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What is an ESOP

An employee share ownership plan (ESOP) is a type of employee benefit plan that is intended to encourage employees to acquire shares or ownership in their company. Most companies create employee share ownership plans to provide the motivation, inspiration, and retention associated with ownership. Employees can buy the shares directly, be given them as bonus, receive share options, or obtain shares through a profit-sharing plan.

ESOPs are very common with publicly listed companies, but are also seeing a growing adoption rate within privately held companies as well. Companies regulations in Saudi Arabia, the UAE (ADGM, onshore, and various free zones), the Cayman Islands, and the BVI accommodate structuring ESOPs and offering employees ownership schemes, with various applicable parameters.

Benefits of ESOP

An ESOP typically yields a higher pay and set of benefits for employees than mere financial, while creating true job security and gratification. This plays well with cash-strapped startups and growing companies. ESOPs are most commonly used to attract, motivate and reward employees. That said, there are other uses commonly seen in other markets such as the U.S. where ESOPs are also used for tax-related purposes. Employees with share entitlements feel united, validated and more invested in the success of the company. An ESOP can be a great tool for a company looking to attract otherwise expensive talent, enhance organizational performance, help employees prepare for retirement, and allow business owners to create liquidity to meet growth or diversification goals.

Establishing an ESOP

The common approach to establishing an ESOP is for the company to establish a trust of which the company’s employees are beneficiaries. The employees then make contributions to the trust via the employer (usually through payroll deductions or bonus allocations), and the trust in turn purchases the shares of the company. These purchases are allocated to the benefit of the individual employees beneficiaries of the ESOP. The other approach is to allow the employees to directly own shares in the company, but this may result in added formality hurdles in connection with KYC and transfers.

Companies can allocate contributions to employees in a number of ways, but contributions usually revolve around signing bonuses or the employee’s years of service and compensation. A formal plan document is developed and published setting forth the terms and conditions of the ESOP, and describing how the plan operates, who is eligible to participate, and who performs administrative and trustee functions.

After becoming fully vested, the company “purchases” the vested shares from the retiring or resigning employee. The money from the purchase goes to the employee in a lump sum or equal periodic payments, depending on the plan. Once the company purchases the shares and pays the employee, the company redistributes or voids the shares. In most instances, departing employees do not take the shares with them, only the cash payment. Fired employees often only qualify for a portion of their vested shares.

Considerations relating ESOPs

As attractive as the benefits of ESOP are on different aspects, there are some considerations companies and management should keep in mind when contemplating establishing an ESOP. Setting up the structure for the ESOP is relatively complex. Administration is also an ongoing task that requires specialization attention. Most commonly, these are done through attorneys or specialized administrators, which means that they do come at a cost. In addition, if an employee terminates his/her employment or passes away, the company will most likely be required invest some money to repurchase that employees shares.

Is ESOP Right for you?

An ESOP, or employee share ownership plan, is a great tool to attract, motivate and retain talent. It creates a sense of belonging to the employees and enable them to feel connected to the company and its management. It can also foster a sense of transparency and shared ownership. That said, it also requires administration and management, and if mismanaged, can be a source of dissent and claims against ownership, which are red flags for investors and funders.

The Liquidation Preference term is frequently used in fund-raising rounds. It is a major economic term to be negotiated in the term sheet between the founders and the investors, and is arguable the preference of the preferred shares.

Definition of Liquidation: A liquidation is the procedure according to which a company dissolve its business. Prior to such resolution the company goes through a number of steps with the aim of settling all its financial obligations to third parties and distributing any excess assets to the shareholders. Such liquidation occurs with a trigger, which is commonly named a “Liquidation Event” Liquidation Events usually includes:

• A merger or consolidation (other than one in which shareholders of the company own a majority by voting power of the shares of the surviving or acquiring company).
• Sale, transfer of all or substantially all of the assets of the company.

Liquidation Preference: In Venture Capital (“VC”) deals, the Liquidation Preference functions as a protection to the investors, granting them the right to get paid first when a Liquidation Event occurs.

• The Participating Liquidation Preference “Double Dip”:

In the Liquidation Preference with Participation, the preferred shareholders (ex. the investors) are eligible to receive the Original Subscription Price[1] in addition to accrued dividends plus declared and unpaid dividends. Thereafter, the preferred shareholders will participate along with the ordinary shareholders (ex. the founders) on a pro rata basis in the distribution of the remaining assets. In effect, the preferred shareholder receive its invested amount first, the shares in whatever is left, if any.

• The Non-Participating Liquidation Preference:

In Liquidation Preference with Non-Participating, the preferred shareholder will only be eligible to receive the Original Subscription Price in addition to the accrued dividends plus declared and unpaid dividends. But this does not mean that the shareholder does not participate in the upside, because fundamental to such election is the preferred shareholders right to convert their shares to ordinary/common shares at any time. Therefore, if the liquidated assets after the satisfaction of third party obligations are equal to or less that the Original Subscription Price, the preferred shareholder will not convert, and will receive all the liquidated assets.

If however, the liquidated assets less obligations are more than the Original Subscription Price (i.e the company was sold for a profit), the preferred shareholders will convert their shares to ordinary shares and receive Pro-rata a portion of such assets.

There are two (2) more commercial terms that are commonly used in the Liquidation Preference and frequently negotiated between the founders and the investors and they are as follows:

• The Multiple:

In the Multiple, the preferred shareholders shall have the right to a multiple of the Original Subscription Price. This can be added to a participating or non-participating liquidation preference. For a better understating of this term, let’s assume the following:

• The investor invests USD 1,000,000 in a company and receive preferred shares.
• The pre-money valuation of the company is USD 3,000,000.
• The post-money valuation of the company is USD 4,000,000 (investment amount + pre-money valuation).
• This means that the investor will have 25% of the company’s share capital (investment amount divided by the post-money valuation of the company).

Case 1: The parties agree to a 2x Participating Liquidation Preference.

In this case, the investor will have the right to receive USD 2,000,000 (the investment amount x2) in addition to the accrued dividends plus declared and unpaid dividends, thereafter the investor will have the right to participate along with the ordinary shareholders (usually the founders) on a pro rata basis in the distribution of the remaining assets. So, if the Company had sold its assets and had USD 10,000,000 to distribute to the shareholders, the investor will receive USD 4,000,000 (2x investment amount + 25% of interest). If the Company had USD 4,000,000 to distribute to the shareholders, the investor will receive USD 2,500,000. If the Company had USD 2,000,000 to distribute, the investors will take it all.

Case 2: The parties agree on a 2x non- participating Liquidation Preference.

In this case, the investor will have the right to obtain USD 2,000,000 (the investment amount x2) plus in addition to the accrued dividends plus declared and unpaid dividends without participating with the ordinary shareholders in the distribution of the remain assets. Otherwise, they can elect to convert their preferred shares to ordinary shares, forgoes the liquidation preference and participate pro-rate.

If the Company sold its assets and had USD 10,000,000 to distribute to the shareholders, the investor can elect between remaining preferred shares and receiving USD 2,000,000, or convert and receive USD 2,500,000 (25% of USD 10,000,000) of course they will convert. If the Company had USD 4,000,000 to distribute, the investor will keep its preferred shares and receive USD 2,000,000.

• The Cap:

The Cap is designed to protect the founders and keep a balance between all the shareholders by putting a ceiling on how much the investor can receive.

Following the above example, the below demonstrates the use of the Cap in a Liquidation Preference clause.

Case 1: The parties agree on a 2x Participating Liquidation Preference with a 3x Cap.

In this case the investor will have the right to obtain USD 2,000,000 (the investment amount x2) in addition to the accrued dividends plus declared and unpaid dividends. Thereafter, will have the right to participate along with the ordinary shareholders on a pro rata basis in the distribution of the remain assets up to USD 3,000,000. However, their participation shall not result an amount more than USD 3,000,000 (the investment amount x3).

If the Company sold its assets and had USD 10,000,000 to distribute, the investor will receive USD 4,000,000 as the example before. But if had USD 20,000,000 to distribute, the investor will receive USD 5,000,000, only (2x investment amount + 25% of the rest with a cap of 3x investment amount). Without the cap, the investor would have received USD 6,500,000.

Conclusion:

The Liquidation Preference is a major term in VC investments, and we highly advise all the founders to fully understand it and to appoint a counsel to negotiate it on their behalf. The Liquidation is not necessarily a disaster or unfair for the company, but if not negotiated, it can remove the incentive of the founders to sell early, and the cling on to a higher valuation.

[1] The Original Subscription Price is the price of each share issued to the shareholder. It differs based on valuation.

A fundraising for a startup is always good news and helps in the growth of the company. That said, the process accompanying any round of financing can be lengthy and complicated, especially when not well planned, structured, or organized.

An entrepreneur seeking to raise fund should firstly consider if she/he is prepared to lose a chunk of her/his equity in the company and subsequently be diluted as long as the company is moving forward. The prevailing thought is: a smaller slice of a bigger pie.

We previously discussed the transactions documents needed for the completion of a round of financing http://www.smelaw.com/introduction-seed-round/. Transaction documents, however, are not everything, and a large number of startups, especially the early stage ones, underestimates the efforts and time required to close a round of financing.

In this article we highlight the major points, we commonly see necessary to properly close a round of financing, and the different solutions to reach this goal.

The goal is closing not signing.

Founders in a fund-raising scenario are focusing on completing the paperwork as fast as they can in order to obtain the investment amount needed for the growth of their company. they commonly expect investors to pay as soon as the subscription agreement is signed. Unfortunately, the signature of such agreement or the whole pack of the transaction documents does not mean it is time to receive the investment amount. The investment amount will be due when the company fulfill its conditions precedent and reach the closing as defined in the subscription agreement.

What is Needed to Close a Round of Financing?

In a typical round of financing, the investors usually set some conditions to be completed by the founders in order to release the investment amount. These conditions vary from a company to another, and they are based on the due diligence exercise conducted by the investors. They tend to address risks the investors see needing remedy.

Here are some of the conditions that we usually come across for early stage companies:

• Corporate restructuring for the company;
• Rescinding of certain agreements executed by the company; and
• Intellectual property protection measures to address intellectual property risks.

Our advice to the founders in relation to reaching a proper closing for the round of financing is to follow four (4) basics rules.

• Hire a competent VC lawyer to represent you and the Company;
• Always speakwith the lead investor; keep the lead investor up to date with the growth of the company and familiarizes it with the conditions precedents and their expected time impact set by the investors before finalizing the transaction documents;
• Start working to work on the conditions set out by the investors once they are identified without any delay, even before the signing of the transaction documents; and
• Set out a rational closing date, accommodating the negotiation period of the transaction documents and the timeline required for the fulfilment of the conditions precedent.

In addition to the above, we advise the founders to be prepared for the required paperwork related to the issuance of the shares for each investor and the procedures to amend the company’s articles of association, where necessary. These procedures usually involve many submissions to various authorities.

Running Out of Cash

In case the startup is rapidly growing and investment funds is immediately needed to keep the company working, the founders, directly applying rule number two (2) above and keeping the lead investor up to date with the growth of their startup a part of the investment funds to be advanced in the form of a Convertible note (such as a SAFE Note). This can allow all parties a reasonable time to complete the transaction without the risks that result from a rushed job.

During the past three years, the economic cycle of the region, coupled with the influx of western-educated college graduates returning to the gulf, spurred an enormous level of attention to startups and technology, and spurred a venture focus that was hardly seen before. Young and capable entrepreneurs (commonly referred to as “Founder(s)”) and seasoned venture stage investors started coming together and looked to combine efforts to build business and generate value in the region.

Naturally, these ventures looked to the US’s thriving venture capital market for inspiration. And with that, the terms, Seed and Series A started being used commonly.

We previously, wrote about mechanics of venture investments, and discussed term sheets and due diligence, but it is worth taking a moment to fully explain the first real investment a Founder receives, the seed round, and set out what the parties expect to see in such round.

First, we start with the question, what is a Seed Round: In simple words, the Seed Round is the first organized investment round received into a business from a third-party investor. Founders commonly raise seed round during or at the end of the proof-of concept stage of the business and is geared to obtain funding in order to be able to launch a product as a service (“Seed Round”).

Before the Seed Round, the business would have been funded by the Founders and some of the “three Fs”, friends, family and fools. But because this is an organized investment by third parties who are mostly professional investors, Founders should expect this to be different, and to mark a change in the life of business.

Phases of the Seed Round:

Founders seeking to raise a seed round start by applying for funding with various venture capitals and angels. This process commonly involves many demands, meetings will include a one or two pages’ teaser about the business and a well-prepared pitch presentation. This process ends with an investor or a syndication of investors offering a term sheet to the Founders setting out a proposed investment terms.

What is a Term Sheet:

Once a founder receives a term sheet, it is highly advisable that she/she appoints a counsel to help with the rest of the transaction. But it is also common to see Seed Round without Founders’ counsel if the investment amount is small. The term sheet commonly sets out the following terms:

1. Subscribed shares by the parties.
2. Pre-valuation of the Company and its authorized capital.
3. Distribution of shares amongst the shareholders.
4. Amount of investment injected in the Company and the milestone (if any) set to reach this agreed investment.
5. Agreed liquidation preference rights.
6. Management of the Company.
7. Transfer restrictions.
8. Employees share option plan (if applicable).
9. Intellectual property (“IP”) rights.
10. Confidentiality and non-compete provisions.
11. Governing law and the competent jurisdiction.

Once a Term Sheet is signed, the Founder and the Investor are ethically committed to negotiate and reach closing on an investment into the business. And with that commitment, the lawyers can proceed with the drafting of the Definitive Agreements.

The Definitive Agreements:

1. Subscription agreement: An agreement where all the parties and the Company undertake their representations and warranties, the allotment and issuance of subscribed shares.
2. Shareholders’ agreement: An agreement to draw the relationship between the shareholders and the legal structure of the Company, this agreement will include more details on most of the points agreed on in the Term Sheet.
3. IP assignment agreement: To ensure that the Founder will assign and transfer to the Company all the copyrights and IP related to the Project, including but not limited to (trademarks, domain names, etc.).
4. Founders’ agreement: An agreement between the Founder and the Company to ensure his/her commitment to the Company and to avoid any malpractice by the Founder. This agreement is usually requested by the Investor in order to protect their investment.

The above-mentioned agreements, in principal are considered the core of any Seed Round for a tech-startup. Naturally, some cases of course vary and Founders should not be rigid about variation.

Completion:

Once the Definitive Agreements are negotiated and finalized, and closing takes place, (ie. Funds are wired) the process is perfected by the various issuance of shares, enactment of resolutions, appointments of directors, and putting in place the new management structure.

The Seed Round is a very critical step for a business as it marks its graduation from a project that the Founders are passionate about to a business others believe in. it is important for all parties involved to complete the round and enter the new chapter in the life of the business with strong and well organized documents. We always advise the Founders to think about choosing the right fund needed for the business and not necessary the biggest one, for the investors to exercise a proper due diligence on the business and make sure that it is fully understood from their side before taking a decision of funding.

Corporate or company governance is a term that has been trending in recent periods amongst the startup growth circles, and no doubt that good governance is a key ingredient in the formula for sustainable growth. Yet many entrepreneurs (and perhaps even some corporate managers) remain uncertain as to what the term actually means, and what they should be looking for when thinking about the governance of their businesses. The following are 3 major items every entrepreneur should consider when making governance considerations, be it putting together or updating a governance manual, or seeking shareholder or board approvals on authority and systems:

I.The Organization: how the organization should look like and function
The first pillar of governance is identifying how the company is organized and structured, and who is responsible for doing what in the organization. This involves clearly mapping the board and its authority, executive management and their domains, and the reporting lines for every department and division. Entrepreneurs should take extra effort to clearly establish and divide roles and responsibilities to minimize conflicts and delays caused by intersecting spheres. The key elements in building or structuring an organization are:

a.Roles and responsibilities of each management level
b.Clear reporting lines
c.The organization chart

II.Delegation of Authority
The second pillar of governance is mapping where the authority to make decisions and spend company funds reside along the company pyramid. The constitutional documents (articles, memoranda of association, and shareholders’ agreements) delegate authority from the shareholders to one or two levels of higher management. The further flow of delegation should be mapped, ideally in line with the roles and responsibilities of various positions in the organization. The entrepreneur should pay attention to approval and spending authorities, noting that the two can be distinctly managed (example: CTO to approve a purchase, but CTO and CFO to approve the transfer of funds to the seller), and to spending within and outside of the approved business or operating plan.

III.Policies
The final part of a business’s governance is the set of policies and procedures the business follows in carrying out its daily activities. These are very much driven by the operational needs of the business, but some are very common today that every business is expected to have them. These common policies include an IT policy, email use policy, privacy and data maintenance policy, and vehicle use policy. The entrepreneur should assess what are those certain operations that should be carried out uniformly, and develop the set of policies or procedures to ensure that every employee adheres to such methods.