By Mariam El Tagy, Associate
In the Gulf Cooperation Council (GCC) region and especially in the United Arab Emirates (UAE), national efforts are ongoing to maximise foreign investments. One of the main areas of rising investment flows into the UAE is venture capital (VC). The UAE understands that small and medium-sized enterprises (SME) are eager to expand their business to other countries across the Middle East by tapping into VC investment.
Venture capital investors
VC investors can be individuals, companies or investment banks. In GCC countries, sovereign wealth funds, which are governmental institutions, choose to fund different local and regional start-ups.
VC investors take on risk in a start-up (the target company) to fund their innovative solution. They provide funds with unsecured loans to the start-up, seeking a return on their investment over a long-term period, and receive an equity stake in the business. If the VC investor has experience in the sector, it typically shares its expertise with the target company, acts as an adviser and helps to guide the decision-making process.
As an alternative, a start-up may consider a bank loan. However, without a long track record of business, the start-up may find it difficult to obtain a bank loan. Even if it does, a bank loan may place huge liabilities on the start-up in terms of guarantees. For these reasons, start-ups consider VC as a good option. If the start-up is willing to issue equity shares and prepare a solid business plan to illustrate the future projections of the company, entering into a VC deal may be worth exploring.
Venture capital deal
A VC deal is arranged between the founders of the target start-up company and the VC investor. To negotiate the terms of the deal, VCs conduct a valuation to determine the amount of equity to acquire in exchange for the proposed funding to the target company. They also conduct legal and financial due diligence to identify potential risks and opportunities.
Certain legal documents will be drawn up to govern the VC deal.
First, a memorandum of understanding (MOU) between the start-up founders and the VC investors is drafted to outline the transaction in the form of a term sheet.
Second, a subscription agreement is prepared as a binding engagement on the terms of the investment, providing conditions set forth by the VC investor regarding the target’s management restructuring and operations. It may be stipulated, for example, that the company will not make any important decisions without the investor’s prior approval. Investor control can be implemented by incorporating a veto right in relation to a list of reserved matters.
Third, a shareholders’ agreement can define the rights of the founders and investors in relation to the operation of the company, while highlighting safeguards. The investor may wish to participate in the company’s governance by having a representative on the board of directors. Exit rights can be enshrined through tag and drag along clauses.
Also, investors can choose to have preference shares over ordinary shares in the event the company goes into liquidation, which provides a fixed amount before any distribution of assets. Furthermore, some restrictions can be reconfigured in relation to changing the identity of the company’s controller.
Unlike traditional lending, VC is a type of equity investment that promotes the competitiveness of start-up businesses, especially in innovative and technology-based areas. Some new industries, such as health and food tech, are considering VC as a main source of funds, especially post-COVID-19. Moreover, the pandemic has changed consumer behaviour toward accessing medical services, impacting significantly on the healthcare industry and encouraging more investors to inject funds in health tech through VC investment.
The UAE constantly encourages foreign investment. For foreign VCs looking to fund companies operating inside the UAE, transitions do not require prior approval, as long as the investment is outside a regulated sector (such as banking or telecommunications). Moreover, the UAE recently amended its Federal Companies Law, allowing foreign direct ownership of some limited liability companies by removing the requirement of 51 percent local sponsorship.
Furthermore, the UAE continues to facilitate the formation of VC funds, whether onshore or offshore. Onshore VC funds can be established after gaining the appropriate licence and by complying with Securities and Commodities Authority (SCA) regulations.
For offshore VC funds, through a rapid process underpinned by regulations, several UAE free zones provide a range of choices for fund structures. The Dubai International Finance Center (DIFC) and the Abu Dhabi Global Market (ADGM) have gained international recognition for efficient, proactive approaches and innovative techniques for investors. In addition, UAE free zones provide funding, training and strategic advice for entrepreneurs. Furthermore, the formation of VC funds through the DIFC and the ADGM offer tax incentive schemes, including a tax-free VC fund.
UAE free zones also seek to make the VC funding process as easy as possible. To this end, the DIFC offers various licenses that help facilitate management of different types of funds (such as public funds, exempt funds and qualified investor funds.) Public funds are open to retail investors, while exempt funds are available to professional investors that commit to a minimum of $50,000, while qualified investor funds are available for those committing at least $500,000.
In addition, the DIFC has eased the pressure on VC fund managers by removing the need for internal audits and by exempting the fund from maintaining a minimum capital requirement. The ADGM has also introduced a licensing regime for start-ups in the technology sector, to help them obtain an operational licence to access a pool of business advisers. Each free zone competes to attract investments.
If a VC investor wishes to exit a target company, it can choose to sell its shares to another investor. International companies often look to acquire Middle Eastern companies to gain a foothold in the MENA region. Recent examples include the acquisition of Souq by Amazon and Careem by Uber.
In addition, a start-up company may opt to launch an initial public offering (IPO) on a stock exchange. Two examples of this are Anghami and SWVL, which were originally boosted by VC investment before being listed recently on Nasdaq.