How to Setup a Startup for Venture Capital
VC funding is a tech startup’s major proof of viability, and without VC funding, most startups stumble, die or remain as stunted SMEs. Since angels and early stage VC funds mostly find startups unprepared for funding, SME Law decided to share with startups in the GCC, during Design + Code Day at ArabNet Riyadh, how to structure themselves to receive venture capital and prepare for due diligence.
The Valuation and Limited Liability Company (LLC) Issue
The major obstacle in GCC jurisdictions is that laws require that LLC shares must have a unified value, meaning the per share value must be equal among shareholders. This legal requirement prevents founders from issuing shares to investors at higher valuations, and Joint-Stock Companies (JSCs) are too expensive for startups.
The Preferred Solution: The Offshore Share Class Solution
The most utilized solution for this issue is to hold the local operating LLC through an offshore holding company ‘HoldCo’ that contains both the investor’s and the founder’s share. The HoldCo allows for investment amounts to be raised via different share classes and different valuations.
The higher valuation translates into:
- Shares issued for a premium to par value
- Preferred shares with minimal input into company management but senior distribution preferences
- Share-class specific reserved matters
The British Virgin Islands (BVI) and the Cayman Islands are commonly used as the jurisdiction of the HoldCo, with a possible second-tier RegionalCo registered at a UAE offshore or free zone jurisdiction for localization purposes.
Preparing for Due Diligence
Legal Due Diligence (DD) refers to the detailed examination by investors of the target to assess the non-market risks of the business and the verification of the information presented by the founders during the valuation negotiations. The DD exercise allows investors to have a deeper understanding of applicable risks, and therefore work to address them with the founders, commonly through conditions precedent to closing.
The result is a compilation of a requirements that fall under different headings which include corporate, regulatory, management, financial matters, material contracts, moveable assets, real estate, intellectual property, employees, customer information, insurance, litigation and investigations and change of control and consents. The DD report summarizes for investors the documents reviewed, documentation and contracting gaps, and the legal, governance and contractual risks identified. The length of the DD list and requirements varies based on the size and history of the startup, yet all DD’s should be approached with transparency and collaborative risk mitigation.