise provision for all parties involved.

CONCLUSION:

Founders and investors should, however, be mindful of anti-dilution provisions as such provisions can give investors controlling rights in the Startup for a long period of time. Such long-term controlling rights may be a hurdle to future funding rounds and may also not align with the growth plan of the business. A way to mitigate the effect of an anti-dilution provision is by limiting its operation to a particular period or funding round. In addition, Startups should always ensure that they engage experts before signing investment agreements so as not to create future problems for the company.

 

[1] Dollar examples are only for explanatory purposes.

KEY PROVISIONS OF THE FINANCE BILL 2021

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By Aderonke Alex-Adedipe and Eustace Aroh 

Introduction

In line with the tradition of the current administration, the Finance Bill 2021 (the “Bill”) was recently presented before the legislature for passage into law. Similar to its predecessors, the Bill proposes to amend twelve federal statutes in furtherance of the government’s objectives to foster the growth of the economy, stimulate investment into Nigeria, and boost revenue generation. In this article, we highlighted some key provisions of the Bill.

Proposed Amendment to Companies Income Tax (CIT)

i. The Bill specifically introduces taxation for lotteries and betting companies. These companies will be under obligation to pay income tax on the profit earned from the business of lottery and gaming. To determine their profits, prizes of customers, contribution to the lottery trust fund, agent commissions, and regulatory levies among others will be considered as allowable deductions.

ii. The Bill also confers powers on the Federal Inland Revenue Service (FIRS) to assess foreign digital and technology-driven companies with significant economic presence in Nigeria and charge income tax based on their turnover attributable to their presence in Nigeria.

iii. Income accrued from exports of companies engaging in the upstream, midstream or downstream petroleum operations are no longer exempt from CIT. Therefore, such income is now classified as taxable under the CITA.

iv. Unit trusts are no longer required to pay the usual CIT. Rather, the withholding tax deducted from income generated by the unit trust shall be full and final tax liability due to the unit trust.

v.The minimum CIT of 0.25% (as opposed to 0.5%) for companies that have recorded a loss or no profit has been extended to the period between 1st January 2019 to 31st December 2021. However, the application is only available for two accounting periods (2019-2020 or 2020-2021).

Proposed Amendment to Companies Income Tax (CIT)

vi. The Bill proposes a 5% Capital Gains Tax (CGT) on the proceeds from the disposal of shares in a Nigerian company exceeding 500 million Naira. Nevertheless, where the proceeds (or a portion of the proceeds) are reinvested into any Nigerian company within the same year, the proceeds (or the portion of the proceeds) will be exempted from taxation.

Other Taxation

vii. The Bill proposes the removal of the 0.25% National Agency for Science and Engineering Infrastructure Levy paid annually by commercial companies with over 4 million naira turnover.

viii. The FIRS has also been charged with the task of implementing the provisions of the Nigeria Police Trust Fund (Establishment) Act, 2019. Consequently, the FIRS will be required to assess and collect 0.005% of the net profit of companies operating in Nigeria to be paid into the Nigeria Police Trust Fund.

Conclusion

In addition, the provisions of the Bill attempts to remedy some loopholes in the tax laws (such as appointing the FIRS as the collecting agency of the Nigeria Police Trust Fund) as well as providing obtainable advantages to doing business in Nigeria.

Nevertheless, the annual amendment to the tax laws has made the tax regulations complex by creating a labyrinth of provisions. This will create a herculean task for the FIRS as the agency required to implement these changes. These annual amendments also create confusion among taxpayers on what applies every financial year.

A FOREIGNER’S GUIDE TO ESTABLISHING A BUSINESS IN NIGERIA

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Aderonke Alex-Adedipe and Oghenekaro Faith Isiorho

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INTRODUCTION

As the most populous African nation, Nigeria continues to attract an increasing number of foreign investments annually. In 2020, the United Nations reported that Nigeria’s inflow of Foreign Direct investments (FDI) increased by 4.3% despite the outbreak of COVID-19. As the market expands, the government continually issues policies aimed at creating a conducive business environment. As a result of the existence of multiple regulations, however, a potential foreign investor may require some guidance in relation to establishing a business and navigating the Nigerian business environment.

 

In this article, we highlight some crucial considerations for foreigners seeking to do business in Nigeria.

 

  1. Company Registration

Generally, any individual or company registered outside Nigeria and having the intention of carrying on business in Nigeria must be registered at the Corporate Affairs Commission(“CAC”), except such company is exempt by law.[1]  The company is permitted to have 100% foreign shareholders except it operates in specific sectors such as oil and gas, aviation, domestic coastal carriage, etc, which require local ownership and control. A foreign entity must also have a minimum of two shareholders and two directors. Other requirements for registration may vary from one sector to another.

  1. Nigerian Investment Promotion Commission (NIPC) Registration:

The NIPC is empowered by the Federal Government to promote foreign investments in Nigeria. Every business with foreign participation is mandated to register with the commission and obtain a certificate of registration. To obtain a NIPC certificate the evidence of registration at the CAC is required.

  1. Business Permit

A business permit is issued by the Ministry of Interior in Nigeria. Every company with foreign participation in Nigeria is required to apply and secure the permit before commencing business activities. The process for the application has now been fully automated, thus registration can be made online.

  1. Tax Registration

It is important that after incorporation a registered company registers with the Federal Inland Revenue Service (FIRS) and obtains a Tax Identification Number (TIN). The TIN is often required to secure other licenses and operate a bank account. It is also necessary to register with the State Inland Revenue Service located in the state in Nigeria where it wishes to carry on business.

  1. Trademark Protection/Registration

 Companies that already have an existing trademark in their home countries are encouraged to register such trademarks in Nigeria to secure their usage by the company. A search must be conducted at the trademark registry to determine if the trademark is already in existence before registration will be approved or rejected.

Note that approval for trademark registration will not be granted where the trademark is already registered by another company unless permission or assignment of that trademark has been granted by that company.

  1. Operating a Bank Account

 A company will generally require capital to set up its business in Nigeria. Commercial banks in Nigeria are appointed by the Central Bank of Nigeria as authorized dealers for the purpose of importing foreign exchange and guaranteeing repatriation of foreign capital which may have been imported through a Commercial Bank. Commercial banks also play a crucial role in facilitating the importation of goods into the country.

Generally, the requirements for operating a bank account vary from one bank to another. Evidence of company registration, identities of a company’s directors, TIN of the company, proof of registered address, are however standard requirements.

  1. Sector-Specific Licensing

 A foreign company must enquire about the licenses required to do business in its proposed sector of operation.  Some sectors may have special licensing requirements which must be fulfilled by operators. For instance, a foreign company interested in the sale of cosmetics in Nigeria must first obtain a permit from the National Agency for Food and Drug Administration and Control; a company seeking to import and distribute electronics must obtain a certificate from the Standard Organisation of Nigeria (SON); also, a company that wishes to provide logistics services must be licensed by the Nigerian Postal Service (NIPOST).

  1. Advertising

 It is worthy of note that a license to operate may not always confer permission to advertise. A foreign company must ensure it obtains the requisite advertising permit before advertising to its consumers.[2]

CONCLUSION

It is advisable that a foreigner interested in doing business in Nigeria engages the services of a business lawyer who will offer transactional guidance specifically tailored to the sector which it seeks to operate.

 

 

[1] S. 80 of the Companies and Allied Matters Act 2020, exempts foreign companies engaged in specific individual loan projects on behalf of the donor country or international organization, export promotion activities or engineering consultants or technical experts engaged in individual-specific projects with the government or any of its agencies, from registration at the CAC.

[2] In Lagos state, the agency empowered to issue advertising licenses is the Lagos State Signage and Advertisement Agency (LASAA).

 

Regulation of Collective Investment Schemes (CIS) in Nigeria

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By Aderonke Alex-Adedipe and Omotola Abudu

  1. Introduction

Recent reports by the Securities and Exchange Commission (SEC) show that there has been an increase in the total net asset value of CIS in Nigeria, from N782.64 billion in May 2019, to N1.322 trillion in May 2020. This is a clear indication that despite the coronavirus pandemic, investments made via CIS have maintained their profit yield. In today’s newsletter, we provide a cursory overview of CIS in Nigeria.

  1. What is a CIS?

According to the Investment and Securities Act, a CIS is a scheme or a company which invites members of the public to invest money or other assets in a portfolio and share the risk and benefit of investment in proportion to their participatory interest in the portfolio of the scheme.  It is essentially a joint investment vehicle which allows investors to pool funds to invest in select securities, boost returns and minimize risk.

  1. What types of CIS are available in Nigeria?

Under Nigerian law, there are five recognised types of CIS. They are Unit Trust Scheme, Venture Capital Funds, Open-ended Investment Companies, Real Estate Investment Schemes and Specialized Funds, with the most common type being Unit Trust Scheme. A Unit Trust Scheme is a fund into which individual investors or subscribers contribute small sums of monies to form a pool and enable professional fund managers invest in money market instruments, shares and stocks on their behalf.

  1. How are Investors protected?

The provisions of the Securities and Exchange Commission 2013 Rules (“the Rules”) along with the recently released Amendment to Rules on Collective Investment Schemes 2019 (“the Amendment”) jointly ensure the protection of investors who wish to pool their funds into CIS and the accountability of fund managers. The Rules and the Amendment contain provisions which prevent self-dealing and ensure that interests of the investors are placed above those of the fund managers.

  1. Who are the relevant parties to a CIS?

For every CIS, there is a relationship between key parties, which promotes a strong level of accountability and clarity.

  1. The Unit Holder/Subscriber
  2. The Fund Manager
  3. The Trustee
  4. The Custodian
  5. The Registrar

6. Conclusion

While the SEC has gone through commendable lengths to ensure proper accountability and transparency of the parties involved in CIS, attention should also be placed on the actions of digital players who operate CIS related platforms, in order to regulate them and ensure due process is followed in the handling of customers funds .