Category Archives: Publications

When monitoring the investments management world, it is very easy to see a strong move by investors to invest in a manner that reflects certain social values they hold important. Investors generally, and sovereign wealth especially, are taking active steps that seek to ensure that their money supports companies that align with their values, be it socially, economically, or religiously driven. Of these values, investing according to certain social values, or Socially Responsible Investing, has become a widespread practice that has skyrocketed in popularity.

This article discusses socially responsible investing, and how fund managers or general partners (referred to as “GPs”) and fund investors or limited partners (referred to as “LPs”) may use excuse provisions in fund documentation to ensure that their investment dollars are invested in line with their social values.

What is Socially Responsible Investing (SRI)

Socially responsible investing (“SRI”) refers to investing in a manner that supports companies that are good corporate citizens and have a beneficial societal impact. SRI, over time, has developed into a strategy adapted by investors in issuing their investment mandates or selecting direct and indirect investments. The basic premise of such strategy is that social responsibility derives sustainability and results in long-term returns. In a survey carried out by TIAA, one third of investors have specific SRI investments.

SRI inspired former-acting United Nations Secretary-General Kofi Annan to ask the world’s leading institutional investors in 2005 to help develop the U.N. Principles for Responsible Investment (UN PRI), and the U.N. officially announced its UN PRI in April 2006 at the New York Stock Exchange. Now, the number of investment managers that signed up for the program stands at over 3,000 investment managers.

Recognizing this trend, a significant number of fund managers started offering investment funds that fully or partially invest in socially responsible businesses, or follow a specific SRI policy or guidelines. But for LPs in private equity or venture capital funds that have specific SRI goals, an additional tools is available that helps them direct their investment dollars in accordance with such goals. This tool is the excuse provision commonly negotiated in private fund documents.

SRI and the Excuse Provisions

An excuse provision is a provision that is commonly negotiated into private fund documents (be it the terms and conditions, limited partnership agreement (“LPA”) or side letter) that permits the investor to excuse itself from participating in a fund investment into a company or opportunity. This provision is a powerful tool for investors that allows them to dictate the social (and other environmental, national, or religious) parameters pursuant to which their capital is invested by the GP. To effect the use of such provision, LPs tend to deliver to the GP a set of social (or other) investment parameters along with their investment documents to make the GP aware of the type of opportunities that the LP will avoid through the exercise of its excuse right if they are pursued by the GP.

Standard excuse provisions provide for the LP to notify the GP of its exercise of the excuse right within a specific period following receiving the GP’s capital call. This of course requires that the GP specifies in its capital calls the names and details of the potential fund investments from the called capital.

GPs commonly negotiate restricting the right of anchor or large LPs to excuse themselves such that the excuse right may only be exercised to excuse the LP from investments that violate previously communicated investment guidelines or directions. This restriction aims at avoiding committing the fund into an investment it is unable to call meaningfully representative capital to fulfill, and at avoiding significant variations in fund returns.

Mechanically, being excused from an investment varies the fund returns of the excused investor from standard fund returns, and varies the investor’s capital account. This means that GPs and fund administrators should be prepared to maintain capital accounts by investor, rather than a single commingled partnership or fund capital account.

Institutional investors commonly use external third-party research agencies to find out whether a specific company complies with their preferred SRI or other investment restrictions. As many investors align their standards with the Ten Principles of Socially Responsible Investing established by the United Nations, fund managers also usually run (or outsource running) a UN PRI verification for the benefit of their LPs.

Investors also commonly undertake to re-evaluate fund portfolio companies periodically to determine whether their practices and impacts still align with their investment standards. If not, they may discuss with the GP how they may dispose of their investment. This, however, is not commonly a contracted right, and will be subject to discussion and agreement with the fund manager.

The GP Series

The GP Series is a series of practical guidance notes prepared by Hammad & Al-Mehdar’s PE and VC team that are designed to guide GPs and practitioners on best practices relating to private equity fund management.

The attorneys at Hammad & Al-Mehdar represent over 35 years of experience in providing legal services in Saudi Arabia and the UAE at international standards. Contact us today to discuss how we are able to support the legal demands of your private equity fund.

The key to great company culture is to have employees who are satisfied, motivated, challenged, and loyal. This can be accomplished in a number of ways, but one particularly effective way to achieve this is to implement an employee stock ownership plan (ESOP). In this guide we will review the benefits of ESOPs, how they work, and discuss the similarities and differences in ESOP implementation and use in Saudi Arabia, the United States, and the United Kingdom.

What is an ESOP?

Otherwise known as an employee stock ownership plan, this is a benefit plan that companies offer to employees. It gives workers shares or interests in the company depending on seniority, length of service, and the role served by the recipient. ESOPs are typically set up as trust funds or other independent legal entities to which the company contributes newly issued shares or cash to buy already existing shares. Employees are granted participation interests at hiring and over time.

Why is it Beneficial for Companies to Offer ESOPs?

When employees have ESOP shares, they are shareholders in the company. The idea is that since employees are also owners in the business, they will have the company’s best interest in mind at all times while employed at the company. With an additional stake in the future success of the company, they are incentivized to produce their best work.

Offering an ESOP has the following benefits to a company:

• It retains highly-skilled employees;
• It increases employee commitment and loyalty, boosting productivity;
• It is a cost-effective alternative to monetary bonuses;
• It attracts investors looking to invest in a forward-thinking business; and
• It has potential tax benefits.

Existing shareholders should be mindful of the unavoidable dilution that will result from the introduction of an ESOP. Nevertheless, shareholders are likely to agree to such dilution if it means that the workforce is dedicated to the success of the business, improving the chances of revenue growth and resulting increase in company valuation, which is to the benefit of all parties.

ESOPs are particularly useful for companies that are in the early stages of their growth. An employee who is granted options at an early stage in the company’s life cycle has a strong incentive to turn down a move to a larger company if it means that they have a chance at realizing large gains in the value of the stock as the company grows.

How Does the Process Work?

The company’s board has the final say in how the shares are allocated and administered. Employees, directors, and consultants of a company are all eligible to participate in an ESOP program depending on the needs of the company. The board should consider the maximum number of shares to be issued and how the shares will be apportioned, as well as the ESOP vesting schedule, which sets out the period of time an employee or beneficiary must remain at the company before receiving his/her shares.

Typically, a portion of ESOP shares will vest each year of service. If the participating employee stays a certain number of years, their ESOP shares are considered fully vested and the employee is thereafter able to benefit from the value of their entire shares. It is common practice to vest the ESOP shares over four years, with the first portion of shares vesting in one lump sum at the end of the first year (what is known as a one-year “cliff”). By way of example, a typical ESOP plan might include a one-year cliff for 25% of the shares, with the remaining 75% of the shares to vest in quarterly or monthly increments over the subsequent three years.

If an employee leaves before being fully vested, the unvested grants will be cancelled. Once fully vested, it is immaterial if the employee is retiring or leaving for another job as they will have the full economic benefits of the shares. Many ESOP plans that grant legal title to the shares include an option for the company to “buy back” the vested shares, which permits the company to redistribute repurchased shares to one or more employees, or cancel the shares altogether. Employees should be made aware that the granting of ESOP shares does not provide any guarantee of continued employment with the company.

There is usually no up-front cost to the participating employees as the ESOP shares are offered as part of the employee’s compensation package. ESOP shares do not customarily possess voting, information, or conversion rights for the holders. However, if a company undergoes an acquisition, the underlying shares may, subject to the terms of the transaction, be converted into ordinary shares in the acquiring company and benefit from the rights granted to such shares.

ESOPs in the United States

Companies in the US have long used ESOPs as a tax-qualified retirement program allowing employees to acquire shares in the company. They have become particularly popular with startups and emerging companies in the technology industry that unable to offer skilled workers the high wages that they can command elsewhere, but instead can offer shares in the business and a chance to be part of the growth story.

ESOPs in the United States generally operate through a trust, set up by the company, that accepts tax deductible contributions from the company to purchase company stock. The company is therefore offered the ability to reduce its corporate income taxes and increase its cash flow by issuing newly issued stock to its ESOP. Employee participation in the plan may be contingent on a minimum number of years of service to the company. Companies should carefully consider tax implications of the length and manner of the vesting schedule.

Fiduciary obligations exist on the trustees who manage the ESOP, as regulated by the Employee Retirement Income Security Act (ERISA) and implemented by the Department of Labor and the Internal Revenue Service. Trustees must act in the best interests of the employees to whom such ESOP shares are credited, and may be liable if found to have knowingly participated in improper transactions.

ESOPs in the United Kingdom

The government of the United Kingdom supports and encourages companies to implement ESOPs. In fact, over 2 million employees in the United Kingdom hold employee shares. Shares acquired under the main types of employee share incentive schemes, including the Company Share Option Plan (CSOP), the Enterprise Management Initiatives (EMI), the “Save As You Earn” Share Schemes (SAY) or the Share Inventive Plan (SIP), are generally free from income tax and National Insurance contributions and are therefore a cost-effective method of compensating employees.

The United Kingdom allows both public and private companies to offer an employee stock ownership plan. However, when it comes to private, unlisted companies, employee ownership typically does not exceed 10%.

ESOPs in Saudi Arabia

It is not yet commonplace for Saudi companies to offer employees company shares. An increased sophistication among private investors, when combined with recent efforts to boost the private sector to diversify the economy, has resulted in more Saudi companies, and start-ups in particular, offering this benefit plan to employees.

Governmental Regulations of ESOPs

Neither Sharia law nor statutory law dictates how employee stock ownership plans must be carried out by companies that choose to offer them. This provides companies discretionary freedom to tailor their ESOP to fit the needs of both the company and the employees, and to modify it as their needs may change. However, stipulations exist on the rights of both the employee and the company when it comes time to “cash-out”.

Resident companies in Saudi Arabia must be mindful of the tax implications of offering ESOP shares to foreign employees operating in the Kingdom as the company will be subject to a 20% tax on income generated by shares owned by non-Saudi shareholders.

Publicly listed companies are additionally subject to the Securities Depository Centre Rules of the Capital Markets Authority, whereby shares can only be offered to employees who have been registered with the Saudi Stock Exchange.

Foreign Parent Companies

Foreign parent companies that have operations in Saudi Arabia can offer ESOPs to employees. This is most typically done to:

• increase incentives offered to those who are not employees; and
• avoid restrictions on the offering of shares to foreign employees operating in the Kingdom.

Administering the ESOP

In the early stages of a company, the board of directors is usually appointed as the administrator of the ESOP, and may delegate such responsibility to a committee as the company grows. Recently, we have witnessed a proliferation of third-party service providers that offer to act as an administrator or trustee of the ESOP, with the responsibility of ensuring that the ESOP is operated in accordance with the plan document approved by the board, and that the required information is reported to both regulators and participants.

The decision by the board to appoint a service provider will come down to balancing the cost of the service against the benefits of appointing a third party. Such benefits include assigning fiduciary risk away from management, as well as freeing up of time which the board can instead redirect towards growing the company.

Ready to Implement an Employee Stock Ownership Plan for Your Company?

Hammad & Al-Mehdar Law Firm has years of experience in helping individuals and companies navigate corporate legal issues. Establishing an ESOP will require compliance with regulatory requirements and certain securities laws in the jurisdictions in which the company operates. If you’re ready to take your business to new heights and develop an ESOP, our licensed attorneys can help navigate the applicable laws and best practices in Sharia law. Contact us today for more information.

Most private equity (“PE”) funds are structured as limited partnerships.  Under private equity jargon, distribution waterfalls manage the split of fund returns amongst the investors (referred to as limited partners or “LPs”) and the fund manager (referred to as general partner or “GP”).

This article discusses the differences between two standard distribution waterfall models used by private equity funds: the European and the American equity waterfall models.

What is a Distribution Waterfall?

Distribution waterfalls, or equity waterfalls, determine how the income of a fund is allocated between a fund’s investors and the fund manager as the fund exits its underlying investments. PE funds almost always provide for performance-oriented compensation to the GP to align its long-term interests with those of the LPs. The performance compensation is referred to as carried interest or ‘carry’ and is paid through the allocation of fund income or the ‘waterfall’.

The waterfall model should be clearly set out in the fund’s limited partnership agreement (the “LPA”) or terms and conditions to ensure that both the LPs and the GP have a clear understanding of how the GP will be compensated.

How are Equity Waterfall Models Designed?

Most equity waterfalls adhere to a tiered cash flow structure. These models distribute the fund income to a cascading structure made up of different levels. Parties assign specific rates of return, or hurdle rates, to each distribution tier. Once a tier’s investment structure meets its goal hurdle rate, the next level starts.

Investors compare this equity model to a fountain of water whose pools become full and then spill into the next tier. Once this financial basin fills, it trickles into the one beneath it, and the process continues. It finally ends when all parties receive their initial investments and rates of return upon completion.

There are three common tiers in a distribution waterfall in PE funds:

1. Return of capital – On the initial tier, the fund allocates 100 percent of distributions to the partners (both LPs and GP). They continue to receive these returns until each partner recovers all of its capital contributions. Some funds provide for LPs receiving their capital contributions in preference to, or prior to, the return of capital to the GP.
2. Preferred return – Once the partners (or limited partners, as the case may be) recover all of their capital contributions, they continue to collect 100 percent of fund distributions until they reach a preferred rate of return. This rate is sometimes referred to as the hurdle rate. This amount will vary from fund to another, but it generally hovers around seven to nine percent.
3. Carried interest – After the return of capital and the preferred return are satisfied, additional distributions from the fund are split between the GP and the LPs, where by the GP will receive a stated percentage of the distributions, while the rest goes to the LPs. While the simple form is that the GP receives a percentage (generally between 15 percent and 20 percent) from all further distributions, some funds provide for a tiered carried interest allocations, where the percentage received by the GP increases with higher distributions.

Different Equity Waterfall Models

There are two broad equity waterfall models practiced by the PE industry: European waterfall and American waterfall.  These terms do not refer to geographical locations of investment, but rather to distribution paradigms.

1. American Waterfall: The GP’s performance is evaluated against the hurdle rate on a deal-by-deal basis, and the GP is paid carried interest on a deal-by-deal basis.
2. European Waterfall: The GP’s performance is measured against the hurdle rate at the fund level, and is only paid carried interest once the fund returns all capital contributions and the preferred return (if any).

Note: Hybrid Waterfall: Certain types of funds, such as real estate funds, may use hybrid-type waterfall that designates American waterfall model for certain types of income (for instance operating) and European waterfall for different income (like sale proceeds).

The American model favors the GP because it can earn carried interest from certain fund exits irrespective of how other fund investment fare. It also accelerates the payment of carried interest to the GP. The European model is friendlier to investors because the GP only earns carried interest after the LPs recover all their capital contributions.

Most emerging managers will be pushed to European waterfalls, but it may delay GP growth.

The Importance of Claw-back

Fund LPAs are advised to carry claw-back provisions that permit the LPs to recover from carried interest or performance fees paid to the GP any shortfalls in the return of their capital contributions and preferred return and any excess of paid carried interest over the agreed percentage. This is a very important provision in PE funds that have an American waterfall, and also useful in cases of European waterfall.

The GP Series

The GP Series is a series of practical guidance notes prepared by Hammad & Al-Mehdar’s PE and VC team that are designed to guide GPs and practitioners on best practices relating to private equity fund management.

The attorneys at Hammad & Al-Mehdar represent over 35 years of experience in providing legal services in Saudi Arabia and the UAE at international standards. Contact us today to discuss how we are able to support the legal demands of your private equity fund.

The strength of private equity funds lies in their ability to invest in illiquid opportunities that take years to mature and yield returns. At an initial take, however, this can sound very dangerous to investors. But the way private equity fund managers were able to raise record amounts of capital to manage despite this seemingly long horizon and lack of liquidity is through giving investors comfort in the fund terms, and developing practices that align investor interests with fund manager interests over the life cycle of the fund.

Amongst such developed practices is the establishment of fund advisory boards and limited partners’ advisory committees. This article discusses the roles each of these bodies plays within a private equity fund.

Advisory Boards and Limited Partner Advisory Committees in General

It is important to note that private equity funds are not mandated by law, considering the commonly used fund jurisdictions, to have advisory boards or committees. Yet, it is best market practice to include both because each can serve an important purpose for the management of the fund.

Advisory Boards

Advisory boards provide advice and market insight to the fund manager (referred to as General Partner or (“GP”). Their advice assists with sourcing transactions, and the advisory board’s existence lends credibility to the fund. With this in mind, advisory boards should be composed of industry experts or service providers in the area of the fund’s focus. Common candidates for advisory boards are established private equity fund managers (assuming there is no direct competition), economic experts, and service providers to the private equity industry.

Limited Partner Advisory Committees

Limited Partner Advisory Committees (“LPAC”) differ from advisory boards. While an advisory board consists of industry and financial experts who can advise the GP, an LPAC is composed of a representative (3 to 5) group of investors (referred to as limited partners or “LPs”) that are appointed by the GP. Rather than providing high-level guidance to the GP, an LPAC helps handle more sensitive matters that the GP faces to ensure that they are managed to the comfort of the investors. These include:

• Conflicts of interest. An LPAC allows a smaller, focused group to make decisions about conflicts of interest between LPs and GPs. Common conflicts of interest include investments in affiliated funds, purchases from or sales to affiliates of the GP, service contracts with GP affiliates, and review of valuations prepared by the GP. The LPAC has the power to approve or disapprove conflict-of-interest transactions.
• Waivers of LPA restrictions. The Limited Partnership Agreement or fund terms and conditions (referred to as an “LPA”) may include restrictions on the fund or the GP, including the partnership term, caps on investments, industry restrictions, restrictions on investment in foreign companies, investment period, and change of control restrictions. The LPA may provide that the LPAC can take action to waive certain restrictions or approve certain decisions.
• General oversight. Depending on how the LPAC is structured, the committee may have the power to provide additional oversight and transparency to the fund. The LPAC could receive additional financial and other data including access to fund auditors and approval of accounting variances. If granted this power, the LPAC acts as a balance to the GPs power over the fund.

In order to have a highly effective LPAC, it is advisable that it is composed of knowledgeable LPs that are not affiliated with the GP. Any duties or powers allocated to the LPAC should be clearly detailed in the LPA, and each member should be aware of the scope of their responsibility. Members of an LPAC are likely to be concerned about their own liability based on the fund’s actions, so you will need to consider insurance and indemnification provisions.

Make Smart Decisions

If you are considering establishing or investing in a private equity fund, it pays to focus on the details of the fund’s structure. Take some time to determine whether the fund would benefit from an advisory board or an LPAC. Then spend the time to make sure either or both bodies are effectively staffed and that all details are included in a well-drafted LPA or fund Terms and Conditions.

The GP Series

The GP Series is a series of practical guidance notes prepared by Hammad & Al-Mehdar’s PE and VC team that are designed to guide GPs and practitioners on best practices relating to private equity fund management.

The attorneys at Hammad & Al-Mehdar represent over 35 years of experience in providing legal services in Saudi Arabia and the UAE at international standards. Contact us today to discuss how we are able to support the legal demands of your private equity fund.

What is Venture Debt?

Venture debt is a form of debt financing that can be used by early and growth stage startups to raise capital. It can be used instead of, or in conjunction with, equity financings. Venture debt is an attractive form of raising capital for startups because it can usually be arranged much more quickly, an important consideration for startups facing a limited runway.

The main difference between venture debt and traditional debt financing is that venture debt is available for companies that lack assets or positive cash flow, or that want greater flexibility in the lending terms. Traditional lenders are often reluctant to finance equipment for startups based on the widely-accepted notion that startups have a high rate of failure. Venture lenders have emerged to fill this gap; such lenders can be individuals, venture capital investment companies or funds, or banks specialized in venture lending. The market for such lending in the Middle East is still in its infancy, but we envision growth in the sector in the near future.

Venture debt has benefits for both entrepreneurs and investors. Valuation of startups proceeds in a stair-step fashion between financing rounds, meaning that the inclusion of incremental capital from a loan allows startups to achieve greater progress between rounds, increasing the company’s valuation ahead of the next equity financing, and helping startups meet their milestones.

Types of Venture Debt

1. Venture term loans:

Venture term loans are generally structured as three-year loans (or series of loans) with warrants for equity. They can be used for runway extension, acquisition financing, project financing, growth capital, or equipment financing. The interest rate is usually 0-4% higher than traditional loans to compensate for the increased risk to the lender.

2. Lease financing:

Lease financing is a type of financing where the owner of the asset leases such assets (i.e. permits the lender to use the asset) in exchange for periodical payments. This can be especially useful for startups that require equipment to scale, and may also provide a tax benefit in certain jurisdictions where ownership of the asset is taxable (consider Saudi Arabia).

3. Revenue-based investments:

Revenue-based investments are a type of venture debt where repayments are tied to monthly revenues rather than a typical amortized payment schedule, often with a cap on the total amount (1.3x to 2.5x of principal amount of the loan). This reduces the payment (cash flow) risk on the company and offers lenders the comfort of a repayment commitment, but without a harsh timed payments requirement on the startup that does not look to its fluctuating cash flows or revenues. This type of venture debt product is commonly seen in angel and seed financings globally.

4. Convertible Notes:

Convertible Notes are the most commonly used form of venture debt, but unlike the other forms of venture debt these debt instruments can be converted into equity in the company. SAFE Notes and KISS Notes are the standard forms of convertible notes or securities, often used in venture investing because they allow parties to avoid complex term negotiations for investment in the earliest stages of growth companies.

Terms

Both startups and lenders should pay particular attention to the terms of the venture debt agreement, in particular the costs involved in borrowing. These costs can include a cost for borrowing the money, a cost while the money is being loaned, and sometimes even a cost to exit the loan.

The amount of the loan will be up for negotiation, but startups will generally be successful in borrowing around 30% of the last round on favorable terms. Lenders protect their rights by receiving warrants on the company’s common equity, and will often include covenants to ensure repayment, but borrowers will not be required to put up any form of collateral. The debt is usually short term, unlike more traditional commercial loans, due to the growth trajectories of VC-backed companies and the standard equity raise path (with a new equity financing every 18 months).

When to USE Venture Debt:

• To purchase equipment during the growth phase;
• After eliminating the concept phase risk and identifying product market fit;
• When aiming to reduce founder and investor dilution;
• To avoid exhaustive due diligence.

When to AVOID Venture Debt:

• If there exists a significant risk of default. Venture debt lenders can call the loan and force the company to be sold or liquidated.
• When a new raise is imminent. Investors will have to agree to repay the debt or invest below the debt in order of preference

Remember: Venture debt may be an attractive means of avoiding dilution, but it should be used carefully by entrepreneurs. If you are unsure about product market fit, venture debt can end the company before it even has a chance to begin. Entrepreneurs should remember it is sometimes better to have a smaller shareholding, than to have no company at all.