Pan-MENA tech companies
Corporate structuring for venture readiness
When founders and venture capitalists look at business ideas, they use a slew of performance metrics, analytics and valuation methods to assess whether a company will be successful. They evaluate the product market fit, addressable market, unit economics, customer and revenue growth and a range of other metrics and methodologies.
While a lot of time and effort is spent assessing the business case of any given company, assessing and optimising the business’ corporate structure is an often overlooked but imperative step in the process. The consequences of a defective structure can be costly, widespread, and in some cases, fatal to the continued operations of the business.
Historically, investors preferred a single company structure; it’s simple, straightforward, and effective. All property, regulatory licences and consents, contractual relationships with suppliers and customers, and revenue streams would sit with one entity which produces one set of accounts and issues shares to all its shareholders. The company, its founding shareholders and any new investors would be bound by a single suite of constitutional documents which govern the relationships between them.
This may all remain true in more mature venture markets like the US and the UK, particularly during the early stages of a company’s life cycle prior to embarking on cross-border growth. However, the same can't be said within the more fragmented and less permissive legal systems of the MENA region. While various factors influence founders and shareholders to adopt one form of corporate structure over another, generally the 'single stack' approach is rarely used and unsuitable for a start-up operating in the region.
While various factors influence founders and shareholders to adopt one form of corporate structure over another, generally the 'single stack' approach is rarely used and unsuitable for a business operating in the region…”
Many founders and investors may view MENA as a single market under the lens of a total addressable market as they would look at the US and the UK independently, but the region is, in reality, comprised of several countries, each with its own laws, regulators and legal framework.
Each country may have, within its borders, separate and independent free zone territories. By way of example, the UAE alone has over 40 separate multidisciplinary free zones each with its own applicable laws, licensing requirements, independent regulators and in certain cases, its own courts.
Therefore, each time a company decides to expand its services into a new country it’s effectively entering one or more new legal jurisdictions. Subject to very limited exceptions, this typically requires the incorporation of a subsidiary in that jurisdiction to operate the business, and will almost certainly introduce unforeseen barriers to entry, including the need to localise the service or product offering to adhere to local regulatory requirements in the relevant jurisdiction.
The legal system
The legal systems across MENA are predominantly civil code systems. Sharia law also has an influential role to play in certain jurisdictions. In addition, some countries in the region have established free zones that draw their legal frameworks from common law systems, for example, the UAE’s Dubai International Finance Centre (DIFC) and the Abu Dhabi Global Market (ADGM).
Historically, VC funding terms were built on common law principles which prioritised the primacy of contractual rights and the principles of contractual freedom; particularly where shareholder arrangements are concerned. While there are similar features shared between civil law and common law jurisdictions, there remain a few key differences between them that cannot be overlooked.
Replicating the features and contractual provisions of a traditional common law venture capital transaction may seem like a straightforward solution, but several legal and regulatory issues arise that prevent a simple ‘copy and paste’ approach.
There are, for example, differences and limitations on the contractual authority related to the disenfranchisement of a shareholder under certain civil code systems. Furthermore, the ability to create different classes of shares - a foundation upon which investor class rights are protected in VC transactions - is not always recognised, and if recognised, may be difficult to implement and enforce in practice.
In addition, introducing substantial amendments to the model form of a company’s constitutional documents is not always permitted by regulators or registrars in the region, which hinders the ability to comprehensively enshrine shareholder rights into a suite of constitutional documents, thereby casting doubt over the enforceability of these investor rights if they were to be tested.
The holding company and the operating company
How do you resolve these issues?
The most common approach is the use of a two-tier structure; a single holding company incorporated in a common law jurisdiction with the necessary operating subsidiaries, each in the relevant jurisdiction where the business intends to operate.
The holding company would be the principal entity where all investors and shareholders of the group would sit. Bespoke investment documents would be concluded at that level and the constitutional documents of the holding company would be amended to include all rights and obligations agreed between the shareholders and the company.
In the Middle East, the ADGM and the DIFC offer excellent platforms to host VC-backed holding companies. Both the ADGM and DIFC offer similar platforms and are built on a legal system founded upon international common law principles, while still maintaining synergy with other regional jurisdictions and regulators.
They have a robust contractual enforcement framework with proactive regulators and their own independent courts familiar with local and international legal best practices. This, combined with sufficient reciprocity with international jurisdictions, ensures the enforceability of market practice contractual provisions.
Once the holding company has been incorporated, it would then set up operating subsidiaries in jurisdictions where it intends to carry on its business. This is a must as certain jurisdictions prohibit undertaking business activities without a physical presence in the region, or at least without an appropriate consent or licence from a regulatory authority to offer a certain service within the jurisdiction.
With this structure, the holding company may well be a special purpose vehicle that doesn’t undertake any business activity or serve any business function other than an entity that houses the shareholders of the group and owns the equity of each operating subsidiary. It’s the operating companies that would hold the assets, enter into contractual agreements, and secure licences and approvals from regulators in each jurisdiction for the relevant business activity.
The two-tier structure may seem cumbersome, but it carries some distinct advantages when navigating the legal and operational framework in the region; it allows investors and founders to have common law principles (and common law courts) govern and have jurisdiction over their investment documents, while simultaneously tapping into the diversity offered by the MENA’s various jurisdictions. From an operational perspective, this facilitates talent acquisition in the region, approaching regulators in certain jurisdictions (where others may be reluctant to cooperate) or benefitting from advantageous tax positions in certain jurisdictions.
While it may still be possible to operate in the MENA region using a single corporate entity, there are numerous challenges from a regulatory, commercial and legal perspective which make a multi-layered structure the favourable option, particularly if a company seeks to enter various markets within the MENA region quickly.
Having to restructure a business after it’s initially commenced operations with a less than ideal structure can prove costly and may require a substantial amount of time and resources (including valuable management time) being spent to re-optimise corporate and operational structures.