NATIONAL INNOVATION SYSTEMS AND THE NIGERIAN CHALLENGE

 

The Need for Innovation

Developing nations with unique features like large market size and growth rate, access to regional markets and skilled/cheap labour, have a lot to offer. Asides serving as consumer nations and probably manufacturing centres due to relatively cheaper labour, the earnings of these nations would be greatly increased when they begin to add a certain level of originality to their products.

For such nations, their global competitiveness can be greatly increased when it is difficult to find alternatives for their products and services without violating proprietary rights. In many of Nigeria’s industrial sectors, finding originality would be the next step after achieving an effective manufacturing capacity and the firms that would solve this riddle would be the kings of the future.

The nation of India, for example, has achieved tremendous feats in becoming one of the manufacturing hubs of the world. She has, however, not particularly done well in the area of increasing home-grown innovation contribution. This shallowness would be the bane of developing nations that rely more on assembling and manufacturing (rent-seeking) led industrialisation without commensurate increase in innovative capacity.

This concern is justifiable because, though manufacturing and assembling is a great place to start as it opens up the nation to direct foreign investment, the demands for the product of such industries can change with changes in the technological, political and economic landscape. This was the case with some South Asian nations like Vietnam and Malaysia when the multinational companies moved to more promising India and China. The future of a nation’s economy is more assured when they’re the ones creating the products of the future and not just the place to mass produce them.

In this respect, Nigeria though far from achieving sufficient manufacturing and assembling capacity can create a system of innovation that could help her lead the future in a post-industrial knowledge based economy. One major likely advantage is that unlike India, China and other South Asian countries that built their economies around rent provision for Multi-National Companies, Nigeria may not suffer the inertia that such institutional paradigms creates. It could be easier to build a knowledge-based industry from the scratch than to transform a purely mass-production paradigm to an innovation hub.

Innovation, however, does not just come about. According to the founder of modern management, Peter F. Drucker, it is a product of a cold-eyed commitment to the source of innovation; it demands deliberate inquiry and organisation.

What really is innovation?

Innovation is the means by which entrepreneurs either create

new wealth-producing resources or endow existing resources

with enhanced potential for creating wealth - Peter Drucker

Innovation is the profitable implementation of strategic creativity

- Elaine Dundon

National Innovation Systems

The term “National Innovation Systems” is used to describe the set of complex processes of interactions between private and public actor-institutions that are involved in the development, transmission, modification and commercialisation of new knowledge and technology within a nation. It is a process-based concept that seeks to evaluate the innovative capacity of a nation from the standpoint of the processes that lead to innovation.

The Innovation system approach is a deviation from the linear approach that evaluates inputs rather than processes and linkages. Before the concept of National Innovation Systems became common, a Nation like Nigeria could assess her commitment to developing new technologies and enterprise by measuring the amount of funds committed to research and development in both the public and private sector: the number of publications from her academic institution, the number of postgraduate qualifications and also by the amount and ease of access to R & D funding by the Industry.

The linear approach assumes that as long as researchers engage in research activities and government provide the right incentives that someday, the spark would happen. This has not been found to be true; experience has shown that the level of interaction between the actors plays a more important part. Like a chemical reaction, Innovation requires some raw materials to happen but catalysts are often required to reduce the barriers to change and ensure that useful outcomes emerge. Hence, the emphasis should be on the quality of the linkages and not just the quantity of inputs. Also, the demands for the outcomes of this chemical reaction should be sustained so as to ensure a self-sustaining reaction.

It is observed that certain localities happen to have a relatively higher level of innovative capacity. In these regions, nations or parts of a nation, the amount of inputs and the degree of interaction required for innovation to happen has been achieved and sustained. This is seen in the notable trend towards the creation of specialised knowledge centres near leading universities that are oriented towards research and development on particular technologies.

The Silicon Valley in California (near Stanford University and the University of California), a biotechnology cluster in the Boston area (near the Massachusetts Institute of Technology) and a communications cluster in New Jersey (near Princeton University and the former Bell Laboratories) are examples of such innovation-clusters in the United States of America.

In these clusters, we can say that a self-sustaining reaction has been achieved as high levels of technical collaboration, technology diffusion and personnel mobility within these sectors has contributed to the improved innovative capacity of enterprises in terms of products, patents and productivity.

Nigeria’s National Pharmaceutical Innovation System

Within the Nigerian Pharmaceutical Industry, for example, the actor-institutions include the pharmaceutical companies, academia, public pharmaceutical research institutions, clinical research centres, technology transfer offices, government, financial institutions, media, and knowledge management consultancy firms.

Fig. 1 Schematic Representation of National Innovation Systems

The concept of National Innovation Systems is based on the premise that provided there are sufficient inputs from the actor institutions like increase in Research and Development funding, increased access to finance, technology transfers and adequate government policy and regulation. The focus should be on aligning the interests of these actors and decreasing barriers that militate against such interactions.

These interactions could be in the form of industry-sponsored research collaborations, contracts, research industry forums and technology prizes.

An examination of the level and efficiency of the interaction between these actors would provide valuable insight on the state of the Nigerian Innovation System. The quantity and quality of the interactions between actor-institutions in this industry could be evaluated along these lines:

1.               Interactions among enterprises, primarily joint research activities and other technical collaborations.

2.               Interactions among enterprises, universities and public research institutes, including joint research, co-patenting, co-publications and more informal linkages.

3.               Diffusion of knowledge and technology to enterprises, including industry adoption rates for new technologies and diffusion through machinery and equipment; and

4.               Personnel mobility, focusing on the movement of technical personnel within and between the public and private sectors.

From my experience in the knowledge management Industry, the actor-institutions within the Nigerian pharmaceutical ecosystem have achieved a certain level of development sufficient to be active participants in sustainable innovative systems. The missing link, I believe, is the deliberate commitment to processes that ensure sufficient and effective interactions. This will demand conscious steps to remove the traditional barriers that impede these interactions.

In other industries, the actor institutions may not have been well developed and the development of such institutions is the first place to start. A major Industry of concern is the agricultural sector which is in dire need of innovative strategies. Besides the development of innovative products and processes, a major area that requires innovation is in management. The need for management innovation is very much needed across the actor-institutions to ensure quality linkages.

Areas for Innovation

The challenge is therefore three-fold:

a.      To create value (product and service innovation)

b.      To offer value (process innovation)

c.       To sustain the offering (management innovation)

Let’s consider a software developer who has completed a demo for an enterprise information system that would be of great help to a particular segment of the manufacturing industry. The software developer has succeeded in creating a solution. His work must have been helped by the things he learnt at the university (actor-institution). The strategy for offering that solution to the market in a way that assures maximum profitability for him is often of more significance than the solution itself. Assume that he would need additional financing (another actor) to be able to get his solution across to the market (as a company most likely) that needs his software. How can he negotiate to obtain this finance, reach his market and still maintain considerable ownership of the proceeds of his invention? The strategy that answers these questions is often an innovation in itself.

The processes that would help this innovator create, modify, own, transmit and sustain the provision of his innovation demands a lot of linkages across different institutions like: Academia, Private firms, Intellectual property offices, trademarks, financial institution (debt or equity) and the government who regulates the business arena.

Definitions

Product innovation is the development of new products or services with enhanced value or the addition of greater value to old products or services. Google, Facebook, iPod, iPad and BlackBerry are product innovations.

Process innovation is exemplified by Michael Dell’s direct sales marketing of computers, e-bay’s online sales of virtually everything and Apple’s iTunes application that sold single tracks rather than the conventional CD album. These firms did not develop new products or services; rather, they developed new and better processes for doing the same things.

Management innovation was what happened with the development of the Franchise system for business expansion. It is seen in the management style at Apple Computers. At Onel Consults Ltd, a business development consultancy firm in Nigeria, the management system is such that allows a horizontal leadership structure and an ownership structure for employees.

Venture financing and public limited liability companies are more or less a system of management innovation.

The challenge therefore is to allow each actor to understand their roles within this system and maximise their contribution by achieving effective interaction.

WHY NATIONAL INNOVATION SYSTEMS?

Some of the many reasons for this overwhelming need for such relationships include:

1.      The application of knowledge is the value expanding factor for all resources.

2.      Global competitiveness and mass scale production has placed a huge demand for greater productiveness.

3.      Economic activities have become increasingly knowledge-intensive.

4.      In today’s world, the determinants of success of enterprises, and of national economies as a whole, are  increasingly  more  dependent  on  their effectiveness  in  gathering  and  utilising knowledge  – whether they be in the private sector, public  sector or academia. 

5.      Knowledge is domiciled in people, proprietary documents and institutional systems.

6.      The increasing cost of developing new products and services requires effective collaboration.

Given the relatively different paradigms that exists within the industry, government, research institution and the myriad of other concerns that relate to intellectual property management; actor-institutions that promote interaction within the national innovation system would have a great role to play in achieving a sustainable innovation system within the Nigerian industrial sectors.

As shown above, at the heart of the National Innovation System is the innovative firm which must find within the myriad of actors; processes and strategies that would result in the profitable development of new products and services. The role of the government would be to stimulate greater inputs across the participating actor-institutions and reduce barriers to interaction.

The Nigerian Science, Technology and Innovation Policy document that was released of late has these words as the statement of commitment from the president, Goodluck Ebele Jonathan.

”We are going to run our economy based on Science and Technology….because there is nowhere in this World now that you can move your economy without science and technology. For the next 4 years we will emphasize so much on S&T because we have no choice, without that we are just dreaming….”

The President is very much correct; towing the path of innovation is no longer the characteristic high sounding ideals of beady eyed researchers or is it restricted to corporate vision statements hung on the wall to massage the ego of executives and perhaps impress shareholders. Driving innovation in today’s global knowledge economy is basically a question of survival.

For many Nigerian industries, it could decide who would be here ten years from now.

References

1.      Drucker, P.F. (2003). The Discipline of Innovation. In Best of HBR, The Innovative Enterprise, Harvard Business Review, EBSCO Publishing.

2.      Federal Republic of Nigeria, (2011). Science, Technology and Innovation (STI) Policy, September, 2011.

3.      Okwonna, N. (2012). The Heart and Art of Innovation, Onel Media Services, Lagos, Nigeria

4.      Organisation for Economic Co-Operation And Development. 1996. National Innovation Systems, 1996.

5.      Rajan, Y. S. (2012). ‘Shaping the National Innovation System - The Indian Perspective.’ The Global Innovation Index 2012, Chapter 7, p. 131-141

VENTURE FINANCING/RISK EQUITY FINANCING

CHAPTER 16

VENTURE FINANCING/RISK EQUITY FINANCING

In business we do need money to either start a new business, increase operations or buy out other shareholders or partners.

This money is always somewhere; either in our pockets or as depositors’ funds in the bank or loans/donations from friends and family, the other alternative is to find an individual or institutional investor.

The process of finding someone or an organization that will invest in your business in exchange for ownership in the firm is known as risk equity or venture financing.

Venture financing is not a loan. It is a kind of financing where the investor gets a share of the company in exchange for the sum invested. The purpose of which is to make a substantial rate of return to the investor within a reasonable period of time, typically three to five years.

WHAT VENTURE FINANCING IS NOT

Venture financing is therefore not:

·         A partnership: unlike partnership agreements, the instrument of ownership in a venture financed company is units of shares in an incorporated company.

·         Secured: there are no collaterals and hence no guarantee.

·         Time limited; there are no guarantees that the investment will be recouped within the projected time.

·         Certain: the investor shares the risk of the business.

·         Liquid: once invested, it is not easy to get the invested money out.

·         Suitable for core investment; it could be considered too risky.

You may be wondering, “Why would an investor want to go into venture financing?” The answer is found in the same reason why people go into business in the first place; to make profit. The investor is convinced of the possibility of good returns on investment.

Venture financing is simply a business man asking someone or an organization with deep pockets to come along for the ride with no guarantees. It is a leap of faith.

There are many reasons to believe that venture financing is the best viable option for developing businesses in Nigeria, some of which are:

1.      We are in a knowledge economy; knowledge products will define the face of the market of today and tomorrow.

2.      Knowledge products are relatively risky investments and debt financing is often risk averse.

3.      There are still tremendous opportunities in developing nations like Nigeria offering some of the highest rate of returns on investment compared to western nations.

4.      There are idle cash sitting around in deep pockets and in institutional facilities abroad and in Africa.

5.      Venture financing has worked tremendously in the West, generating 20% of American jobs.

In this book, the term venture financing will used to describe all forms of equity financing in unquoted businesses made by parties external to the original business for one or a combination of purposes which could be;

·         To initiate trading (Start up capital)

·         To change market position (Development capital)

·         To effect change of ownership (buy out or buy in capital) 

The term Venture capitalist (VC) will refer to individual or institutional investors.

The VC own shares in the invested company and could sit on the board as a non-executive or executive director.

Unquoted businesses are businesses not quoted on the stock market.

Sources of venture financing

1.      Business angels

2.      Business angel networks

3.      Venture capital funds

Business Angels

A business angel is an individual that invests a certain sum in a business in exchange for shares of the business, most times a business angel is well informed on the business in which he is investing and would want to take part in the day to day running of the business. Business angels on the average invest in the range of One to hundred million. They are usually wealthy professionals, business men and women, with years of experience.

Business Angel Networks

They are often referred to an Angel Networks. They are a group of business angels that pull funds for the purpose of venture financing, they could individually own specific units of shares in the company or own the shares as an organization, these networks could invest from a hundred million to a billion naira. Angel networks are usually formed between friends and close associates and may have specific investment preference or taste.

Venture Capital Fund

This is an organization whose sole business is to invest in venture businesses. They are institutional investors and represent wealthy clients, insurance and pension funds. These funds are managed by the venture management company which is usually structured as a corporation where the investors are limited partners and the fund managers (the venture management company) receive a management fee and a percentage of the profits made from the invested sums. The average rate is about 2-2.5% of invested sum and 20% of profit.

Venture capital funds are big figure investors and invest sums in the range of tens of billions.

BANKS AND VENTURE FINANCING

Someone would think: “why are banks not involved in venture financing?”

The Chukwuma Soludo- led Central bank of Nigeria initiated an equity scheme for small and medium scale enterprises. The aim was that banks would hold equity positions in businesses they invested in rather than the reliance on collaterals as the sole means for securing debt. The aim was to make the loan an equity contribution.

The failure of this system was because the current crop of banks was not designed to “venture.” Venture financing requires a much different investment culture, one that requires a closer relationship with businesses. The traditional banking system does not have this structure at the moment.

However, the successful bank of the future will participate actively in venture financing either directly or indirectly.

WHERE VENTURE CAPITALIST WILL NOT INVEST AND WHERE THEY INVEST

A venture capitalist (individual or organization) will not invest in:

            A sole business

            A husband and wife business

            Businesses with character issues

The reasons for the above are obvious. The nature of the investment demands a strong accountability structure and these are hard to find in sole proprietorships, husband and wife businesses or in businesses where the integrity of the management is in doubt. Venture capitalist normally invests in private limited liability companies.

Venture capitalist invest in businesses that offer a considerable rate of returns, considerable in this case implies at least 30-35% returns in the first year and a 100% returns on investment in the second year. He can, however, wait till the third year to get his money doubled.

This is the least that a venture capitalist expects.

The major types of businesses in which venture capitalists invest include:

·         Communication

·         Software businesses

·         Pharmaceuticals

·         Internet based businesses

·         Biotech

·         E-commerce

·         Leisure and Hotels

·         General retail

·         Engineering and Machinery

·         Support services

 KNOWLEDGE PRODUCTS

The times have changed, there is a shift in the predominant factor of production. Intellectual property is now the most important factor in generating greater value. This intellectual property is in the form of product, process or management innovation. It includes the knowledge of the management of finance and resources.

The first six businesses in the list above are smart-businesses. It is acknowledged that all industries are “smart” to the extent that they are, in some part, dependent on knowledge inputs. It is equally true that some industries, and parts of industries, are increasingly relying more on knowledge intensity than others. 

The sectors of an industry with the greater knowledge input like administration, research and development, marketing, advertorial and information technology are increasingly becoming the determinant factors of production and this is seen in the earnings of these sectors.

The agricultural industry can be smart too, take a look at the supermarket and evaluate the food items we spend the greater amount of money. They are the most processed products. The processes that generate these products are knowledge inputs. The same with every other thing we spend money on; a greater amount of our money goes to goods and services with the greater degree of knowledge input.

New businesses that major on this knowledge inputs are relatively risky. Imagine a young entrepreneur looking for money to finance a new “innovative” computer system or young men looking for plenty dollars to finance an online search engine. The former was Steve Jobs, the latter are the founders of Google. They found their finance from venture capitalists. The same happened with the expansion of Starbucks, the kings of Coffee. The relative risky nature of this knowledge industry and the large capital outlay often required makes start-up and expansion most convenient for venture financing rather than other forms of financing.

YOU MAY NOT NEED VENTURE FINANCING

Not every business needs venture financing and not every entrepreneur can handle the challenge of taking venture financing. There is an added scrutiny of a second party once venture financing is accepted. The business owner must learn accountability as he is no longer the sole owner of the business- it is like a termed-marriage.

It could be like sharing the bed with a superior, not everyone can handle this. It is, therefore important that this issue be evaluated before making the decision to take on venture financing as the entrepreneur would now have to consider the opinion of the board in which the investor could be a member. Some venture capitalist may decide not to take part in the day to day operations of the firm.

Apart from the issue of shared ownership, there is still the pressure to deliver. Though venture money is not debt financing. The investor still wants to make a whole lot of profit and could become impatient with time. The difference however is that the risk is shared by both parties and when the venture doesn’t yield as expected, most investors would utilize all the available legal provisions to recoup their investment or at least some of them. These should be expected and there are modalities spelt out for situations when the business would have to liquidate.

The good thing though is that the entrepreneur unlike in debt financing does not bear personal liability.

WHAT VENTURE CAPITALISTS LOOK OUT FOR

In his book, “Venture capital funding; a practical guide to raising finance”, Bloomfield highlighted the three M’s of venture financing which are;

·         Mathematics

·         Market

·         Management

The venture financing proposal should show these three and the exit strategy.

Mathematics

The mathematics of the proposal must be right i.e. the returns on investment. This is usually the first thing the investor looks at. How much is the returns and how fast? The ideal venture financing proposal should give at least a hundred percent return in the first two years and a potential of 300% to 600% returns in the third year.

Market

This is the “how” of the matter; how you hope to achieve these stunning figures? Note that a venture capitalist is not a novice to the business or he would not consider it. The idea and strategy has to sell sufficiently with him regardless of the appeal of the mathematics. It should show the market opportunity which must be wide enough. The ideal opportunity should not be limited to a very short window in time or restricted to a very narrow range of customers.

There should be some characteristic unique to the company that is seeking the investment; something known by marketers as the unique selling point.

Management

It takes individuals to grow a business and the reputation of these individuals is the most important thing in evaluating an investment opportunity. In writing a proposal to a venture capitalist, it is usually recommended that the resume of the managers be attached first.

The management ‘s record of achievement in the resume, the quality of the business plan and the management’s ability to explain the opportunity to an outsider are key indices that gives the investor an opinion of the management’s capacity to deliver. An investor will not commit money to a management whose integrity is in doubt regardless of the enticements of the mathematics.

THE EXIT STRATEGY

A venture capitalist will also be looking for a planned exit strategy worked out at the time of investment, this should be proposed in the proposal but the details will be negotiated together.

It will be very beneficial to work out the ideal exit strategy for potential investors before you seek funding. Investors will need to know when they can realize a return on investment so this is a crucial area of the proposal to get right.

Investors want a maximum return on initial investment and a well thought-out exit strategy provides them with the incentive to invest in your venture.

EXIT OPTIONS

In Nigeria, these options more likely occur as an exit strategy;

1.      Trade Acquisition

This involves selling the business venture to a buyer. This could be an individual or a company. Business venture that developed new pharmaceutical or technological products are often easily purchased by bigger firms with the ability to make the most of the innovation. Real estate developed with venture money can be sold and the investment recouped easily.

This type of exit route is popular with investor.  A savvy entrepreneur could build a business with a clear vision that in say 3 years they wish to be acquired by a particular company within their niche. This approach has been greatly used in the biotechnology industry where University Professors and PhDs start firms with venture money knowing full well that should they develop their products before they run out of venture financing, they won’t be short of a buyer.

The bigger companies also fund such start-ups as investors with options of buying the entire outfit should the journey be successful. These businesses known as corporate venture companies provide the funding company with a reduced development cost, flexibility and innovation capacity of a smaller company without the normal bureaucratic bottlenecks.

This could be done with herbal medicine in Nigeria. A group of University researchers can develop an effective remedy and obtain the necessary intellectual protection. Limited by finance for clinical study in human subjects, they can incorporate a company and seek venture financing for the clinical trial (between ten to twenty million Naira ) knowing that if successful a much larger company would buy them out.

2.      Management Buy Out

The investor could be bought out using the proceeds of the business over time. This is often longer but implies that the entrepreneur utilizes his own share of the profits to buy out the ownership of the investor. We will discuss more on how this can happen in the deal structure. This is sometimes known as cash-flow settlements.

3.      Franchise

A franchise is another good way for an investor to cash out with a sizeable sum. It is an expansion drive that brings in other business players and could generate the money required for the investor to exit.

This would involve effectively running the business for a period of time. It entails fine tuning the processes, proving the business model and franchising the business concept for others to replicate. This is particularly successful for businesses with large scale growth potential. The food and catering industry, sporting and other service industries could utilize this form of exit strategy.

4.      Merger

This is similar to a trade acquisition but the entrepreneur still retains an interest in the business. The combined resources of the two businesses enable further growth and the entrepreneur and the new investor receive increased profits from the joint activities, the money realized from the merger is used to pay out the initial investor.

5.      Initial Public Offering

This is the rarest and most difficult of all exit strategies but often the most popular with Institutional Venture Capitalists. The advantage of floatation on the stock exchange is tremendous for both the Entrepreneur and Investor. Major shareholders usually maintain control of the company. The investor can release stake in the business for cash, and most importantly the returns can be very high indeed.

The disadvantages of IPO are numerous. The business must have phenomenal growth potential to receive IPO. It is also a very costly process with no guarantee of a positive outcome.

Globally, this approach is becoming increasingly less popular.

NEED FOR EXIT PLANNING

A well thought-out exit procedure increases investor confidence, and therefore, increases the chances of successfully raising the capital the entrepreneur requires.

It is advisable that one displays some favoured exit options in the proposal to potential investors. This shows that you’ve thought about the exit strategy and how the investor will cash out.

THE VENTURE FINANCING PROCESS

1.      Business /Expansion /Buyout Plan

2.      The “we need venture money” decision

3.      Preparation of the Venture Financing Proposal

4.      Initial approach to an Investor

5.      Preliminary Consideration and subsequent investigation by the investor

6.      Preliminary offer from the investor

7.      Discussion of terms by the applicant

8.      Acceptance of terms

9.      Due diligence by the investor

10.  Results of due diligence studies-preliminary offer confirmed or modified

11.  Terms approved and a Full Offer made

12.  Formal Acceptance of terms

13.  Legal Stages; to iron out terms and clauses

14.  New investor joins company (and probably board)

15.  We live happily ever after.

This can take three weeks to a year depending on how it is gone about; the rate determining steps are;

1.      Finding the investor who will take the deal

2.      Due diligence stage

3.      Legal Stages

WHERE TO FIND A VENTURE CAPITALIST

Business angels are everywhere, from our nuclear family to our extended family, to people at church or work. Recommendations from people that know you could make all the difference when looking for venture financing. The key is to keep the process very formal, legal and reasonable.

Be sure the 3M’s are compelling enough and your figures are realistic. If what you are offering is good enough and you are willing to share ownership, the chances are that you will always find investors.

There are many serial business investors who are constantly looking out for specific kinds of investments. I see the growth of this industry in the near future where wealthy informed individuals would attend investment clubs where new businesses are presented and evaluated for possible investment.

Such investment clubs were frequently used to raise money for investments on the stock market, with the crash of the stock market and the demise of stock market investment clubs, risk equity investment will emerge as better alternatives for investors with cash to spare.

These investors have preferences. Individuals prefer to invest in businesses they understand. This should be borne in mind when looking for a venture capitalist.

Factors that influence the investor includes:

The purpose of financing: for a start up, a business angel is generally preferred. Institutional investors could be more preferable for more bulkier and complex financing projects utilized for business expansions, management buyouts or even for preparation for an initial public offer.

The amount of financing required: there is a limit to the amount of money an individual would want to put in a single investment, institutional investors have the advantage of having several investment options and so can “hedge their bets” by investing in multiple ventures, they also have the capacity to do an effective due diligence for billion naira investments.

           

The Field of Investment: Most venture capitalists have preference for certain kinds of investment and certain industries, this preference reflect the peculiar competence of the business angel or the venture managers. The entrepreneur need to do the necessary due diligence to ascertain the investment “taste” of the potential investor.

The following should be considered in selecting an investor:

1.      Select a funder who has some experience in the sector you are working in and would have a healthy respect for your project.

2.      Select someone who at least believes that your mathematics is achievable.

3.      If you anticipate further rounds of funding, it would be best to select someone who

can either supply this or will take a constructive attitude to having his investment diluted.

4.      Ensure that there is a degree of personal empathy between you and the investor (or his representative).

5.      Be sure you understand from the outset the intentions and aspirations of the investor which will be different from yours.

6.      Make sure that you are both clear as to the timing of any eventual exit and the

need for an opportunistic attitude to realization before the initial target date.

7.        Make sure that the legal agreement stipulates the degree of control and the manner in which the investor can interfere in the day to day running of the business.

WHAT A PROPOSAL SHOULD CONTAIN

·         The Curriculum vitae of management

·         The Business plan containing the 3M’s

·         An idea of the Exit Strategy (ies)

STRUCTURING THE DEAL

Let’s assume you’ve found an investor and he likes your M’s. The next challenge is how to structure the deal. It is always good you have a good idea of what your business is worth and the degree of ownership you are willing to share.

You will however need to be flexible as it is quite unlikely that your valuation of your business and that of the venture capitalist will be the same. Valuation is not a precise science, it is only normal that two parties will see the same things differently.

Also take into consideration the fact that you may need additional funding as the investor may not want his shares diluted by an additional round of financing. This may require you leave a  “headroom” for this additional financing.

You would need the help of advisors: legal, accountant and a risk equity/venture financing consultant. Note, however, that these are to help you package the deal and not to do the packaging for you. Having professionals help along the way could also increase the likelihood that the potential investor would favor the deal as the assumption is that an expert has taken a good look at it and must have addressed their concerns.

The onus however is still on the entrepreneur to present and negotiate this deal with the investor. A lot is learnt along the way. As both parties interact, they learn about each other and the information garnered will go a long way to determine how the business will eventually thrive. The investor will try to learn the most about the management at this time and their attitude to money. Since trust is essential, one must maintain candor.

The degree of effort and the complexity that will go into this deal structure depends on the investment sophistry of the potential investor and the structure of the enterprise. A business angel would generally prefer a simple deal structure; a percentage of the company in ordinary shares, institutional investors would opt for more complex structures.

Ideally, investors would want to own about 30 - 40% of the business as they do not want to become owners of the business. The use of preference shares by venture funds allow them to provide the required amount of cash without owing the business out rightly. The use of preferred shares could allow an investor to contribute about 70% of the required sum and maintain about 30% ownership.

What are preferred Shares?

Let’s go back to the drawing board to evaluate financial instruments.

The simplest of all financial instruments is the loan. You are lent money and you pay back at the end of a fixed period of time with the accruing interest paid all the while. Loan does not command an ownership structure and VCs will leave this arena for the banks.

Next is the ordinary share. They command rights of ownership and are permanent. Ordinary shares live as long as the business does, they can be increased but not decreased. They are the ideal instruments for funding young businesses and this is what most business angels would ask for as they are not complicated.

When more funding is required, more ordinary shares could be added thereby diluting the voting power of existing shareholders, an investor could ask for an “anti-dilution” clause in the article of association to prevent this from happening. As said earlier, the need for future financing should be considered in the deal structure and the terms spelt out.

 Ordinary shares have a right to vote at meetings of shareholders though this right will be determined by terms set out in the company’s articles of association.

Next are the preferred ordinary shares also known as preferred shares which are generally preferred by institutional investors as it is entitled to a slice of the distributable profits before ordinary shares. It is “preferred” in the ranking of entitlement to dividend. Voting right may or may not be the same depending on what the article of association says.

Characters of Preferred ordinary shares

1.      They often do not have voting rights: this is to ensure management control as the main use of preferred shares is to get finance without reducing management control or ownership.

2.      They could earn fixed interest over time: these are called participating preferred ordinary shares (PPO), also known as participating ordinary. They get a fixed percentage of the distributable profit. E.g. a 5 percent PPO gets 5% of the distributable profits. Mainly used by an institutional investor, it is used to give the investor some fixed returns regardless of how the business fares, as long as there are profits. A deal could contain these to give certain fixed returns to an investor. This instrument is not commonly used.

3.      The dividend could be cumulative; so we can have Cumulative participating preferred ordinaries (CPPO) This implies that a dividend not paid for a particular financial season will be paid in the next once the money is available. This is still to ensure earnings for an investor.

These two forms are not very common in financing venture deals.

4.      Preferred shares could be Callable or Redeemable; redeemable shares are a bit like loans but unlike loans there are no guarantees. These Redeemable Preferred shares have a predetermined value (par value) at which the issuing company (venture financed firm) can call them back. E.g. a million unit of shares at 5Naira each could be given   per value of 8Naira (60% ROI profit) on or before one year of investment.  This implies that the company can payout this investment even before the maturity date.

Since the number of units of a company share cannot be reduced, redeemable shares are redeemed either from distributable reserves or from a fresh issue of shares.

Redeemable shares have the advantage that it motivates the entrepreneur to perform and pay back quickly for greater ownership while increasing the speed of returns for the investor.

The disadvantage is that the investor will not get all the profits if the business outperforms this 60% returns.

Most deals involve the combination of these shares; ordinaries and preferred.

5.      Preferred shares can be convertible; this convertible is often a one way road and can occur at a predetermined event stipulated in the article of association such as the failure to redeem at a particular time or when management is perceived to be inefficient.

An investor can use this convertibility to convert his preferred shares to ordinary shares thereby giving him the voting rights required to influence management decisions. This usually is the structure reserved for scenarios where things do not go as planned.

So, one can have:

Convertible Participating Preferred Ordinary shares (CPPOs) or Redeemable Convertible

Participating Preferred Ordinary shares (RCPPOs) or even Cumulative Redeemable Convertible Participating Preferred Ordinary shares (CRCPPOs).

There is no limit to the combination of characters. A preferred share can have and these are stipulated in the article of association.

NEED FOR THIS STRUCTURING

The variations in deal structure allows for the following:

·         An investor can incentivize the entrepreneur by using redeemable shares as good performance is rewarded with greater ownership while he enjoys a quick returns on the investment.

·         Reduce the risk of an investment having a faster return in time; if all the shares are ordinary shares, the investor cannot enjoy the fixed redeemable option.

·         Allow for further financing as the redeemable shares can be treated as a loan, thus fresh equity can be issued without diluting the investment.

·         The use of convertibles can be used to increase the control of the investor should things go wrong; by converting the shares to ordinaries he can swamp the board and take over management.

A CASE STUDY

Remember the young man we mentioned earlier that needed four million naira to launch his business but had only two hundred thousand naira.

There are two ways to maintain ownership and still get the funds he needs provided the investor is convinced of his 3Ms.

Assuming the conviction on both sides is that this business should with a four million naira make a ten million naira profit in two years; our options could go like this:

1.      To take a percentage of his salary and convert the rest to an equity contribution.

2.      To use redeemable shares

He can incorporate his company as a private limited liability company and create 2,000,000 (two million) units of shares.

Assuming he has judged his sweat equity to be worth 1.8million naira (part of his salary for the next eighteen months and the intellectual property), he can offer 800,000 units of this company as ordinary shares at 3Naira each to the investor (totaling N2,400,000) and another 600,000 units as Redeemable Preferred Ordinary Shares at N4 (totaling N1.8million) at a par value of N6 redeemable in eighteen months.

This implies that he has raised N4,200,000 for his business and the business will pay off the redeemable shares in eighteen months at N 6 each (N3,600,000).

The remaining 600,000units of shares (worth 1,800,000) retained by the entrepreneur is adjudged sweat equity and includes the worth of his time (including a part of his salary for eighteen months) and the intellectual property.

The entrepreneur is motivated to make money and pay this three million six hundred thousand naira so that he can retain 60% of the business. Meanwhile the investor has recouped almost all his investment in eighteen months while maintaining 40% interest in a business that should be worth about ten million in two years.

This is how facebook was funded.

The entrepreneur could also use any of the exit options outlined earlier.

NOTES

The redeemable shares could be seen as loan yielding a hundred percent returns in eighteen months, unlike a conventional loan however there are no guarantees and a clause in the investment agreement could state that “in the event that the business is unable to ‘call back’ or ‘redeem’ the shares in eighteen months, another window would emerge at the 24^th month and should the business fail again to redeem these shares they would be converted to ordinary shares”. These would give the investor the controlling ownership right of the firm.

Instead of N3, the redeemable shares could also be offered at N4 and could be offered to a different investor different from the VC that obtained the ordinary shares.

An entrepreneur should not be afraid of these seeming “complexity” as they help to assure the interests of all parties.

The use of ordinaries alone might appear simple and straightforward but with increasingly large investments, preferred shares should be used to avoid complete loss of ownership. Imagine looking for three hundred million to expand a ten million naira business. How much ownership should the entrepreneur maintain? Preferred shares allow the entrepreneur maximize ownership on good performance.

Business angels could prefer to own ordinary shares of the company as they may not have the expertise or stomach for the legal fees that such complexity may require.

However, the ideal deal structure that has ordinary shares representing the amount of ownership the investor intends to end up with and some redeemable preferred shares  (more of a loan equity) is a good arrangement to finance the average deal.

|LOCAL PECULIARITIES

There is a very poor management culture in the Nigerian and African Scenario. This is due to the low level of corporate governance in many businesses. The greater majority of businesses, even very successful ones are still run as family- mum and dad affairs. This creates a general lack of supply of good managers. The good ones are the MBAs from prestigious universities who would rather take a great job than start a business.

This is not to say that there are no great managers but rather that we don’t have the managerial culture and there is a near absence of good corporate structure that allows for accountability.

This deficiency would tilt venture financing towards financing very large deals with firms that have accountable structures in place. However, the average knowledge product may not be found in such established firms. Thus, the need for a venture management company or an angel network to create systems that can allow for a relatively safer investment and also for potential entrepreneurs to understand the rudiments of management.

Investing parties could establish structures like:

CONTROLLING ACCOUNTS

Rather than trust that the entrepreneur would make all the best decisions and be accountable, it is be best to have a central accounting structure that handles the accounts of the businesses in which the network or venture management firm has made investments.

This structure should not be made to stifle the relationship, there should be a mutual agreement on how and when funds should be released and established project goals for each round of financing. The investment agreement should also stipulate the reporting responsibilities of the management to the investor. If the investor or his representative is on the board of directors, the article of association will stipulate the frequency of meetings.

The investment agreement could also stipulate the limits of cash transaction for which the authorization of the investor must be sought.

These are to handle the prevailing poor accountability and regulatory culture and avoid a situation where an entrepreneur can disappear with the funds.

OTHER ISSUES IN VENTURE FINANCING

·         Before looking for investors, the firm should develop a proper management team which should be complete and adequate.

·         The management members should hold stock. This could be in exchange for sweat equity contributions, intellectual property or cash. A firm can start with management taking 40% of the normal pay in exchange for shares of the company.

·         In the event of death or disability of the key-individual, the legal agreements should stipulate the next person to take over the business.

·         This key individual could be made to take a life insurance policy.

·         Management members could be made to forfeit their shares or part of their shares should they die or leave the firm before a stipulated time (say eighteen months) This is particularly when sweat equity is the contribution.

·         There should be legal stipulations for sacking a director; whether to enforce a total loss of ownership or compulsion to sell at a fixed amount before a particular time. The conventional is that before eighteen months, monetary contributions should be bought out by the firm at a predetermined rate; shares to accrue from sweat equity will be lost.

THE LEGAL ANGLE

             From the above, it is obvious that there are a lot of legal angle to be handled:

·         Structuring of the deal

·         Writing the article of association and the relevant clauses

·         Drawing the investment agreement

·         Intellectual property right issues

·         Management agreements

·         Issuing of share certificates

It is wise then that a competent lawyer and an investment accountant be used for these finer details and the cost of these services should be built into the amount needed for the business ab initio.

APPLICATIONS

With this knowledge, I think the unemployed youths in Nigeria should rather than keep looking for non -existent jobs or for soft loans from individuals, create structures that allow for equitable investments from third parties.

They need to demonstrate:

·         Right Mathematics

·         Right Market

·         Right Management

·         Mutual understanding with the investor

·         Willingness to share ownership

For such teams or firms, the management can take very little salaries and the difference from the standard salary converted into equity.

On the average, a good idea with the right management can get a good entrepreneur the following;

·         30-40% ownership with a buy back option (via redeemable instruments).

·         Salary; regular income though small

·         Control of your own business in which you can live your dream

·         An opportunity to deliver

The good thing about venture financing is that once you deliver on your numbers, you will never lack for investors.

All the best!

CHAPTER 17

|SIDE BITE

THE NIGERIAN OPPORTUNITY

In his book “Business Stripped Bare”, English billionaire businessman, Richard Branson states; “if you want to see entrepreneurs go to Africa, go to Nigeria and see the spirit of entrepreneurship”. He went further to say that there were just too many opportunities here.

Mr. Branson couldn’t be closer to the truth, the opportunities here are so immense. Every obstacle to good business endeavour in Nigeria I have found out is of itself a good business endeavour! If we lose our selfishness and employ more of patriotism and patience we would reap great fortunes from such “obstacles”.

Consultants Needed: The Joseph Strategy

Though the term “consultant” is broad, here I refer to an individual that could understand a problem of another individual, group, organization, industry or state, identify a solution and fashion out strategic objective solutions to the problem. He is the prime business man, an Innovator. He must also have the ability to execute his proposals.

These groups of individuals are really lacking and their largest clients (perhaps unwilling) are policy/decision makers in public/private organizations. The consultant must be proactive; the magnitude of Nigeria’s problem cannot stand a dogged assault from well meaning inspired Judaic Consultants. By “Judaic”, I mean men and women with the Spirit of God in them. They are the Daniels of our time, men from Judah.

It is the Joseph strategy; it is not enough to interpret the kings’ dream, make him a proposal!

Who said you’ve to be a Pharaoh or a Nebuchadnezzar to govern an empire, just be relevant and therein is your own fortune and better you’ll save a nation! Bottom line; write a proposal and if you must, present it for free. If Pharoah wants it then you’ve got your first client. If the problem is large enough, you might need an office space, internet connection, some staff and some allowance to tackle the challenge.

Not to talk of the fact that you can structure a venture financing arrangement or a percentage of revenue/profit option for your managerial acumen.

It is not a coaster ride however and has never been, but it’s much better than complaining and imprisonment.

 THE TIPPING POINT.

For Nigeria to achieve rapid economic growth we must reposition ourselves for the tipping points. For every generation and industry there are always tipping points that churn out the new phase of billionaires and mega economies.

These economies are built on the shoulders/strengths of previous ones (that is why Asia could emerge as a world power in 25years). The Fords, Bill Gates, Bransons, Rockefellers, Dangotes and Adetola’s are products of particular tipping points. No age would last forever (though the money might and could be used to enter the next tipping point) and history has shown that the entry requirement for the next entry is not cash but service.

There is no technology that we really need that Nigeria cannot afford (never forget that) Entrepreneurs must be able to identify the next “age” in every industry and position themselves for the flow. With or without you, things will definitely shift and with it a new phase of billionaires, significance and economies.

Nigeria can lose her timidity and inferiority complex and boldly enter the new realm of telecommunication, postal delivery, banking, technology etc.

It is plain that there is a lot of space out there; there are no movements that are moving ahead rather there are individuals that are moving ahead.

Nigeria is an individual, she can be you or you can let the cap pass (or the headtie!).