Venture capital (VC) investments play a major role in fostering innovation, supporting entrepreneurs, and driving economic growth globally. However, despite the burgeoning potential within Nigeria’s emerging startup and technology ecosystem, only five venture capital fund managers are officially registered with the Securities and Exchange Commission (SEC or the Commission) in Nigeria[1].
This article examines the factors contributing to the limited presence of Nigerian-registered venture capital firms and fund managers, with a specific focus on regulatory perspectives (while recognizing that other factors could contribute to such scarcity[2]). It examines the regulatory factors contributing to this low turnout and the sluggish pace of fund formation in Nigeria. Is the regulatory framework in the Nigerian VC sector genuinely conducive and attractive to potential investors in the industry?
Current Regulatory Landscape of Nigeria’s VC Industry
Different laws and regulations govern the operations of venture capital funds in Nigeria, including, inter alia, the Companies and Allied Matters Act, 2020 (as amended) (CAMA), the Venture Capital Incentive Act, the recently enacted Nigerian Startup Act, etc. However, this article focuses on examining the regulatory landscape of the Nigerian venture capital industry from the perspective of the SEC according to the Investment and Securities Act, 2007 (ISA)[3] and the other extant rules and regulations issued by the SEC.
To start with, under Section 13(h) of the ISA, one of the numerous functions and powers of the Commission is to “register and regulate the workings of venture capital funds and collective investment schemes in whatever form.”[4] This clause presupposes that venture capital funds (in whatever form) are subject to the registration and regulatory oversight of the SEC. Accordingly, the Commission has issued different rules, regulations, and guidelines applicable to the operations of the venture capital industry in Nigeria, with the unequivocal implication that the SEC regulates the venture capital market at three core levels,; (a) the venture capital fund; (b) the issue/securities by the venture capital fund; and (c) the venture capital fund manager. The article explores the relevant regulatory framework applicable to each of these categories.
Regulation at the Fund Level
Further to Section 13(h) of the ISA, the Commission issued Sections 555 and 556 of the Consolidated Securities and Exchange Commission Rule 2013 (the SEC Rules), which primarily regulate the operations of venture capital funds and venture capital fund managers. Specifically, Section 555 sets out the “[r]equirements for authorization” of a venture capital fund including the filing of an application for authorization of the fund by the ‘manager’ on the prescribed form accompanied by numerous documentary requirements including but not limited to two (2) copies of the draft prospectus, letters of consents from the prospective parties to the venture capital scheme, two (2) copies of the partnership agreement between fund providers and venture capitalist (in the case of classic venture capitalist[5]), detailed information about the fund provider, copy of the certificate of incorporation of manager of the venture capital fund, payment of filing fees, compliance with the minimum capital requirements, etc.[6]
The combined effect of Section 13(h) of the ISA and Sections 555 and 556 of the SEC Rules is that (without any exception or exemption), any entity that desires to operate a venture capital fund in Nigeria must register with the SEC as a venture capital fund and fulfill every stringent requirement in the SEC Rules and applicable laws. This strict requirement is not consistent with leading venture capital industries in other jurisdictions, for example, the U.S., which this article further explores.
Regulation at the Venture Capital Manager Level
Section 38(1)(a) & (b) of the ISA provides that: “[n]o persons shall – (a) operate in the Nigerian capital market as an expert or professional or in any other capacity as may be determined by the Commission, or (b) carry on investments and securities business unless the person is registered in accordance with this Act and the rules and regulations made thereunder.” Further to this, Section 45 (1) & (2) of the SEC Rules provides that fund/portfolio managers are capital market operators and are subject to the registration requirements imposed by SEC.
Therefore, considering that according to Sections 555(1) of the SEC Rules, only ‘managers’ are permitted to apply to register a venture capital fund, the position of the law is that venture capital fund managers must register with the Commission. This requirement is also reflected in the documentary requirements (for registering a venture capital fund) set out in Sections 555 & 556 of the SEC Rules. For instance, the venture capital fund manager is also required (as part of the application for the registration of the fund) to submit its certificate of incorporation including its memorandum and articles of association with a provision authorizing the company to manage funds. The SEC has also issued a Form SEC 3B applicable to the registration of venture capital managers which also sets out additional documentary requirements imposed on such managers[7].
Accordingly, and in compliance with this requirement (without any exception and exemption), venture capital fund managers are required to register with the SEC in addition to registering the venture capital fund with the SEC. Similar to the strict requirements imposed on venture capital funds, these registration requirements are not reflective of modern market practices.
Regulation of the Issue/Securities
In addition to the regulation of the venture capital fund, and the fund manager, the SEC also regulates the means through which the securities of a venture capital fund may be issued. The starting point is Section 555 of the SEC Rules which requires a venture capital fund applicant to submit two copies of the draft prospectus to the SEC (among other requirements) (as part of the registration process of the VC fund). Section 556 of the SEC Rules further sets out the content of such prospectus including inter alia, summary of the issue (including key performance forecast), the placement offer, directors and parties to the issue, the name and every detail about the “Super Deal”[8], procedure for application and allotment, draft copy of introduction materials and names of the prospective investors (which cannot be more than 25 in number (in other words, prospective investors in a venture capital fund registered with the SEC cannot be more than 25 investors), etc.
The implication of the foregoing is that the SEC expects a venture capital fund to also register its prospectus with the SEC as part of the registration process of the fund. This requirement is contained on the face of the application form that the applicant venture capital fund would submit to the SEC i.e. Form SEC 6A (which refers to Sections 282 & 283 of the SEC Rules).
A further review of Section 282 of the SEC Rules reveals that it is unlawful “for any person to offer for sale or to buy or sell securities which are subject to the provisions of the [ISA] or these rules and regulations . . . ” Section 283 of the SEC Rules however provides different exceptions to Section 282 including that a notice given by an issuer concerning a public sale of securities will not be deemed to be an offer of securities for sale if such notice states that the offering will only be made utilizing a prospectus. The foregoing (read together with Sections 555 and 556 of the SEC Rules) also provides additional justification for the submission of a prospectus during the registration process of the venture capital fund.
Similar to the restrictions applicable to the fund and the fund manager, in the absence of a safe harbor/exemption, an applicant venture capital fund must meet the further stringent requirement of preparing and filing a prospectus in addition to the other documentary requirements.
A recurring theme in the analysis of the various regulations applicable to the venture capital fund capital industry is that the regulations are inherently complex, archaic, inhibitive, and strict. It is a clear case of over-regulation and an unnecessary bottleneck in a country struggling to grow its local venture capital industry. This problem is however not unique to the venture capital industry, as Nigeria’s SEC unlike its counterparts in other jurisdictions has always adopted a “regulate-first” approach to products and services the Commission perceives to be under its ‘control.’ This is not the model adopted in sophisticated economies where securities regulators often “regulate by enforcement.” Another important theme is also that the law has not evolved and is not reflective of current market realities; without doubt, raising capital in foreign currency has become significantly expensive for Nigerian technology companies (especially in the face of uncontrollable loss of value for the Nigerian currency)[9], thus, one would ordinarily expect regulators such as the SEC to think of ingenious ways to grow participation in the local VC industry by reducing the barrier to entry in the market which could potentially make it cheaper for local startups to raise funds and ultimately grow. Without saying more, the current regulatory regime in Nigeria is primarily anti-innovation, as it is strange to the idea of nimbleness one would expect to see. The counter-arguments to a free/flexible market would include the financial risk from opening up the market, etc. and the adequate response would be that the call is not for a total lack of regulation but for an alternative regulatory approach that reflects the current market realities and supports the growth of the industry at large.
Based on the foregoing, the sections below consider some of the better alternatives to regulating the venture capital industry, particularly in the US which attracts the most VC investments in the world[10].
Lessons from the US Venture Capital Regulatory Landscape
The US venture capital regulatory landscape has fewer similarities with Nigeria’s; the central regulatory theme in the US (for the venture capital industry) is one of exemption/safe harbors as opposed to stringent regulations. Specifically, the only similarity with Nigeria’s regulatory landscape is that the US regulations also apply at three levels; to the fund, the fund manager (the management company), and the securities; nonetheless, the US laws also provide different exemptions/exceptions that can be leveraged by market participants.
Starting with the management company (which arguably is the equivalent of the ‘manager’ in Nigeria); Section 202(a)(11) of the Investment Advisers Act (1940) (Advisers Act) defines an “investment adviser” as any person that makes investment recommendations, or provides analysis or reports concerning the advisability of investing in securities in return for compensation, and is in the business of providing such services.[11] Therefore and following (Section 203(a)), every individual or entity that qualifies as an “investment adviser” under the Act is required to register with the U.S. SEC. These entities are referred to as “Registered Investment Advisers” (RIA). However, the Act offers exemptions from the prohibition applicable to investment advisers; such investment advisers are said to be “exempt from registration” because they need not register with the SEC to avoid violating the prohibition (in Section 203(a)). This analysis focuses on two exemption regimes under the Act, namely, the Venture Capital Fund and the Private Fund exemptions (together the Exempt Reporting Advisers (ERA)).
Section 203(L) provides an exemption from SEC registration for investment advisers that solely advise venture capital funds. To qualify as a venture capital fund, a fund generally cannot:
- Permit shareholder redemptions (except in extraordinary circumstances);
- Incur leverage over 15%
- Invest less than 80% of its committee capital in the stock of qualifying portfolio companies and short-term investments.
The fund must also represent itself to investors as following a ‘venture capital strategy’ and meet the definition of a private fund.
Also, Section 203(m) provides an exemption from SEC registration for investment advisers that solely advise “private funds” with aggregate assets of less than $150m. Section 202(a)(29) of the Advisers Act defines a “private fund” as an issuer that would be an investment company under Section 3 (15 USCS § 80a-3) of the Investment Company Act of 1940 (the “1940 Act”) but for the exclusions from the definition of “investment company” under Sections 3(c)(1) or 3(c)(7) of the 1940 Act.
The effect of the foregoing is simply that under the Advisers Act, management companies in the US can leverage the ERA exemptions in the Advisers Act to operate legally in the US without subjecting themselves to the extent and stringent regulatory requirements applicable to RIAs. This has significant implications including lesser filing requirements (in the Form ADV which must be filed with SEC), compared to entities registered as RIAs. ERAs are however still subject to ongoing reporting and compliance obligations with the SEC[12], but with this exemption regime, management companies may operate in the US without obtaining any “formal license” per se (as is the case in Nigeria).
Concerning the fund, the provisions of the Investment Company Act (ICA) are instructive; generally, venture capital funds are investment companies under the ICA unless the fund relies on one of the exclusions under the ICA. The ICA provides that any issuer that is or holds itself out as being engaged primarily in the business of investing, reinvesting, or trading in securities is an investment company[13]. Nonetheless, the ICA provides three exclusion regimes that might apply to venture capital funds namely; (a) Section 3(c)(1) exclusion; (b) Section 3(c)(1)(C)(i) exclusion; and (c) Section 3(c)(7) exclusion. Section 3(c)(1) exclusion permits a private investment fund from being an investment company if they have outstanding securities that are beneficially owned by not more than 100 persons and does not make a public offering of its securities. The foregoing was the only exemption available but it was limiting (as it only permitted 100 members) until the creation of Section 3(c)(7) exemption. Section 3(c)(7) excludes from being an investment company any issuer whose outstanding securities are owned exclusively by persons who (at the time of acquisition of such securities) are qualified purchasers; and does not make a public offering of its securities. The foregoing exclusions are often leveraged by venture capital funds and private equity funds in the US; thus, funds relying on Section 3(c)(1) or 3(c)(7) are collectively referred to as “Excluded Investment Companies”. There is also the qualifying venture capital fund exemption under Section 3(c)(1)(C)(i) of the ICA which also excludes from being an investment company, a qualifying venture capital fund provided that such fund would not have more than $10m in aggregate capital contributions and uncalled committed capital, will have no more than 250 beneficial owners and is not making and does not presently propose to make a public offering of its securities.
Therefore, a venture capital fund would qualify as an investment company under the ICA unless it relies on any of the exclusions provided above. The key takeaway for our analysis is that the US laws also permit venture capital funds to leverage exemptions in the ICA to avoid stringent registration requirements.
Lastly and concerning the securities, the general rule (is that all offers and sales of securities must be registered with the SEC (in the US) unless an exemption is available. Generally, fund managers do not want to register the offers and sales of interests in their funds, primarily because of the costs, the public disclosure obligations, and the ongoing compliance obligations that flow from registration. Thus, unlike in Nigeria where a venture capital fund is required to register a prospectus with the SEC during registration, fortunately, in the US, there is no such requirement to submit a prospectus with the SEC and there are several exemptions available to venture capital funds and private equity funds such that they need not register the offer or sale of their interests under the Securities Act. For instance, under Section 4(a)(2) of the Securities Act, the obligation to register the offer and sale of securities does not apply to transactions by an issuer not involving a public offering; this is also known as the private placement exemption. Such an offer must satisfy certain requirements including ensuring that the sale is only to not more than 35 sophisticated purchasers (but accredited investors and cohabiting spouses are excluded from this count of purchasers), and neither the fund nor any person acting on behalf of the fund may offer or sell interests in the fund by any form of general solicitation or general advertising. Also, a fund may leverage Regulation D (RegD) exemption/safe harbor, if the offer/sale of securities by an issuer meets Rule 506(b) or 506(c) requirements in the Securities Act, thus, such offer will not be considered a public offer under Section 4(a)(2) of the Act. Reg D (particularly 506(B) exemption) exemption is popular amongst venture funds in the US, as there is no limit to the amount that can be raised under this safe harbor, although, certain additional restrictions and tests apply.
In summary, the preceding analysis demonstrates that the VC regulations issued by the SEC in Nigeria are restrictive and unsuitable to engender the type of local participation the country requires at this critical time compared to other advanced economies such as the US.
Recommendations and Conclusion
As identified above, the over-regulation of the Nigerian VC industry, at the fund formation level, is one of the reasons many VC sponsors — both local and foreign — prefer to set up their funds in other jurisdictions that offer flexibility. While an argument may be made that the SEC’s traditional approach to regulation of the Nigerian VC industry is in the public interest, i.e., to protect investors from fraud, promote transparency, and reduce information asymmetry, the traditional method of regulation adopted by the SEC is not effective or efficient. The SEC can achieve the same public interest objectives more efficiently and effectively.
The goal of the SEC should be focused on opening up and creating opportunities within, the Nigerian “underdeveloped” VC sector, and an efficient way to begin is for the SEC to conduct a holistic review of the existing laws to create a better regulatory regime, perhaps through the creation of an exemption regime that will make the Nigerian VC market attractive to VC sponsors. Efficiency reduces costs of registration and compliance without impacting the set policy objectives of the regulator; in other words, the SEC can, through an alternative method of regulation, attract more market participants without compromising its public interest objectives of protecting investors.
As could be seen from the discussion above, an alternative approach to regulation — regulation by exemption — is being used, successfully, in the U.S., and Nigeria can borrow a leaf. Thus, the SEC is strongly recommended to adopt rules and regulations that will provide VC funds and VC fund managers an alternative option to the current compulsory registration requirements. Under this recommended approach, a two-level alternative regulation would apply: a general requirement for VC funds and VC fund managers intending to set up in Nigeria to register with the SEC; and an exemption from the general requirement if certain requirements or conditions are met.
At the funds level, the SEC may inter alia adopt rules that exempt funds from registering depending on:
- number of limited partners/investors a fund intends to have;
- whether interests/units/shares in a fund are held by qualified institutional and high-net-worth investors, i.e. the sophistication of the investors;
- the amount of capital committed by investors; and
- whether the fund seeks to invest in foreign portfolio companies.
At the management level, exemption requirements or conditions may inter alia include:
- the amount of assets under management;
- the limit and type of investments that could be made by a manager;
- offerings to private or public investors; and
- the sophistication of the investors.
The above are examples of the requirements that may be imposed by the SEC under a potential exemption regime. Any safe harbor requirements to be adopted by the SEC should not be overly burdensome, costly, or difficult to satisfy. In addition, the adoption of an exemption regime as an alternative method of regulation would not prevent the SEC from monitoring VCs and managers’ compliance with applicable securities law. VCs and managers would still be required to continue to submit reports or make returns to the SEC but only to the extent required by the SEC to protect investors.
In a world that has become increasingly competitive and where foreign investments have become a key driver for economic growth, the SEC’s goal should be aimed at using its regulatory power to make the Nigerian market competitive and attractive. Its extant traditional approach to regulating the Nigerian VC market does not make the sector competitive or attractive. The sector has a lot of trapped potential and opportunities, which may only be fully unlocked if the SEC adopts an alternative regulatory approach of providing exemptions within the Nigerian VC market. Given that the SEC has recently proposed a draft rule that would exempt private equity funds from registration requirements,[14] it should also extend a similar approach to VC funds and VC fund managers in Nigeria.
[1] See https://sec.gov.ng/cmos/- these include CAN Fund Manager Limited, Cowry Asset Management Ltd, FBNQuest Funds Ltd, Trium Limited, and Verod-Kepple Nigeria Partners Limited, according to the SEC’s official records. The available data on the SEC’s website only refers to venture capital fund managers, and it is unclear whether these fund managers are also registered with the SEC as venture capital funds (in compliance with extant regulatory requirements).
[2] Including but not limited to; choice of jurisdiction by sponsors, tax considerations, access to capital, ease of doing business, investors’ sophistication (especially with the technology and innovation industry), etc.
[3] The ISA is the primary legislation that sets out the roles and responsibilities of the Commission in Nigeria and inter alia dictates the regulatory landscape of the securities market in Nigeria including regulating market operators and security products.
[4] This is the only reference to “venture capital” in the entire ISA, thus, unlike some of the capital market operators (such as brokers, dealers, etc.), the ISA (without more) does not extensively provide the regulatory framework applicable to venture capital funds in Nigeria.
[5] Which is not defined in the SEC Rules.
[6] See Section 555 of the SEC Rules. Also see Form SEC 6A which further sets out additional information that the fund applicant must provide.
[7] These include inter alia the fund manager (entity) having a minimum of three (3) sponsored individuals, a minimum paid-up capital of NGN20m, evidence from the sponsored individuals of having the minimum of four years post-graduation experience to perform the ‘function’, police clearance for each Sponsored Individual (including a requirement to report at the SEC head office in Abuja or Lagos Zonal office) with two recent passport photographs to commence the process, etc.
[8] Described in the SEC Rules as projects of high potential with characteristics such as high profitability with great industrial dominance, e.g. electronic/information technology, a company led by an industry superstar, with proven entrepreneurial experience, etc.
[9] See https://www.reuters.com/markets/currencies/what-is-pushing-nigerian-naira-record-lows-2023-10-27/
[10] See https://dealroom.co/guides/global
[11] Note that the Advisers Act excludes certain individuals from the coverage of the “investment adviser” definition, with the implication that these persons are not considered investment advisers for purposes of the Act and do not require any registration. Some of the excluded persons include: certain publishers, banks, and bank holding companies; persons whose advice relates only to securities issued or guaranteed by the U.S. federal government; and family offices, lawyers, accountants, engineers, teachers, brokers, and dealers, provided in each case that the advisory services are solely incidental to the other profession and, in the case of brokers and dealers, are not specially compensated
[12] For instance, Sections 206(1) and (2) of the Advisers Act provide that it is unlawful for any investment adviser, whether an ERA or IRA, to use any device, scheme, or artifice to defraud a client or a prospective client. Investment advisers (including ERAs or RIAs) must also refrain from engaging in any transaction, practice, or course of business that operates as a fraud or deceit upon a client or prospective client.
[13] See 15 USCS S80a-3 – S3(a)(1)
[14] Proposed Amendment to Rules on Private Equity Funds, Exposure of New and Sundry Amendment to the Rules and Regulations of the Commission, 22 December 29, 2023.