This article originally appeared in The National on 30th March 2017
At Dubai Internet City’s tech incubator “in5”, dozens of start-ups from all over the world have pitched to us with the hope of being selected to join our community. I’ve followed several of the most promising ideas to the stage where the priority was to scale up, which required funding.
Many start-ups in the UAE look to Silicon Valley for inspiration and advice that includes how to raise money from investors. Start-up ecosystem legend Paul Graham and his now famous Y Combinator have published guides on how to fundraise and a series of well-designed legal templates for start-ups to use. This has saved many expensive legal fees when drafting company formation and fundraising documents.
Much of the knowledge produced by the Valley ecosystem is somewhat universal in application. When it comes to fundraising however, these legal templates face serious limitations posed by differences between countries with respect to commercial law.
Loans versus shares
Many UAE start-ups I meet plan to raise funds through a Convertible Note. Convertible Notes initially provide money to a start-up via a loan (not your typical shares). They usually feature a mechanism whereby at a future point in time (often at the next round of investment) the Note “converts” into shares of the start-up company using a predetermined formula. Conversion happens at this future stage as it’s easier to determine a fair valuation because the start-up has customers or revenue. This avoids founders and investors having to agree on a valuation early on.
In the US, Convertible Notes have become the standard for many early-stage start-ups to raise money. The US legal system explicitly supports their use and recognises them as an investment instrument under Federal Law and the Securities Act of 1933.
Current laws in the UAE, however, (and pretty much the entire GCC) make it riskier to use Convertible Notes than in the US, particularly when it comes to enforcement. In the UAE the principles of a Convertible Note are not explicitly articulated by law. In a Convertible Note dispute between an investor and a UAE start-up, a resolution would be likely to require legal proceedings. These may be both lengthy and costly.
In the event an investor wins a case, an award would probably be in the form of damages (money) rather than shares in the company. A monetary payout may fairly compensate the investor up to that point in time, but is unlikely to allow any participation in the start-up’s equity and future growth, including any IPO. It’s easy to see how different the outcome could be, depending whether an investor ends up with the shares they initially wanted or only gets paid damages.
Onshore, offshore or the Caribbean
What is also misunderstood is that limitations to using Convertible Notes apply to companies in most free zones. As most entrepreneurial activity is carried out by expats, these free zones are supposedly the bastions of innovation and entrepreneurship, allowing 100 per cent foreign ownership. It strikes me as counter-productive that foreign ownership and tax-free incentives can be undermined by subtle shortcomings in commercial laws. Unless the UAE wants to continue to see successful start-ups quickly redomicile to the British Virgin or Cayman Islands – where the legal system is more developed – local jurisdictions need to evolve quicker.
The other issue is the regulation around raising capital. Onshore and offshore UAE jurisdictions each have their own regulators. These rules determine how and who can solicit investors to invest in a private company. Certain exemptions found in the US or UK for “accredited investors” don’t have a direct comparable in the UAE. When start-ups grow and raise more money from even more investors, they could find themselves breaking the law, particularly when dealing with private individuals. It’s not so much the regulators going after the start-ups I’m worried about, but disgruntled investors seeking the return of their money when investments go sour.
The UAE ecosystem has co-working spaces, incubators, accelerators, conferences, VCs and several local companies with valuations in the hundreds of millions of dollars. The UAE has a massive first mover advantage when it comes to Middle East tech entrepreneurship. Now it’s time to refine that advantage with the support of the UAE legal system.