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THE VALUE OF A TERM SHEET

Many businesses, small and large, retain attorneys to draft transaction documents and simply let them have at it. This is especially the case if there is a pressured timeline. What many business leaders forget, however, is that bare-bone, “high-level” agreements amongst themselves are not always sufficient to reach execution of the intended transaction. So when lawyers return with first drafts, most of the terms, many of which are vital to the transaction, will be seen (or maybe even heard of for less weathered SMEs) for the first time by the decision makers. Negotiations then ensue on commercial terms, sometimes transaction structure, as well as drafting and legal language. Not only does such a wide scope of negotiations results in delays to closing, but it also yields a high transaction cost with lawyers at both sides attempting to address a minefield of commercial, structural, drafting, and legal input. This takes place despite agreement on some of what the proprietors thought were the “high-level” terms, mostly commonly: valuation, duration, and what is being transacted, and results in frustration and agitation with the process. In many instances a deal falls apart despite agreeing on price and duration because the parties fail to reach agreement on other major terms such as warranties, guarantees, protective provisions, and liability limits.

In some circumstances, incurring high transaction cost can even form additional pressure to close on the transaction and therefore weaken the party’s negotiating hand because it will not be able to justify the high legal costs on a failed or abandoned transaction.

Enter the well-structured term sheet: a summarized version of the major terms of the transaction set out in a simple table format that can be easily understood and negotiated by the business proprietors and decision makers, and provides a concrete basis for legal drafting. The term sheet is brief and flexible enough to allow the commercial teams to negotiate the various terms without needing to incur the added expense of lawyers, yet is detailed enough to give a solid foundation for the lawyers when they draft the definitive documents. Putting together the term sheet is commonly advised on in the first instance by lawyers, but its existence reduces the scope of negotiation after the decision makers sign the term sheet to drafting and legal language.

To give an example from our practice, a corporate client (“Buyer”) shook hands with its counterpart (“Owner”) of a healthcare facility to acquire a 51% share of the facility company for USD 10,000,000, and sent us an email to commence drafting with definitive document drafts due at the soonest as the parties reached agreement and wanted to execute. Soon after we commenced drafting, it surfaced to us that while Owner understood that the transaction was for the sale of shares, the Buyer had intended subscription, with the funds going to the co-owned company for use in the facility rather than going to the Owner. It then took two months of negotiation and several rounds of meetings to agree on a combined subscription and partial exist structure, and of course new documents had to be drafted. After that, negotiations ensued on the scope of the representations and warranties, board and shareholders’ rights, company capital structure, and many other vital terms the parties had not considered previously, with each change and revision by the client requiring changes to the definitive agreements, and necessitating a full review of the documents to ensure that the change is reflected and harmonized throughout the documents. At the end it took nearly 6 months for this transaction to reach signing.

This prolongation and the costs associated with it could have been avoided had an accurate, well-structured, and professionally-advised term sheet been drafted at the forefront, then negotiated and agreed by the parties. The Owner and the Buyer would have had clarity and mutual understanding of the major commercial and legally material elements of the transaction before incurring definitive agreement drafting costs.

Methodical transaction-focused businesses deploy term sheets with rigor. We see this with banks, venture capital and private equity firms, and professional joint venturers. These transaction experts have honed their transaction skills and optimized transaction costs, including legal spend, and as lawyers, we concur with their practice. Term sheets help reduce legal fees, and provide for a better overall transaction structure and experience.

The Organization of Economic Cooperation and Development (OECD) has put a spotlight on the privileged tax regimes of all zero and low tax jurisdictions. In order to level the playing field between jurisdictions in a context where taxpayers can easily relocate their mobile activities in response to tax considerations or with the intent to evade applicable substantial activity requirements, OECD aim to impose substance criteria on zero and nominal tax jurisdictions and provide guidance on their implementation. The OECD’s substance criteria is mainly grounded in minimum operations requirements and transparency of information.

Whom it applies to (OECD, 2018):

1. Jurisdictions that do not impose a corporate income tax.
2. Jurisdictions that impose only nominal corporate income tax to avoid the requirements.
3. NOT jurisdictions that have been reviewed on the basis of the preferential regimes they offer (unless they undertook reforms that abolish their corporate income tax altogether).

The business activities that are subject to the substance criteria fall into the categories of headquarters, distribution centers, service centers, financing, leasing, fund management, banking, insurance, shipping, holding companies and the provision of intangibles (OECD, 2018).

The requirements (OECD, 2018):

1. Define the core income generating activities for each relevant business sector.
2. Ensure that core income generating activities relevant to the type of activity are undertaken by the entity and are undertaken in the jurisdiction.
3. Require the entity to have an adequate number of full time employees with necessary qualifications and incurring an adequate amount of operating expenditures to undertake such activities.
4. Have a transparent mechanism to ensure compliance and provide an effective enforcement mechanism if these core income generating activities are not undertaken by the entity or do not occur within the jurisdiction.

Note: OECD’s report points do not automatically bind any entity until legislation has been enacted for the purpose of complying with these requirements; therefore, it is important to observe the precise laws Saudi Arabia and other jurisdictions will introduce in this regard.

For more information regarding OECD’s substantial activity requirement please contact Kenan Nagshabandi at:

E: kenan.nagshabandi@13.233.247.59

M: + 971 (0)502355321 / +966 (0)599986020

We’re looking to raise one million dollars at a valuation of five million.” This is a common line with which entrepreneurs conclude their raising pitches. But a closer attention to the applicable company regimes in the GCC will reveal that executing these terms is not very straight forward. Limiting our focus for now to the two largest SME hubs the region (KSA and UAE), the applicable laws of both jurisdictions employ a structural obstacle by mandating a unified share price for LLCs.Such legal requirement prevents founders from causing the issuance of shares to investors at a higher valuation, because it mandates that the per-share value must be equal among all shareholders. The investors in our example will not be able to pay one million for 20% of the company if the entrepreneurs did not pay four million for the remaining 80%. And while such obstacle, from a legislative perspective, is addressed through the availability of joint stock companies (JSCs), which allow the issuance of stock at premium and the issuance of different classes of stock, the administrative costs associated with forming and maintaining JSCs remain prohibitive for most SMEs. So how do entrepreneurs and venture capitalists overcome such obstacle and recognize the value of early stage work without fronting hundreds of thousands in costs to convert into a JSC?

The common solution deployed by regional SMEs is to hold the local operating LLC through an offshore SPV that houses both investor and founder shares. The SPV would allow for investment amounts to be raised via different classes of shares at different share prices, and authorize surplus to be paid on top of share par value. The higher valuation will translate into shares issued for a premium to par value, thus lowering the number of shares issued to the investors versus the founders. The valuation can also be translated into preferred shares with minimal input into company management but senior distribution preferences.

BVI and Cayman Islands are commonly used for the jurisdiction of the SPV, with a possible second-tier SPV registered at a UAE offshore jurisdiction for localization purposes. See Chart 1 for common holding structures. While we agree that such structures do add administrative costs to SMEs, they remain much cheaper than the cost of meeting and maintaining the administrative requirements of JSCs.

We recognize that facilitating capital inflows into SMEs through lowering obstacles such as this one has the attention of many MENA jurisdictions, and Saudi Arabia’s recent lowering of the minimum capital requirement for JSCs to SAR 500,000  is a leading example of that. It remains, however, that the structures outlined here offer cheaper, more flexible, and more commonly used processes for founders and investors to set valuations of rounds in growth companies.

How to close a round of financing?

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 An Introduction to the 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:

1-      Corporate restructuring for the company;

2-      Rescinding of certain agreements executed by the company; and

3-      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.

1-      Hire a competent VC lawyer to represent you and the Company;

2-      Always speak with 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;

3-      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

4-      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.

Abu Dhabi Global Market (“ADGM”) is an international financial center for local, regional, and international institutions established as an independent legal jurisdiction in Abu Dhabi in 2013. The ADGM draws significant similarities to the Dubai International Financial Centre (“DIFC”), which is a well reputed and leading financial center established in 2002.

ADGM and DIFC are different from other free zones within the UAE, as they have their own legislation and are legally considered as separate jurisdictions. Both ADGM and DIFC have strong basis in common law, distinguishing them from the UAE civil law regime.

Below, is a table summarizing the key points of the newly adopted startup licenses by each jurisdiction.

On September 20, 2016, the U.S. Department of Transportation released the Federal Automated Vehicles Policy. This policy set guidelines that highlight for technology developers and manufacturers the most important areas that to consider when designing, testing, and deploying highly automated vehicles (“HAV”).

The 103-page document covers three major areas: (i) vehicle performance guidance; (ii) model policy for state to adopt; (iii) current and potentially upcoming regulatory tools. Seeing that we are mostly advising tech companies, we set out below an early and a highly abbreviated summary of the first section on vehicle performance guidance (or the “Guidance”), which outlines practices for the pre-deployment design, development, and testing of HAVs, i.e. prior to selling them.

The way the Guidance is designed is by setting out key areas to address by the manufacturer prior to testing and deployment. Many areas apply to all automation systems on a particular HAV, but some are more specific and apply specifically with respect to each system. These areas are important to understand even for system developers that do not manufacture vehicles because vehicle manufacturers are likely to imbed such the requirements set out in the guidance into their development and procurement processes.

From the Guidance applicable to all HAV systems we highlight the following:

1. Data Recording and Sharing: The manufacturer should out in place a documented process for collect event, incident, and crash data for the purpose of recording the occurrence of any malfunctions or failures in a way that can be used to establish the cause of the occurred event and develop new safety metrics;
2. Privacy: The manufacturer should take steps to ensure the protection of consumer privacy and data collected by the vehicle;
3. Safety System: The design and validation process deployed should be robust and based on a system-engineering approach with the goal of producing an HAV system that is “free of unreasonable safety risks,” and should include the ability to place the vehicle in a safe state even when errors occur;
4. Vehicle Cybersecurity: The manufacturer should follow an engineering process that minimizes risks due to cybersecurity threats, including continuous HAV system risk assessment and response;
5. Human-Machine Interface: The HAV system should consider the interactions and the need to communicate information to the driver, especially where the driver will assume certain control functions. The system should also consider communications with pedestrians and conventional and automated vehicles around the HAV regarding its state of operation relevant to the circumstances (example: signaling);
6. Crashworthiness: HAVs must meet the NHTSA crashworthiness standards irrespective of their technology. In addition, the manufacturer should develop systems for occupant using the information delivered from the advanced sensing technologies needed for HAVs; and
7. Post-Crash Behavior: The manufacturer should employ and documented process for the assessment and validation of how an HAV is reinstated into service after a crash.

The U.S. DoT’s published policy is intended to be the first step of providing further guidelines ensuring the safety and protection of HAVs, people, and other vehicles in their environment. The policy is not intended to codify as legal requirements the set of guidelines therein, and it is not mandatory yet.

Saudi Arabia recently eliminated the cap for foreign strategic investors in shares of listed companies. The Kingdom eased its rules to increase international funding and diversify its investor base. This decision will allow foreign strategic investors to purchase controlling stakes in the nation’s economic sectors that surpass 49 percent. By 2030, their financial regulators expect the relaxed rules to raise foreign investment to ten percent of the nation’s GDP. International investors can purchase majority ownership in the country’s commercial lenders for the first time in almost 40 years.
The Capital Market Authority (CMA), based in Riyadh, adopted the Foreign Strategic Investors’ Ownership in Listed Companies instructions. According to the nation’s regulators, the new laws will increase their market’s attractiveness and efficiency. It will also expand Saudi Arabia’s institutional investor base. There will be no maximum or minimum limits placed on foreign investors concerning the ownership of listed companies.
According to the CMA, these steps align with the Kingdom’s Financial Sector Development Program objectives outlined in its Saudi 2030 vision program. The directive also adheres to its Financial Leadership Program, a strategic program launched by the nation. These instructions will go into effect on the date of their publication. Additionally, the CMA board amended the Rules of Qualified Foreign Financial Institutions Investment in Listed Securities (Subparagraph (a\2) of Article (14)). They also changed paragraph (2) of Part (3) of the Guidance Note for the Investment of Non-Resident Foreigners in Parallel Markets.
In the 1970s, the Kingdom forced foreign lenders to sell majority stakes in local operations to Saudi residents. Currently, the largest foreign strategic investors in Saudi Arabia are HSBC Holding Plc, Credit Agricole SA, and the Royal Bank of Scotland Group Plc.
During a telephone interview, Bloomberg News spoke with the CMA Chairman Mohammed El-Kuwaiz. “Saudi Arabia, increasingly, is open for business, not just or local investors but for international investors,” the regulatory official said. “It is ironic, I would say, that Saudi is rapidly opening up and embracing the world in a period when the rest of the world seems to be closing down.”
Saudi Arabia started introducing market reforms four years ago to help attract international investment and issuers. The Kingdom’s stock market remains one of the largest in the Middle East and Africa. According to data collected by Bloomberg News, the exchange has a capitalization of $540 billion.
In 2019, the Saudi Stock Exchange has seen an expansion of its international cash flow. The number of qualified foreign investors (QFI) in emerging market indicators rose from 453 QFIs to 1,195 in June 2019. This data represents a 163.7 percent increase. Additionally, the ownership percentage of QFIs in the Saudi Capital Market has skyrocketed from 4.7 percent in January 2019 to 7 percent. QFIs have made investments and purchases worth 51.2 billion riyals ($13.6 billion) by May 2019, and now own 6.6 percent of the nation’s equities.
Although the CMA has relaxed the 49 percent cap on foreign strategic ownership in publicly traded companies, other rules and limitations still apply. For example, industry authorities will need to approve deals that surpass the thresholds in different sectors such as petrochemicals and banking.
Chairman El-Kuwaiz said that the Authority has seen a huge request for investment from non-financial foreign investors. The CMA decided to grant approval on an exceptional basis to this select strategic foreign investor group. Non-financial foreign investors can now invest in Saudi Arabia’s listed company holdings.
According to the Capital Market Authority, qualified foreign investors (QFI) are individuals or companies that can invest in securities listed on the Saudi Stock Exchange in accordance with its rules. These laws regulate how foreign financial institutions invest in the Saudi Stock Exchange listed securities (including equities, debt instruments, and funds).
To qualify as a QFI, an applicant must be a financial institution that has a legal personality that falls into one of the six categories. QFIs must be either banks, brokerage or securities firms, insurance companies, government or related entity, investment fund, or Authority-eligible financial institution. Additionally, the applicant must possess assets under management equating to a SAR 1,875,000,000 (one billion eight hundred and seventy-five million Saudi Riyals), an equivalent amount, or more.
Additionally, the financial institutions must be licensed or monitored by jurisdictions who have standards equal to the CMA’s. The agency must provide an Authorized Persons (AP) who have a dealing or custody licenses in jurisdictions that apply regulatory and monitoring standards equal to the CMA, or pursuant to its Financial Action Task Force (FATF). Newly established financial institutions can submit applications to qualify as QFIs however, they must meet the nation’s minimum assets under management requirement.
Assets under management include those owned by the applicant or its group for investment purposes or owned by foreign portfolio managers or its group. An applicant (or account for another person related to the financial institution) can manage this account. These include assets owned by a foreign portfolio manager or their group for the account of another person or people.
The Kingdom requires strategic investors who buy stakes in a listed company to hold their investments for 24 months before they can sell them. This period doesn’t apply to those who already hold shares in listed companies unless they purchase more. The two-year rule will apply to the new shares.
For a full list of rules, please read the Capital Market Authority’s “Frequently Asked Questions on the Rules for Qualified Foreign Financial Institutions Investment in Listed Securities.”
Are you a foreign investor seeking to invest in Saudi Arabia’s growing economy? Trust the Hammad & Al-Mehdar Law Firm to handle your legal affairs. We are an industry giant with more than 35 years of legal experience. In 2018, the Islamic Finance News named us the Best Law Firm in the category of Mergers and Acquisitions. Our team has veteran attorneys that specialize in international civil law and common law. We can help you in our nation’s sectors, including private equity and venture capital. We also hold alliances with several international law firms. You can trust our attorneys to handle your legal needs. Contact us today for more details.