A key consideration for startups and even existing technology companies in the Middle East is getting the corporate structure right. A robust corporate structure caters not only to the operational requirements of the business but also ownership considerations of the business, particularly those of investors. This piece highlights some key aspects for entrepreneurs seeking investment.
OpCo and HoldCo
Any business will need a company / legal presence in a jurisdiction to carry on its operations (“OpCo”) – a place where its founders and employees are based and often where its potential customers are based. It would need to comply with applicable regulations such as company regulations, foreign ownership regulations (if applicable) and employment regulations. This is an existentialist requirement for any business and one which is front-of-mind for any entrepreneur. There are various options available in the Middle East, such as registering in a free zone where possible or registering “onshore” with potentially a local partner. Each jurisdiction in the Middle East & North Africa has its own sets of regulations in this regard which need to be complied with. With expansion, there may be multiple operating companies.
At the same time, a business looking at raising capital needs to gear up to cater to preferences and requirements of potential investors and centralize the ownership of the business into a holding company (“HoldCo”). Angel investors, venture capitalists, private equity investors and other investors are often quite sophisticated and expect a jurisdiction where they can easily obtain typical rights such as different separate classes of shares (Series A, B, C and so on) having different rights, varying valuations (in case of down-rounds) and liquidation preference.
Key legal considerations for HoldCo
Different classes of shares
This is a key requirement. Investors will invariably want to have specific rights attached to their shares in preference over shares held by the founder(s) and employees. Hence the terms “preference shares” or “preferred stock”. With each round of investment and hopefully increasing valuations, these rights become more sophisticated and often change with each round with the latest investor demanding more senior rights, especially in the valuation and size of the round is higher. A jurisdiction and legal system needs to be able to provide this flexibility.
Typical onshore companies in GCC countries (such as limited liability companies) do not permit multiple classes of shares. Certain free zones such as the Dubai Development Authority (formerly TECOM) contemplate different classes of shares with approval from the authority and we are aware of one recent case where it was approved. However, that is an exception. In addition, any capital change, whether an issue or transfer, requires approvals from the regulator.
Most common law jurisdictions provide this flexibility. Besides, most international investors are familiar with and generally prefer common law jurisdictions. Accordingly, offshore jurisdictions such as the British Virgin Islands, Cayman Islands, Guernsey and Jersey are commonly used for setting up a HoldCo. “Offshore” jurisdictions in the UAE such as the Abu Dhabi Global Market (“ADGM”) which is based on common law is also recently popular with investors. In some cases, Delaware is also used if there is a US connection.
Flexibility in issuing ESOPs
Employee Stock options can be structured in multiple ways. Often shares are vested over time and in some cases, shares are not actually vested to employees but they are granted rights similar to shares on a contractual basis and get the benefit in case of distribution of dividends or liquidity events. Such flexibility is possible under most common law jurisdictions.
Since the core asset and value of many technology-based businesses is the intellectual property, investors prefer to invest in the entity which directly owns the intellectual property. The intellectual property can then be licensed to the OpCo. Hence, another reason for centralized ownership.
An existing business would invariably have set up an OpCo in place. If an entrepreneur is looking at setting up a business then having a HoldCo should be looked at simultaneously. That said, even if only OpCo exists, the shareholder(s) of OpCo (typically the founder(s) and perhaps seed capital investors and employees) can transfer their shares in OpCo to HoldCo in exchange of shares of HoldCo. That would entail an additional process at the OpCo level. This step can be done once funding is imminent so that the structure is in place for funding.
It should be noted that it is very likely that the investor(s) would want to have HoldCo in place before the investment comes in and this would be a condition in the term sheet. However, it might be more efficient if this is structure is put in place at the outset prior to fund-raising.
In summary, a corporate structure and the need for a HoldCo in a suitable jurisdiction is an important aspect for an entrepreneur looking at raising funds. The structure should be in place before the investment comes in.