Dubai has become the undisputed entrepreneurial capital of the Middle East for start-ups due to its soft and physical infrastructure and its openness to business. It attracts investors, world-class advisers and, of course, entrepreneurs.
But at some stage in the growth of a start-up, the founder entrepreneurs of a company will realise their need for venture capital and angel money in order to grow the company. The task will be to attract such money while still maintaining a certain level of founder control and protection. Achieving such a balance necessitates understanding the terms that venture capitalists will try to negotiate to wrestle control of the Company.
In such situations, most commonly, an entrepreneur’s choice will be between raising the funds from family and friends and obtaining venture capital financing. Family and friends may be willing to invest at a lower price (i.e., to accept a higher valuation of the company at the time they invest) but often bring little else to the table.
Venture capitalists may demand a lower valuation but will almost always bring many intangibles that can assist the company to grow faster and to be more successful. They request a business plan but not audited financials, or a track record.
Venture capital can be an attractive funding source for other reasons as well. It may allow the entrepreneur to raise all of the capital from one source, or from a lead investor who can attract other venture funds. Venture capitalists have experience with the challenges of start-ups and know how to grow a company to an initial public offering, sale of the business, or other liquidity event.
Experienced venture capitalists have a large network of contacts who can help the company succeed. Venture capitalists are often able to provide valuable assistance in recruiting other members of the management team. Also, being venture-backed gives an enterprise a certain cachet, which can open doors to other financing and resources.
Venture capital financing has been on the rise in the Middle East and such rise is set to accelerate exponentially in Dubai in the next decade.
Venture capitalists normally request preferred shares in return for their investments. The rights and protections normally given venture capitalists buying preferred shares include the liquidation preference, dividend preference, voting rights, right of first refusal, co-sale rights and vesting on founders’ shares. The following is a brief description of such rights which should be carefully negotiated and even more carefully drafted into a contract:
On general matters, preferred shares usually votes along with common shares and have a number of votes equal to the number of shares of common shares into which it is convertible. The preferred shares also typically have special voting rights, such as the right to elect one or more of the company’s directors or approval of certain types of corporate actions, such as amendments to the memorandum, mergers or creation of a new series of preferred shares.
Right of first refusal
Holders of preferred shares generally will have a right to participate, usually at up to an investor’s current aggregate ownership percentage, in any future issuance of securities by the company.
Upon liquidation of the company, the preferred share will receive a certain fixed amount before any assets are distributed to the common shares.
Generally, a dividend must be paid to the preferred shares before any dividend is paid to the common shares. This dividend may be non-cumulative and discretionary, or it may be cumulative so that it accrues from year to year until paid in full.
Vesting on founders’ shares
As a protection against founders leaving the company after the investment money is in, venture capitalists generally insist on some sort of “vesting” on founder’s shares, so that a percentage of such shares, decreasing over time, is subject to repurchase by the company at cost if a founder terminates his or her employment.
Preferred investors often will require founders to agree to co-sale rights which provide some protection against founders selling their interest in the company to a third-party by giving investors the right to sell a portion of their shares as part of any such sale.
Venture funds and angel investors bring smart money to the table for founders and their companies. However, the demands of venture funds and angel investors for company control must be balanced against founder control (and the company’s best interests) to increase the chances of business success.
The writer practices venture capital law and represents venture capitalists, investors and entrepreneurs. He is a partner at the law firm of Afridi & Angell.