Doing business in the UAE: legal considerations for investment structuring

In 2021, for example, the number of investors financing UAE-based start-ups and early-stage companies grew by 54% when compared to 2020 and there was a notably higher proportion of investors coming from outside of the region in 2022 compared to 2021.

For foreign VC investors, a central consideration is the jurisdiction of incorporation of the target company and its operating subsidiaries and where its overseas branches are based. Companies in the UAE are either incorporated onshore or in a free zone.

Where a company is incorporated onshore it is formed and managed within the mainland jurisdiction of the relevant Emirate, has unrestricted access to the UAE market and is subject to the laws and regulations passed by the local and federal Emirati authorities. Free zone companies are incorporated in special economic zones which are restricted from dealing in mainland UAE and are largely governed by their own legal frameworks, whilst also remaining subject to many of the federal laws.

Considerations where the target company is incorporated in the UAE

In general, mainland UAE companies are not a popular choice for VC investors. This is because:

• the legislation governing mainland companies does not allow for the creation of more than one class of shares;
• parties are limited as to the extent that they can amend the standard articles of association of the company;
• there is ambiguity regarding UAE courts’ willingness to enforce contractual provisions requiring specific performance, particularly with regards to matters such as the mandatory transfer of shares, preferring to award damages instead, which is not always an appropriate remedy in VC scenarios. As these types of provisions remain largely untested for companies incorporated in the mainland, this can lead to uncertainty around an investors’ ability to enforce those types of rights, which is naturally a deterrent for sophisticated VC investors; and
• despite recent changes to the law, foreign ownership restrictions can still apply to certain activities and sectors which will potentially limit a foreign investor’s ability to hold both the legal and beneficial interest in their shares.

Similarly, many of the challenges described above also apply to companies established in the majority of the free zones established in the UAE.

As a result, VC investors often prefer to invest in target companies incorporated in one of the recognised financial freezones which have common law regulatory and legal systems, such as the Dubai International Financial Centre (DIFC) or the Abu Dhabi Global Market (ADGM). This is because they allow investors to benefit from the more complex and flexible shareholder arrangements which are typical for venture capital investments and are enforceable under the common law legal framework of these free zones. For example:

• it is possible to issue multiple classes of shares with different rights attaching to them and to create bespoke articles of association – provided they comply with the laws and regulations of the relevant free zone;
• generally, the procedural and administrative requirements for matters such as share transfers, amendments to constitutional documents or other company secretarial-type transactions are more straightforward and efficient; and
• investors can also obtain greater comfort that more sophisticated contractual rights such as ‘drag and tag’, good leaver / bad leaver provisions, put and call options and so on are generally recognised and enforceable in these freezones.

It is also worth noting that both the DIFC and the ADGM freezones have their own courts which are generally considered to be more efficient and transparent than the onshore courts and benefit from proceedings being in the English language, which is often an important factor for foreign investors.

Considerations where a subsidiary or branch within the target group is incorporated in the UAE

A VC investor will also need to have regard to the jurisdiction of incorporation of any of the target company’s subsidiaries. In particular, where a subsidiary is located onshore, the investor would need to understand whether that company remains subject to any foreign ownership restrictions.

Notwithstanding recent changes to the law which increase maximum foreign ownership in mainland UAE businesses from 49% to up to 100% for many commercial activities, if a local shareholder is required as a matter of law, the investor will need to consider its options in this regard including the potential need to have a suitable local nominee shareholder, together with a full suite of nominee arrangements in place which provide the investor with the maximum management and economic rights permitted under law. Where these agreements are either insufficient or inadequate to protect the investor, the investor should ensure they are amended prior to completing their investment. 

In some circumstances, a target or one of its operating companies may have established branch offices located in mainland UAE. A branch is not considered to be a separate legal entity but an extension of its parent company that can carry out the commercial activities of its parent company in another jurisdiction – i.e., in the mainland. Investors will need to be aware that liabilities of a branch are not ringfenced from the parent as they would be with a separate limited liability company subsidiary.

Other considerations

Other considerations which a foreign investor should be aware of in relation to any minority stake in a UAE company are separately outlined in our guide to acquiring a minority stake in a UAE company.

Funding mechanisms

Convertible loan notes

Convertible loan notes (CLNs) are typically used as stopgap funding to help the target reach a value inflexion point. For example, they will be used when the target needs a quick cash injection or to get it to a certain point in its growth. CLNs allow investors to put money in on a short-term basis as a form of bridging loan which can then convert to equity at a later date. CLNs are also sometimes used in early-stage investment when the investor does not want to put a valuation on the company because it is simply too early to determine a suitable valuation.

CLNs will often have a valuation cap and a conversion discount. These are mechanisms by which the holder can convert their debt position into equity at a lower company valuation than the latest funding round. By investing at a lower valuation, convertible debtholders receive equity ownership at a cheaper rate than the valuation at the time.

CLNs quite often accrue interest which will roll up and capitalise on conversion and will usually also provide that on a sale of the target, the holder of those notes can elect to either get their money back or convert into equity.

SAFEs

Increasingly, start-ups in the Middle East and North Africa (MENA) are using ‘simple agreements for future equity’ (SAFEs) as a mechanism through which to raise funds at seed investment stage. A SAFE is an investment contract between a startup and an investor that gives the investor the right to receive equity in the company on certain triggering events.

As with a CLN, generally, the price of the equity that the SAFE holders receive on conversion will be lower than the price of the shares issued to future investors in a subsequent equity financing, based on both or either of a discount rate or valuation cap. However, unlike CLNs, a SAFE is not a debt instrument and does not accrue interest.

With a SAFE, investors are rewarded for their early investment as the SAFE will allow them to potentially own more of the company and pay less for ownership than others who invest in the business at a later stage – i.e. during the Series A round. However, investors need to be mindful of the fact that a SAFE can be held in perpetuity. This is because SAFEs only allow for conversion in a future round of financing and only where that financing involves the issue of preferred shares, in which case the company could potentially raise equity by way of an issue of ordinary shares and thereby avoid the SAFE conversion trigger; or on a liquidity event, such as a sale or listing. This means there is less certainty on when an investor will get their shares or their money back.

Subscription for equity

In many circumstances VC investors will simply subscribe for shares in the target and will enter into an investment agreement or subscription and shareholders agreement to capture the terms of the investment. The investment agreement will typically include provisions detailing:

• the amount and type of equity being acquired – i.e. the class of share if the target has more than one class of share;
• the purchase price and mechanism through which it will be paid;
• board / observer appointment rights;
• minority investor protections such as reserved matters, tag-rights, founder lock-up provisions etc.;
• share transfer rights and restrictions; and
• investor information rights, which are usually fairly extensive for VC investors.

As mentioned above, VC investors will also seek to entrench their minority protections in the target’s constitutional documents to the extent permitted by the jurisdiction in which the target is incorporated.

Exit strategy

VC investors will typically wish to secure an appropriate exit from their investments at a future stage. Investors will have a number of options available to them, which are analogous to those available in many other jurisdictions.

One option is for the investor to sell its shares to other existing shareholders in accordance with the standard rights of pre-emption. Such rights are usually included in a company’s constitutional documents and investment agreements.

Alternatively, the investor may look to sell their shares to a third party, in which case they will need to ensure appropriate provisions are included in the investment agreements to allow for that. This is becoming an increasingly attractive option as other companies or strategic investors look to acquire Middle Eastern companies to gain a foothold in the MENA region.

Another option is for the investor to seek to launch an initial public (IPO) offering on a stock exchange in the UAE, such as the Abu Dhabi Securities Exchange (ADX), Dubai Financial Market (DFM) or NASDAQ Dubai. Some Middle East investors may also opt to do an IPO in a market outside the region.

Two recent IPO examples are Anghami, a music streaming service, and Swvl, a transit and shared mobility services provider, which were both launched in 2022 on NASDAQ and which were originally boosted by VC investment. Anghami was the first Arab tech company to be listed in this way and they may well pave the way for other tech companies in the region to pursue an IPO as their preferred exit strategy.

A VC investor should do the following both at the outset and through the lifecycle of its investment to ensure the target is “exit ready”:

• ensure the investment agreements incorporate provisions to allow the investor different options for an exit;
• include provisions such as ‘drag and tag’ in the investment agreements;
• ensure the investment agreements afford the investor flexibility to take actions on behalf of other managers / shareholders in relation to the conduct of an exit process; and
• carry out preliminary legal due diligence prior to any decision being made on an exit to ensure the legal contracts and documents in the business are in place, and that any red flags arising from this exercise can be rectified before going implementing an exit.