Legal insights: managing civil law complexities and investor protections
The MENA region, often seen as a single market, is a diverse landscape comprising 22 countries, each with its own legal framework, regulations, and, in some cases, independent free zones within a national jurisdiction with their own distinct legal, regulatory and juridical framework. In many respects, it offers an incredibly attractive market, ripe for innovative companies to build out businesses selling products or services to a large and underserved potential customer base.
We spend a lot of time advising companies entering the MENA markets from other regions such as Europe, the United States and various countries in Asia. One of the issues we see very regularly is a dissonance when we are called upon to advise companies from large, contiguous single markets (the US being the prime example). To scale a business up across the US, with its 360 million population size, is a relatively simple exercise. Company set ups are straightforward. Choice of jurisdiction is typically tax or lifestyle driven, but federal laws and regulations mean that the journey of building out to scale is low on friction.
When start-ups expand their businesses into the MENA region, the first issue they face is having to choose markets that make sense to them strategically and commercially but also where they can operate as much as possible with the minimum of friction. This is often where we first encounter the dissonance with companies coming to MENA for the first time.
The dichotomy of market dynamics vs ease of doing business is often an initial hurdle. The UAE is a relatively small market with a high per capita GDP. Qatar is a tiny market with the world’s highest per capita GDP. Egypt has an enormous population with a much more modest per capita GDP and a currency that has been through intense distress. Saudi Arabia is arguably the prize market because it possesses the ideal combination of scale and wealth.
This being said, the different legal regimes in each of these markets are very different and in all cases many degrees more complicated to navigate than expanding a business say from California to the rest of the US. For operators, the key focus is where to set up, how to set up, and satisfying all the legal and regulatory requirements to be able to operate and generate revenue.
For investors, there are a different set of focal points, most notably around investment and ownership rules, the way capital is treated, corporate governance rules, the way investor rights are protected and enforced and, ultimately, ensuring a smooth and lucrative path to exit an investment. Again, in a market like the US or the UK, this isn’t really a question. If we ignore tax for now, these markets are frictionless in the sense that they do not throw up different challenges to the two primary stakeholders, namely the operator and the investor.
The key issue that many of our clients from the US, UK and Europe face for the first time when they come to the Middle East is that the predominant legal framework across the whole of MENA is the codified civil law framework, inherited from Egypt, that had it introduced to them by the French, more specifically in the form of the Napoleonic Code.
For decades leading up to the early 2000s, anyone who wanted to operate in MENA had to do so under the civil law legal and regulatory framework, whereas investors on the other hand felt compelled to structure investments through common law frameworks such as those of the Cayman Islands and British Virgin Islands that were inherited from the British, who inherited their common law framework from the Romans. Who knew ancient history could be so fascinating?
For several years now, the United Arab Emirates has established financial free zones, like the Dubai International Financial Centre (DIFC) and Abu Dhabi Global Market (ADGM) which exclusively rely on common law and which have common law courts. DIFC and ADGM relieved the Cayman Islands and British Virgin Islands of their status as jurisdictions of choice for investors deploying capital in MENA.
In this article, we will focus on investor rights and the reason that to this day, to protect their interests, investors and start-ups use a two-tier structure: a holding company in a common law jurisdiction for stronger protections and local subsidiaries that follow the laws of each country. For more information on how this works, please see our previous article.
Civil law complexities in VC investments
Venture capital investments in MENA face unique challenges due to the prevalence of civil law systems.
For example, civil law mandates certain contract terms that limit the flexibility needed for venture capital (VC) agreements. Unlike common law systems, civil law does not rely on precedents which leads to unpredictability in legal outcomes. This unpredictability can be a significant concern for VC investors who seek stability and predictability in their investments. Additionally, the traditional regulatory environment in MENA may not align with the fast-paced, risk-taking nature of VC investments.
Protecting minority shareholders
In civil law systems, protecting minority shareholders poses several hurdles. Common VC rights like tag-along and call options lack clear enforceability in MENA's civil law frameworks, potentially leaving minority shareholders vulnerable. For example, civil law often mandates that founders maintain majority shareholding to exercise control over key company decisions.
However, as a company progresses through successive funding rounds, particularly by the time it reaches a Series C stage or later, founders would have typically had their ownership diluted. This dilution can lead to a scenario where founders lose their majority shareholding, thereby forfeiting the legal ability to control critical business decisions.
Such a situation is particularly concerning in civil law jurisdictions because the legal frameworks often do not accommodate the more flexible and nuanced mechanisms – like preferred shareholder rights or veto rights – that are common in common law jurisdictions to protect both founders' control and minority shareholders' interests. As a result, the rigid requirement for majority control in civil law systems can leave founders vulnerable to losing control and exposed to decisions that don’t align with how they intend to run the business that they have successfully grown.
Rights and protections
In civil law systems, essential investor rights such as drag-along, tag-along, and anti-dilution protections may not be as developed or enforceable as in common law jurisdictions.
Drag-along rights
What they do:
Drag-along rights enable majority shareholders to compel minority shareholders to join in the sale of the company, ensuring that a potential buyer can acquire 100% of the company’s shares. This clause prevents minority shareholders from blocking a sale that has been approved by the majority.
Why they are important:
Drag-along rights are vital in ensuring that a majority-approved exit can proceed without being derailed by minority shareholders. In civil law systems, the enforceability of drag-along provisions can be more complex due to differences in how shareholder rights are protected in civil codes, potentially leaving majority shareholders without the means to ensure a clean sale.
Tag-along rights
What they do:
Tag-along rights protect minority shareholders by allowing them to sell their shares on the same terms as majority shareholders if the latter decide to sell a significant portion of their stake. This ensures that minority shareholders can exit the company alongside the majority.
What they typically include:
The clause generally specifies the percentage of shares being sold by the majority that would trigger the tag-along right, the process for exercising this right, and the conditions under which the minority shareholders can join the sale. It also outlines any timelines for notice and response from minority shareholders.
Why they are important:
Tag-along rights are crucial for safeguarding minority shareholders from being left behind in a sale. In civil law systems, the enforceability of these rights has not been tested, making it difficult for minority shareholders to ensure they receive equitable treatment in a transaction.
Anti-dilution protection
What it does:
Anti-dilution protection safeguards investors from dilution of their equity stakes in future rounds of financing.
If the company issues new shares at a price lower than what the original investors paid, anti-dilution provisions adjust the price at which the original investors’ shares convert to maintain their ownership percentage.
What it typically includes:
This clause often includes mechanisms like ‘full ratchet’ or ‘weighted average’ adjustments. A full ratchet provision allows the conversion price of the original shares to be adjusted to the new, lower price, while weighted average anti-dilution takes into account the number of new shares issued relative to the total shares outstanding.
Why it’s important:
Anti-dilution protection is crucial for investors as it safeguards the value of their investment when new shares are issued at a lower price than they initially paid. In civil law jurisdictions, the absence of strong enforcement mechanisms for these protections can expose investors to significant dilution, diminishing the value of their shareholdings and making participating in future financing rounds less appealing. For more information about anti-dilution protection, please see our previous article.
Liquidation preferences
What they do:
Liquidation preferences determine the order in which proceeds from a sale, merger, or liquidation of the company are distributed among shareholders. Investors with liquidation preferences are paid before common shareholders, often ensuring they recover their initial investment before others.
What they typically include:
The liquidation preference clause typically specifies the multiple of the original investment that the investor is entitled to receive before any proceeds are distributed to common shareholders, with common multiples being 1x, 2x, or higher depending on the negotiated terms.
A 1x preference means the investor gets back an amount equal to their original investment, while a 2x preference means they receive twice their investment before any distribution to common shareholders. Additionally, it outlines whether the preference is participating or non-participating. A participating preference allows the investor, after receiving their liquidation preference (eg, 1x or 2x), to also participate in the remaining proceeds alongside common shareholders, potentially increasing their total return. In contrast, a non-participating preference limits the investor to either their liquidation preference or their pro-rata share of the remaining proceeds, but not both, meaning they do not participate in any further distribution once their preference is satisfied.
Why they’re important:
Liquidation preferences are crucial for investor protection, especially in scenarios where the company's sale or liquidation proceeds fall short of expectations. They ensure that investors recover their initial investment, or more, before any distribution is made to common shareholders, thereby mitigating risk.
The specifics of the liquidation preference – such as the multiple, participation rights, and seniority – are often heavily negotiated in venture capital deals, with investors seeking strong protections while founders and common shareholders aim to balance these with fair upside potential. The structure of liquidation preferences can significantly impact the distribution of proceeds in exit scenarios which makes the difference between a profitable exit for investors and one where they do not fully recover their investment.
Additionally, these preferences can influence future funding rounds, as later investors may demand higher preferences or seniority if earlier preferences heavily favour existing investors, complicating negotiations and affecting the company’s valuation and attractiveness to new investors. For more information about liquidation preferences, please see our previous article.
The challenge for investors in MENA is not just picking the right market – it’s about protecting your rights in a region dominated by civil law systems, which may not offer the same investor protections you’re used to. Investing here requires strategic thinking, especially when it comes to securing exit strategies and ensuring your capital is protected.
Reserved matters and veto rights
Reserved matters and veto rights are essential governance mechanisms that safeguard investors’ interests and ensure effective corporate oversight. They allow investors to block specific decisions or actions, whether at the board of directors’ level or among shareholders, that could significantly impact the company’s direction or value.
Shareholder reserved matters
Focus on protecting investors by requiring their approval for certain critical decisions that could affect their investment. These matters are typically outlined in the shareholders’ agreement or the company’s articles of association and may cover significant issues such as changes to the company’s articles of association, issuance of new shares, or major operational shifts.
Board reserved matters
In contrast, address decisions that require board-level approval, ensuring that material actions align with the board members’ fiduciary duties and promote good corporate governance. This includes maintaining robust oversight and ensuring that major decisions are made with due consideration of the company's best interests.
Together, these mechanisms create a comprehensive framework for decision making that balances control and oversight, protecting against actions that could dilute investor equity or significantly alter the company’s trajectory without their consent. This integrated approach aligns the interests of both investors and founders, promoting strategic alignment and mitigating risks associated with major business decisions.