The Nigerian startup ecosystem has experienced significant growth in recent years, driven by youth, increased internet usage, and a lively entrepreneurial culture[i]. The proportional distribution of shares between the owners, investors, as well as employees emerges as an important element for further development and raising necessary capital as these startups grow. Establishing prosperous startups and taking care of the way equity is divided among founders, investors, or employees can be very essential in ensuring that a company is growing sustainably and attracting the required capital.

As startups flourish, the distribution of equity among founders, investors, and employees becomes a critical factor in ensuring sustainable growth and attracting necessary capital.

THE LEGAL FRAMEWORK

The Nigerian legal environment for startups is shaped by various regulations and acts designed to foster innovation and entrepreneurship. Key among these are:

• The Nigeria Startup Act: This act was enacted in October 2022, The Act aims to create a conducive environment for startups through supportive policies and frameworks. The Act outlines provisions for the registration of startups, angel investors, venture capitalists, and other ecosystem players, thereby providing a structured pathway for startup operations.

• The Business Facilitation Act (BFA): The BFA enhances flexibility in managing patent rights and extends trademark protection to include services and branding elements[ii]. These legal provisions collectively aim to streamline procedures and broaden legal protection for startups, thereby encouraging investment and growth.

STRATEGIES FOR FAIR DISTRIBUTION

The term startup equity refers to the ownership of a startup, usually demonstrated as a percentage of ownership (or shares) given to individuals that contribute to the growth of a business. This concept rests on the idea that a company’s stakeholders deserve exactly what that title entails — a stake in the company. That generally means offering early contributors like employees and investors a certain percentage of ownership.

The distribution in startups typically involves founders, investors, and employees.

• The Founders: Retain a significant portion reflecting their initial investment and risk.
• The Investors: Receive equity in exchange for capital, which dilutes the founders’ share but provides necessary resources for growth. And;
• The Employees: Often granted equity through stock options or similar schemes as part of their compensation package, aligning their interests with the company’s success and helping attract and retain top talent.

Equity distribution[iii] is influenced by various factors such as timing, degree of participation, dedication, and company valuation during the time of equity allocation. Generally, founders receive the highest initial equity, not surprisingly. Similarly, early investors usually get larger amounts of equity compared to later ones since their investments take a higher proportion in relation to the firm’s starting valuation. Also, those employees who help startups are more likely to own greater shares compared to those who join later on[iv].

Start-Up Act and BFA have an important role they play with regard to these equity arrangements. For instance, Start-Up Act initiates start-up consultative forums which can help mediate and guide them about their practices regarding equity distribution for purposes of fairness and transparency[v].

CHALLENGES AND CONSIDERATIONS

Despite the supportive legal framework, startups in Nigeria face several challenges regarding equity distribution[vi]:

• Valuation and Dilution: Determining a business’ valuation may be intricate, particularly during its inception phase. Wrong valuations may lead to disagreements between founders and investors over equity shares. Moreover, successive rounds of fundraising could result in substantial dilution of the founders’ stake in the firm; this might demoralize them even further.

• Corporate Governance: Efficient corporate governance is important for equity distribution management. Weak governance systems often lead to problems like fraud, mismanagement, or disputes among stakeholders. These cases indicate that inadequate corporate governance has compelled various start-ups to close doors hence calling for strong governance mechanisms.

• Legal Compliance: Navigating the regulatory requirements for equity distribution requires a thorough understanding of the legal landscape. Startups must ensure compliance with the provisions of the Startup Act, BFA, and other relevant laws to avoid legal pitfalls and potential penalties.

• Investor Relations: Balancing the interests of different investors while maintaining control over the firm is a delicate balance. Establishing acceptable terms of financing can be a challenge in cases where investors pursue aggressive actions and founders require more capital than they can afford losing their power to influence major decisions within the company.

BEST PRACTICES TO NAVIGATE THESE CHALLENGES, STARTUPS IN NIGERIA SHOULD CONSIDER THE FOLLOWING BEST PRACTICES[vii]:

• Engage experienced legal advice to navigate through the complexities of equity distribution, which has to be aligned with all relevant laws and regulations.

• Clear Agreements: These may contain stakeholders, details on equity allocation or profit shares in percentage terms, vesting schedules along exit strategies.

• Assessment Knowledge: This comprises company valuation experts, who accurately assess the worth of companies at different stages of growth.

• Corporate Governance: Have strong corporate governance frameworks where there is routine auditing to ensure transparency in reporting as well as resolution mechanisms for conflicts.

• Stakeholder Communication: It is important to maintain open dialogue with various stakeholders including founders, investors, and employees to foster trust and shared interest around a common purpose.

CONCLUSION

Navigating the legality of equity distribution in the Nigerian start-up ecosystem involves the interpretation and use of provisions contained in the Nigeria Start-up Act, 2022, and the Business Facilitation (Miscellaneous Provisions) Act, 2022[viii]. These Acts provide a holistic legal structure for startups’ development and sustenance through equitable distribution, simplified regulatory frameworks, and incentives to attract investments. This legal framework enables vibrant and dynamic start-up ecosystems in Nigeria by aligning the interests of founders, investors, and employees.

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[i] https://kabbizlegal.com/legal-fundamentals-for-startups-in-nigeria/

[ii] https://www.templars-law.com/app/uploads/2024/02/IN-PERSPECTIVE-REPORT-ii.pdf

[iii] https://www.mondaq.com/nigeria/capital-adequacybasel/1445828/startup-finance-equity-or-convertible-notes

[iv] https://blog.hubspot.com/sales/startup-equity

[v] https://www.templars-law.com/app/uploads/2024/02/IN-PERSPECTIVE-REPORT-ii.pdf

[vi] https://disciplines.ng/legal-challenges-for-startups/

[vii] https://www.mondaq.com/nigeria/corporate-governance/1397414/navigating-legal-considerations-for-startup-success

[viii] https://www.myworkpay.com/blogs/expert-compliance-tips-for-startups-in-nigeria

Written by Maureen Esegi for The Trusted Advisors

Email us: info@cms.trustedadvisorslaw.com

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