BVCA vs NVCA: key differences in venture financing for Middle East deals
Within the greater context of the global venture capital market, the Middle East remains relatively nascent. While it is undoubtedly growing, the infrastructure to accommodate and foster relationships between the various players in the ecosystem is still catching up to what has been available in the US and UK markets.
Clear examples of this are the well-established venture capital industry associations, namely the British Venture Capital Association (BVCA) in the UK and the National Venture Capital Association (NVCA) in the United States. While both organisations have numerous functions, one of the largest assets which has not yet been developed in the MENA region is a suite of locally complaint model equity funding documents.
The NVCA and BVCA documents were each designed to streamline investments, reduce transaction costs and promote standardisation within the industry. The documents themselves are critical tools for entrepreneurs, venture capitalists, and their advisers (primarily lawyers) when negotiating priced equity financings. Given the fragmented nature of the region's legal frameworks, developing a formal and standardised suite of documents presents unique hurdles not faced in more unified legal jurisdictions due to the substantial potential permutations of applicable laws, corporate structures and holding company jurisdictions.
Notwithstanding the different legal frameworks across the region, MENA deals have typically followed a model whereby common law jurisdictions are selected for holding company domicile to facilitate the granting of typical venture capital terms, particularly relating to governance, economic treatment of shares and exit mechanisms.
While a deeper analysis of the comparative disadvantages of VC deals being subject to the application of civil laws (regardless of what specific jurisdiction in the MENA region is applicable in any given case) is beyond the scope of this article (though you can read more about this topic in our previous MENA corporate structuring article), below we examine the manner in which governance terms and economic rights are historically applied in MENA on a similar basis to the UK or the US.
Historically, given their close economic ties, general market practice for private venture capital investments in MENA has been strongly influenced by UK market trends and importantly, the application of terms more closely aligned with the BVCA. However, recently, as the region has been seeing increasing inflows and outflows of capital from and to US players, the trend towards the application of NVCA model documents and concepts has grown. Local founders have often been educated in the US or otherwise are more closely tied to the US. US investors are more familiar with NVCA model documents and prefer using them rather than the BVCA or a more bespoke regional set, particularly where the company has a US-focused exit strategy.
As a result, we have seen a recent trend of Delaware being used as a holding company jurisdiction rather than the traditional holding company jurisdictions of the ADGM, DIFC, British Virgin Islands, and Cayman Islands. This is not to say that the latter jurisdictions are not being used, far from it; they remain the favoured jurisdictions for the majority of the region's venture-backed companies. However, this increase of Delaware holding company structures means that founders and investors alike need to be aware of both the BVCA and NVCA model documents, and importantly, how they are applied in the Middle East.
Deal structure and documentation
The most striking difference between the NVCA and BVCA is the substantively different approach to forms of documents.
The NVCA suite would traditionally include:
a stock purchase agreement
a certificate of incorporation
a voting agreement
an investors' rights agreement
a right of first refusal and co-sale agreement.
You might also encounter a management rights letter, an indemnity agreement and other more minor ancillary documents.
Comparatively, the BVCA deploys:
a share subscription agreement
a shareholders' agreement
articles of association.
In the Middle East, and unless a Delaware holding company is being used, the suite of documents are more closely aligned with the BVCA tradition, namely:
a subscription agreement
a shareholders' agreement
articles of association and/or a memorandum and articles of association.
One important point to note is that the articles of association in the UK are publicly available and sourced easily online. Therefore, many provisions which are considered confidential will be excluded from the articles in favour of the shareholders' agreement which is a private contract and subject to confidentiality. Given that constitutional documents are typically not public in the region, the tendency is to house all the primary transaction terms in the shareholders' agreement and then replicate them in the articles to ensure compliance with local statutory requirements. Note that in most US jurisdictions, and importantly, Delaware, none of the company's documents, including the certificate of incorporation, are publicly available.
All three jurisdictions will use a common and preferred shares (or 'stock', being the NVCA terminology) structure whereby founders or employees are issued common shares with investors being issued preferred shares. All shares will rank equally with respect to voting rights, however the preferred shares will almost always benefit from a liquidation preference (discussed below) as a way to minimise downside loss for the investor.
We have also seen a number of companies in MENA using non-voting common shares in the ESOP rather than the traditional common shares. While this consolidates voting power and often reduces administrative burdens when it comes to shareholder decision making, because of the hurdles it creates when looking to flatten the share structure of a company in advance of listing a company on UK or US public markets (ie making sure that all shares are converted into the same class), it is a concept that is uncommon and rarely used in the US and UK.
Minority veto rights, liquidation preferences and anti-dilution
Minority protections in an early-stage suite of equity financing documents generally boil down to three separate categories: minority governance rights, liquidation preferences, and anti-dilution rights. Minority governance rights are typically housed in both board and shareholder voting and consent mechanisms. Given the investor group are commonly minority shareholders, the suite of documents will reflect that these rights are for their benefit.
Minority veto rights
Both the NVCA and BVCA accommodate investor director rights and shareholder voting and consent rights and the application of these in the Middle East conforms to UK and US standards. However, within the context of board governance rights, this does typically lead to a conversation between investors and founders regarding appropriate board composition and the number of investor directors to be appointed. In the Middle East, and in contrast to the UK and the US, we regularly see the use of an independent director to balance a board that would otherwise be weighted in the founders' favour (particularly at the Series Seed, A, and/or B) or the investors' favour (at Series C and beyond).
This is often determined by the extent of founder dilution and the ultimate control they hold by way of their shareholding in the company. If, for example, the founders own less than 50% of their company's equity, they should be particularly cautious when negotiating shareholder consent rights and ensure that there are commensurate founder consent rights to avoid circumstances where the majority shareholders are able to push through company decisions without founder approval.
The BVCA has traditionally adopted a comprehensive suite of investor director and shareholder veto rights with the former traditionally governing operational matters to avoid reaching out to large swathes, or the entirety, of a company's shareholder base in order to approve company actions. Such actions will often relate to entry into material contracts, approving operating expenses and CapEx budgets, decisions with respect to key employee contracts and/or granting options further to an employee equity incentive plan.
Shareholder veto rights typically relate to matters that will directly impact an investor's equity position in the company and include matters such as the issuance of new shares or events which could dilute existing shareholders, distributing dividends, selling or listing the company and/or permitting a company to go into an insolvency process.
The NVCA is similar to the BVCA in this regard. However, famously, and particularly within the ZIRP era, several NVCA-styled documents tended to go without any material investor director veto rights, electing instead to give full company directional powers to the founders as a way for investors to sweeten the deal for founders in a highly competitive and founder-friendly market.
In the Middle East, not only is the use of an independent director relatively common practice, but you can expect that almost every deal will involve a negotiation on the full suite of board and shareholder governance rights. Moreover, local investment rounds tend to emphasise the importance and weight a lead investor has when negotiating the documents.
Shareholder blocking rights are often given exclusively to an individual or small group of core investors on a named basis. This is in comparison to the BVCA and NVCA whereby consents are given through approval by the holders of a majority of a specific class or series of shares rather than a named single investor. The Middle East approach tends to consolidate blocking rights in the hands of the lead investor(s) whereas the BVCA and/or NVCA would more commonly rely on all the investors of a specific share class or series being sufficiently aligned in order to block a corporate decision.
Liquidation preferences
Liquidation preferences are typically aligned between the BVCA, NVCA and in the Middle East. That is, the holders of the senior ranking class of shares have a 1x non-participating preference correlative to their investment amount.
The effect of this is that, when a company is sold or lists on a public market, the holders of preferred shares are entitled to either:
their money back before the common shareholders get anything, or
their money on a pro rata basis with all shareholders who elect not to get their original investment amount returned.
The last money in/first money out rule generally applies. This means as a company goes through several rounds, the most recent class of preference shares will rank senior in any liquidation waterfall to the earlier rounds' class(es) of shares as well as to the founder and employee common shares. This is the global market standard with respect to investor rights to capital on exit.
However, across all jurisdictions, the ability to deviate from this market standard is possible. Depending on any investor's or founder's leverage position, in the Middle East we have seen liquidation preferences increase to multiples much larger than the traditional 1x. Alternatively, founders have convinced investors to forego the last money in/first money out rule and proceed on the basis that all preferred shares have a liquidation preference that ranks equally across the holders of such shares (but still ahead of the founder's or employee's ordinary shares).
Anti-dilution
Anti-dilution preferences are used to protect investors from 'down round' dilution. The NVCA and BVCA diverge primarily in relation to how the anti-dilution is applied. The NVCA applies a 'conversion ratio adjustment'. Preference shares are treated as convertible to common shares. When an investor first enters the company their conversion ratio is 1:1. This means that when the company exits (ie is sold or lists on a public market) and an investor decides to forego their liquidation preference, their preference shares will convert to common shares on a 1:1 basis and they will get their pro rata portion of the distributable cash thereafter.
If, before an exit, there is a down round, the conversion ratio will be adjusted to compensate for the dilutive impact of the down round. So, when the company is successfully turned around after a down round, and the investor converts their preference shares into common shares, the conversion ratio will increase and they will receive, for example, a 2:1 ratio of common to preference shares as a result.
The BVCA adopts an approach which typically allows for a cleaner equity structure as the company progresses through the business cycle but can be more administratively burdensome. Rather than waiting for an exit event to be compensated for the dilutive impact of a down round, at each down round, the investor is issued compensatory shares without having to wait for the exit or winding up to confirm the overall impact of the anti-dilution provision.
In the Middle East, the NVCA approach has historically been used. However, our experience with Middle Eastern down rounds is that they are often an 'all or nothing' event. That is, a company will only look to raise equity at a down valuation where the alternative is the company exhausting the entirety of its cash reserves and going insolvent. The result is that the traditional application of the anti-dilution provisions has little merit in practice.
Getting ten times the amount of shares you initially hold is valueless if all of the shares are worth nothing. As such, both founders and investors should often look at negotiating the anti-dilution provisions as a method of securing leverage at a potential future down round. In order to raise a company-saving investment, waiving your rights to a conversion ratio adjustment is often used as crucial leverage to negotiate other, potentially more beneficial, provisions as the company starts its turnaround.
Restrictive covenants
Restrictive covenants are company protections that restrict the ability of leaving founders to, for example, establish a competing business (a non-compete), or poach employees, customers and/or suppliers (a non-solicit).
The BVCA suite of documents contain a comprehensive suite of restrictive covenants imposed upon founders during their employment with the company as well as for a reasonable time period after they resign or are terminated. These can traditionally be found in the shareholders' agreement. In contrast, the core NVCA suite of documents will not include a suite of restrictive covenants. However, while still uncommon, you may nevertheless find a separate agreement between a founder and the company setting out basic non-compete terms. The Middle East follows the BVCA and will generally include a comprehensive suite of restrictive covenants in the shareholders' agreement.
The point of contention with restrictive covenants primarily centres around their enforceable length. Conceptually, founders do not want to be in a position where they cannot seek gainful employment in their area of expertise, particularly for extended periods of time, after leaving a company. Famously, non-compete provisions are unenforceable in California, and the current trend would indicate that this approach may be adopted across the US (where each state has its own rules on enforceability).
Recently, the federal government in the US attempted to ban most post-termination non-competes; this was struck down by the courts but appeals are expected and the enforceability of non-competes remains uncertain. In the UK, restrictive covenants are generally treated as enforceable subject to a maximum length. Traditionally, a UK restrictive covenant is enforceable for up to 12 months. In the Middle East, the enforceable length is slightly longer and can extend up to 24 months. In each case, in order to ensure enforceability, they would also be limited in geographic scope. For example, if the original company does business in the UAE, you would find it difficult to enforce a non-compete if the leaving founder sets up a similar business in Europe.
Importantly, notwithstanding whether BVCA, NVCA or local documents are used, the question of restrictive covenant enforceability primarily relates to where the founder and company carries on their business. So, if for example the company has a Delaware holding company with Middle Eastern operating subsidiaries, and the company's business is exclusively in the Middle East, then the fact that NVCA documents are used does not mean that a non-compete is automatically unenforceable locally.
Drags, tags, ROFRs and co-sale
'Drag-along', 'tag-along', 'co-sale rights', and 'rights of first refusal' are only a few of the suite of terms known as the 'liquidity provisions' or 'exit rights'. These provisions govern how shareholders are able to transfer their shares, scenarios where transfers can be forced, or where shares can be converted to a class in order to facilitate a listing on a public market.
Drag-along
A drag-along sets out terms in which a group of shareholders (typically a minimum threshold is required) can force a sale of the entire company. The general idea is that most large entities, whether they are listed companies, large private companies or private equity funds, do not want to buy anything less than 100% of a company. The drag-along prevents minority activist or lethargic shareholders from holding out and blocking a sale where the vast majority of other shareholders are aligned. They are treated nearly identically in the NVCA, BVCA and in the Middle East.
ROFRs
ROFRs, or rights of first refusal, set out the terms where existing shareholders hold rights to purchase shares from other shareholders before selling them to a non-shareholder party. Generally, where a common shareholder is looking to transfer shares, in the NVCA, the right to purchase those shares would first be offered to the company itself followed by a company's major investors. In contrast to the BVCA and Middle East, this restriction in the NVCA is typically only applied to holders of large portions of common stock, it would not apply to transfers by investors.
The BVCA would normally exclude the first ranking company ROFR right in favour of the most senior ranking class of shareholder. In the Middle East, we typically see fewer scenarios with a company holding the first ranking ROFR right, but rather than give the purchase right to the holders of the most senior ranking class of shares (on a pro rata basis) as you would see in the BVCA, it would instead be offered first to the 'major investors' (often a select group of senior investors). It is a good example as to the hybrid nature of the region.
However, as is common in the Middle East, the structure of the ROFR is often dependent on the leverage of the existing parties and can sway further into either the BVCA or NVCA territory depending on the nature of the relationship between the investors, founders, and other shareholders. For example, an investor may adopt a strategy to build its equity position in the company over the long term. In doing so, they may resist giving the company a first ranking ROFR right as this results in a pro rata increase to all shareholders (the company buys back a fixed number of shares, so the percentage ownership of the remaining shareholders increases rateably).
Equally, if they are a 'major investor', they may also want to have a senior ranking right over the other shareholders of the same class in order to take up the majority of the offered sale shares before anyone else has the opportunity. In each case, with a view of growing their equity stake at a faster rate to the remaining shareholders.
Tag-along and co-sale rights
Tag-along and co-sale rights are often used interchangeably. The BVCA however makes a clear distinction between the terms. The NVCA does not include what the BVCA would describe as a 'tag-along' right. The Middle East, as we have seen, will generally adopt a bit of a hybrid model. In the BVCA, a tag-along right occurs if, after going through the ROFR process, a controlling interest in the company is being sold then the remaining shareholders have a right to include their shares in the sale to the third party on the same terms. Generally, this is seen as less favourable to the selling investors as it forces a buyer to purchase additional shares if they want to proceed with the transaction.
The application of a traditional co-sale, in both the NVCA and BVCA, is slightly different in that they:
are only triggered on a sale of shares by the founder(s), and
they reduce the total number of shares being offered to a buyer rather than requiring a purchaser to buy additional shares.
This approach is generally seen as more favourable to investor liquidity as not only are they excluded from having to go through the administrative processes but it won't scare off any prospective purchasers who are only looking to buy a fixed portion of the company.
In the Middle East, the approach again varies. While either of the above approaches have been applied, it's also not uncommon to see a tag-along which triggers on a much lower threshold of shares being sold (ie does not require the sale of a controlling interest) and subsequently, if the buyer is not willing to take up the full allotment of shares pursuant to the tag, convert to a co-sale method whereby the total number of shares is then reduced rateably. Equally, the concept of a co-sale only being triggered on a sale of the founders' shares may not be employed in favour of the tag/co-sale applying to a secondary sale of shares by any, or a defined group, of shareholders.
Conclusion
The BVCA and NVCA model documents differ substantively in detail level, regulatory alignment, jurisdictional specificity, approaches to market customisation and procedural requirements.
Being aware of the differences is absolutely critical when undertaking an equity financing in general and, in particular given the very different approach taken in our region to ‘modifying’ otherwise standardised forms of documentation.
The problem that many MENA founders and investors don’t appreciate is that attempting to negotiate bespoke documents is the enemy of both speed and capital efficiency. There is no question that the interests of the regional venture capital and start-up industry would benefit from a unified and more standardised approach to documentation. But there are also good reasons why, in our region, this is something that will take a bit more time. Ultimately, our venture ecosystem is maturing, and we see a more standardised route to dealmaking as something on the relatively near horizon.