M&A 101 for tech startups

In the UAE’s dynamic tech landscape, founders must master term sheet negotiations to secure investment and protect their vision. Gail Pereira and Tanvi Ahuja of Karm Legal Consultants talk about what to include in a term sheet with investors.

In the rapidly evolving innovation hubs of the United Arab Emirates, where technology and AI SaaS founders are scripting the UAE’s next chapter in global disruption, technology and AI Software-as-a-Service (SaaS) startups in the UAE, are vying to secure investments and funding, often one of the most critical stages in the growth in their business’ lifecycle. While funding is essential, ensuring that the terms of the investment are favourable to the founders, without compromising the long-term vision for the business, is equally important. A term sheet, typically a non-binding document that outlines the key terms of an investment deal, plays a crucial role in defining these details of the investment. For founders, understanding what to include in this term sheet holds the potential to either propel the startup to unicorn status or tether it with golden handcuffs.

This article aims to provide a guide to what AI and technology startup founders should push for in a term sheet with investors in the UAE’s dynamic legal landscape. We will spotlight founder-friendly terms and why founders should not ignore them, particularly in the context of technology and AI SaaS startups. This article will also draw on legal principles under the Federal Decree Law No. 32 of 2021 on Commercial Companies (Federal Companies Law), and relevant frameworks such as the Abu Dhabi Global Market (ADGM) Companies Regulations 2020 (ADGM Companies Regulations) and the Dubai International Financial Centre (DIFC) Companies Law 2018 (DIFC Companies Law), offering both legal and strategic insights.

WHAT IS A TERM SHEET?

A term sheet, while not typically legally binding in itself, sets the stage for the definitive transaction documents such as a shareholders’ agreement or investment agreement. The term sheet generally covers key issues such as investment amount, ownership structure, investor rights, and governance. For founders, the document is both a negotiation tool and a roadmap for future obligations and protections. For AI SaaS startups, where intellectual property (IP) and proprietary algorithms are crucial, a well negotiated term sheet is a chance to safeguard against dilution while aligning investors on the vision of the startup.

THE ANATOMY, A.K.A. KEY TERMS TO INCLUDE IN A TERM SHEET

1. Valuation and Investment Amount

The valuation of the startup at the time of the investment is one of the most critical elements of a term sheet. The valuation will determine the ownership percentage or control that the founders are willing to offer to investors for their capital contribution.

• Pre-money vs. post-money valuation: The term sheet should typically specify whether the valuation is pre-money (i.e., before the investment) or post-money (i.e., after the investment).
• Reasonable valuation: In the UAE, where market dynamics can vary widely depending on whether the company is registered within onshore UAE, or an economic freezone, founders should ensure that the valuation aligns with industry standards, market comparable, and the future growth potential of the startup. It is common to engage with a third-party auditor to assist with a valuation of the startup.

Founders should push for a valuation that reflects the company’s growth prospects but also ensures that the investment is attractive to investors. A fair valuation, agreed on by both parties, helps to maintain healthy investor relations and reduces the potential for future conflicts.

• In-kind considerations: If the startup is incorporated within onshore, the requirements of Federal Decree Law No. (32) of 2021 on Commercial Companies (“UAE Commercial Companies Law”) will apply, specifically where the investment may be sought as an in-kind consideration. Article 118 of the UAE Commercial Companies Law permits founders to provide in-kind contributions in consideration of their shares; however, the valuation of such contribution must take place at the expense of their contributors.

2. Type of investment

There are different types of investment instruments that might be used, including equity, convertible notes, and SAFE (Simple Agreement for Future Equity) notes.

• Equity: The founders must consider is they want to issue preference shares. While equity shares are permitted to be issued across UAE jurisdictions, not all jurisdictions allow for varied classes of shares. Freezones like the ADGM or the DIFC may offer flexibility – thus also warranting any restructuring to allow for such shares. The founders must carefully consider the rights attached to shares offered to investors, such as liquidation preferences, voting rights, and dividend rights.
• Convertible notes: These are loans that convert into equity under predefined conditions (e.g., next funding round). In the UAE, convertible notes should comply with the provisions of the UAE Commercial Companies Law and the regulations of the respective free zones (ADGM or DIFC).
• SAFE (Simple Agreement for Future Equity): A SAFE is a contract under which an investor provides funds to a startup now, in exchange for the right to receive equity in the future (typically when a priced round or liquidity event occurs). It is neither a debt, nor immediate equity, but rather a contingent right to equity on certain trigger events. In many of the freezones of the UAE, SAFEs continue to be a fan favourite for early-stage startups. This is so because, though not formally recognised, based on general legal principles and depending on the jurisdiction where the startup is incorporated, SAFE notes might be enforceable. For instance, certain common law-based jurisdictions might allow convertible equity securities to be issued, thus potentially enabling SAFEs to be executed.

Founders may negotiate for equity investments, if possible, as it does not involve debt obligations. However, if convertible notes or SAFE are used, it is crucial to negotiate favourable terms for conversion, including valuation caps and discounts.

3. Liquidation Preference

Liquidation preference is the order in which investors are paid out in the event of a sale or liquidation of the startup. While the applicable laws in the UAE do not provide for the manner of preference in case of liquidation, some jurisdictions permit for these terms to be agreed to contractually. To elaborate, under the DIFC Company’s Law, in all cases where the nullity of the Company is ruled, the conditions set forth in the Memorandum of Association shall apply to the liquidation of the Company and the settlement of the rights of the shareholders against each other. The debtors of the Company may not request or uphold the nullity in order to be discharged from their debts towards the Company. Thus, it would be advisable to determine such provisions for the memorandum of association at the early stages of negotiations ensuring they form part of the discussions from the term sheet itself. Another key factor to keep in mind while negotiation liquidation preferences, is how ‘liquidation’ is defined under the term sheet, i.e., what events trigger an investor’s right to a payout, and whether a ‘liquidity event’ may also be classified as a ‘change of control’.

Negotiating liquidation preferences is one of the most contentious aspects of a term sheet, especially for founders, and it depends largely on the class of rights being granted to the investors, and often, the investment value.

• Non-participating vs. participating: Investors being granted non-participating preferred shares typically negotiate to receive either the return of their investment or the return on equity, whichever is higher. On the other hand, owning participating preferred shares would allow the investor to “double dip”, meaning they receive both their liquidation preference and a portion of the remaining sale proceeds.

Founders should aim for a non-participating liquidation preference to ensure they retain a significant share of the exit proceeds. However, investors may push for participating preferences, which can be negotiated and leveraged with other rights which may be granted to the investors.

4. Governance and Control

The board and governance structure of a startup should be clearly defined in the term sheet to ensure that both parties understand their roles and responsibilities, specifically where an investor pushes for representation within the decision-making body. Founders should keenly reflect on how many board seats are being allocated to investors, and whether the investor is seeking any additional rights, such as ‘veto rights’ over critical decisions such as issuing new shares, taking on debt, future fundraises, entering strategic partnerships, or sale/ transfer of any core IP of the startup. Founders should carefully consider the scope of these rights and avoid excessive control being ceded to investors. An odd-member board (i.e., 3 or 5 or 7 members) may be considered by the founders to ensure that deadlocks are few, and decision-making remains balanced.

5. Anti-Dilution

Anti-dilution provisions protect investors from the dilution of their equity in the startup in the event of a down round. That said, the nature and the manner in which anti-dilution rights are granted to investors may, over future funding rounds, dilute a founder’s share and control over the startup.

While the UAE Commercial Companies Law does not specifically prohibit or permit the negotiation of anti-dilution rights, founders may find more negotiation room in jurisdictions such as the DIFC or the ADGM, which are premised on and follow common-law principles. In these jurisdictions, founders may also consider a ‘pay-to-play’ clause, which would require investors to fund future investment rounds, or forfeit their anti-dilution right.

6. Restrictions and Exit Rights

Founders may seek to impose certain restrictions on investors with respect to the specific class of shares held by such investors, including lock-in and share transfer restrictions.

With respect to investors’ exits, most investors prefer a quick exit. That said, founders should carefully consider the terms under which the investor can exit the investment. Common exit provisions restrictions include:

• ROFR (Right of First Refusal): Founders may negotiate this transfer and exit restriction to ensure that the control of the startup remains within the existing pool of investors and may not be easily transferred to an unknown third party.

Investors may also negotiate other exit terms such as:

• Tag along or co-sale: Provisions where the investors may be eligible to ‘tag along’ with the founders in case of a founder exit.
• Drag- along: provisions where an investor (including a founder) has the ability to ‘drag’ other investors out of the startup, typically in the sale of a majority shareholding of the startup.

Where a founder is exiting, they should seek to retain as much flexibility as possible in terms of exit rights, and ensure that there are minimal continuing obligations upon them post their exit, including any indemnification obligations.

CONCLUSION

Securing investment is a critical step for technology and AI SaaS startups in the UAE, but equally important is negotiating a term sheet that aligns with the long-term vision of the business while protecting the founders’ interests. Understanding the essential components of a term sheet is key to navigating the complex legal and commercial landscape and can potentially save founders time spent in negotiation of definitive agreements.

The UAE Federal Commercial Law, along with the specific laws applicable within the economic freezones in the UAE, offer a strong legal framework that founders can leverage, remaining steadfast in protecting their interests during negotiations.

By being aware of the crucial terms and negotiating a balanced term sheet, founders can turn the winds between attracting investors and preserving control over their company, into tailwinds for odyssey to growth.

Text by:

1. Gail Pereira, associate, Karm Legal Consultants
2. Tanvi Ahuja, associate, Karm Legal Consultants