If you have ever considered investing in a startup along with a group of other investors but found the legal options available to be suboptimal, read further on a new legal framework first developed in Delaware that has provided a viable legal solution for ad-hoc investing in MENA. Exclusive in-depth research on the optimal solutions of Ad Hoc Investing including the ingenious "Series LLC" brought to you by Levari Law Firm
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Investing Frenzy in the Middle East
So far this year, a record number of venture capital and private equity funds (VC Funds) have been registered or launched in the Middle East with a record number of assets under management. VC Funds backing startups in MENA have invested 132% more in 2021 than in FY'2020. The general outlook is that the investing frenzy through VC Funds will continue. However, VC Funds are only part of the startup ecosystem story for the Middle East and other developing countries.
VC Fund's legal structures are well known and established. However, the legal structures available to other ecosystem players are not. Here we review a new legal framework developed in Delaware that may have major implications for ad-hoc investing in the Middle East.
The Startup Ecosystem
In addition to VC Funds, any ecosystem also needs angel networks, accelerators, incubators, venture builders, and probably most importantly, an informal network of people and organizations that support the ecosystem. For example, the same individuals who may mentor startups in their spare time may also be active angel investors or venture partners at VC Funds. The chief technology officer (CTO) of a large and successful startup may also teach university students how to code. The cluster effect, where there are multiple strands of connections between individuals and organizations is probably the most salient and important facet for our ecosystem. This is the reason why we see some industries cluster in specific geographic areas, from the well-known startup ecosystem in the Bay Area to the auto-industry cluster in North Western Michigan, to the fashion industry cluster in Northern Italy. We will have to wait and see if this high concentration of geographic clustering will continue in a post-COVID world. Chances are that clustering will probably continue to play a role, but will expand from specific geographic pockets to more regional clusters.
The presence of angel networks supported by an educational community like that of AUC Angles in Egypt can remarkably boost Early-Stage venturing. As recorded in our Egypt 2022 Venture Investment Report, Egypt was the only geography to observe an increase Early-Stage funding rounds (<$500K) to account for 55% of all transactions in 2021 (up by 10 PP since FY'2020). This proportion remains remarkable when compared to its peer geographies like the UAE or KSA, both observing a 17PP dip in the Early-Stage deal proportion.
While registering and launching a VC Fund may be the end goal of many investment professionals, VC Funds are incredibly difficult and time-consuming endeavors to undertake. They require a lot of work and time and cost quite a bit in setup, registration, fundraising, and then maintenance. They require dedicated staff, a novel investment thesis, and a credible pipeline. The process can take months or years during which the managers of the VC Fund are essentially working for free.
VC Funds are critical to our ecosystem but not everyone can participate in such an endeavor. Some ecosystem players simply don’t have the time, resources, or stamina to go through this process. While we have seen some angel networks crop up throughout the region, many are still subject to the same pressures that apply to VC Funds - mainly to continuously find new investment opportunities and to fundraise from their members.
What about ecosystem players who are not interested in being subject to the same pressures that apply to VC Funds or formal angel networks? What about the ad-hoc investor?
The Ad-Hoc Investor
The person we are thinking of, for example, is the CTO who teaches coding to university students in her spare time. What if the CTO realizes that one of her students is particularly bright and may have a very good idea for a startup. The CTO, along with four of her good friends, wants to invest a total of $100,000 in this student’s venture. The CTO is not an angel investor and has no interest in being one but realizes the potential of this student and would like to make an exception. The CTO works for a much larger startup so understands the space very well (e.g. we call her an “ecosystem participant”) but is only interested in making this one investment. The CTO and each of her friends will each be investing $20,000.
The university student has one major issue with the CTO’s proposal. He doesn’t want five small investors appearing on his cap table. His argument is that it will make his capitalization table messy. The CTO and her friends agree to pool their resources and make a single investment. However, their legal options on how to structure this investment have traditionally been very limited.
One option is a variation of the “back-to-back” agreement where the CTO makes the investment on behalf of her four friends. This may work if all the investors know and trust each other. The CTO and her friends would need to sign some type of beneficiary agreement stating what portion each of them owns in the company and how decisions are to be made about their investment. However, not all angel investors know or trust each other and organizational investors may want something more formal than this type of arrangement.
The second option would be to register a company for each investment opportunity which may be cost-prohibitive and prove untenable in terms of management since most closely-held companies are managed by their shareholders.
The third option is to register a one-off VC Fund. With the one-off VC Fund, it becomes clearer who manages and how decisions are to be made. All parties would clearly know their rights and obligations since the limited partnership structure with a general partner and limited partners is fairly well known and understood. The issue however is that registering a VC Fund would also be cost-prohibitive.
In many cases, without a viable and cost-effective legal solution to house this small investment, the parties are forced into sub-optimal legal structures. What typically happens is that the CTO and her friends either register a company and incur the cost and burden of managing and maintaining this company or enter into some variation of a “back-to-back” agreement. The final solution, which we discuss below, is for the CTO and her friends to register a Series LLC.
While 40% of all capital invested in the Qatari ecosystem between 2016 and 2021 was invested into funds, this nascent VC landscape has shown unprecedented support to the budding pipeline of Emerging Ventures. As recorded in our 2021 Qatar Venture Investment Report in partnership with QDB, 46% of total transactions in 2021 were a result of accelerators. This comes amidst a 3-year consecutive dip in accelerator activity in MENA which resulted in a 16% accelerated deal proportion of total transactions in 2021.
The Series LLC
The Series LLC was first created in Delaware in the mid-1990s but is now available (or a variation of it) in the Cayman Islands and the British Virgin Islands. Other states in the U.S. have also enacted similar statutes as the Delaware Series LLC statute.
The Series LLC statute allows companies to create one “master” corporation (the Master LLC) and then create separate “mini” or “sub-corporations” called Cells to sit under the Master LLC.
The Master LLC’s primary function is to manage all Cells. Each Cell is treated separately from the Master LLC and all the other Cells sitting under the same Master LLC. This allows companies to create an indefinite number of companies with each Cell having its own members and managers without having to go through the process of officially registering separate and independent companies for each investment opportunity. The cost of registering a Master LLC is about the same as registering a stand-alone company, however, the cost of creating separate Cells is virtually zero to a few hundred dollars depending on the jurisdiction.
The Series LLC structure lends itself well to house special-purpose investments. The management of the Cell mirrored the management structure of a VC Fund with the Master LLC serving as essentially the general partner of the Cell and the members of the Cell serving as the limited partners.
The members of a Cell (e.g. the limited partners) did not have much of a say in how the Cell is managed. Their rights were similar if not identical to the rights they would have as limited partners in a traditional VC Fund. In addition, the economic structure of each Cell also mimicked those of a traditional VC Fund. First, all distributions would be returned to the members of the Cell until they recouped their full investment and then any excess would be split between the members of the Cell and the Master LLC (e.g. the carried interest).
We expect the use of the Series LLC to become more prevalent throughout the region and for ecosystem participants to start using it in a variety of other ways. We believe that over time, in addition to housing one-off investments, the Series LLC will become critical for early-stage VC Funds who have yet to launch or register.
Could Ad Hoc investing be the alternative solution for the dip in Early-Stage ventures, especially in geographies like Saudi Arabia that thrives on family-focused funding? Special thanks to Hisham A. Kassim from Levari Law's MENA Corporate Counsel for this in-depth take on Ad Hoc investing.
The information and content contained herein does not and are not intended to constitute legal advice. All information contained herein is being provided for general informational purposes only. Any reader or user of the above information should contact their attorney to obtain advice with respect to any particular legal matter. No reader of this document should act or refrain from acting on the basis of the information contained herein without first seeking legal advice from counsel in the relevant jurisdiction. The information and content provided herein are provided "as is." No representations are made that the content or information is error-free.
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