Tech M&A in the Middle East: What not to forget
The Middle East start-up market is as buoyant as it has ever been. According to MAGNiTT, startups in the MENA region attracted more than USD1.2bn in funding during the first part of 2021, a 64 percent year-on-year growth. Trends also point to larger round sizes indicating emerging growth companies are scaling faster and more successfully.
As funding cycles move forward, it is inevitable that we will see an increase in regional technology exits; for example, when a matured start-up is ready to move on. These can take any number of forms from a simple sale to the listing on a public market, whether directly or via a special purpose acquisition company or “SPAC”. In this article however we focus on the sale process for regional emerging growth companies and in particular three specific considerations sellers and management should consider when preparing for or engaging in an M&A exit process in the Middle East. In turn, this article will also assist buyers as it forms somewhat of an initial check-list of what to look for in your technology company investment.
Structuring an exit in the Middle East can be a headache. Taking the UAE for example - the advantages of operating an onshore limited liability company (e.g. access to markets outside of the free zones) can be counterbalanced by the requirements to implement a share transfer onshore and dealing with notarial and translation requirements.
Sellers should therefore consider future proofing their business structure early, and in advance of an exit, to frontload time consuming reorganisation work. For example, by incorporating a financial free-zone company either in the Abu Dhabi Global Market or the Dubai International Financial Centre and placing this entity above the operating company to act as a holding (and eventually sale) vehicle, sellers can take advantage of a smoother transaction process without requiring multiple notarial trips to effect a sale. This is particularly important where sellers retain a minority position in the business and the deal terms include future option rights to exit that position (see below for more on this).
Another key item on the pre-exit “to do” list is to ensure intellectual property is adequately maintained and protected. All of the company's intellectual property capable of registration (including domain names, patents, trademarks and copyright) should be registered in the name of the company and not the founders’. Equally, moral rights and rights over unregistered IP (such as trade secrets) should be protected and assigned to the company by robust provisions in both founders' and employees' employment contracts. Typically many “off the shelf” free-zone employment contracts do not contain such provisions therefore sellers should consider updating contracts prior to the sale’s due diligence process.
Finally, maintaining a live internal data room of key information means a diligence process can start quickly once a sale process begins and also gives the impression to the buyer of a highly organised, and therefore more attractive, business investment. The following should be included as a minimum:
- Basic financial and corporate documents;
- Debt and equity financing documents;
- Important contracts;
- Details of any claims or litigation;
- Capitalisation table;
- IT architecture overview;
- List of IP;
- Employee share option plan; and
- Key employee agreements.
Mind the gap
Deals which close simultaneously (i.e. share ownership and funds transferring the same day a purchase agreement is signed) are still few and far between in the Middle East as a result of the some of the processes such as arranging notarial appointments for onshore companies, time delays in company registry updates or low anti-trust approval thresholds triggering filing obligations. As a result of this purchase agreements often contain provisions which restrict the way a business is operated between signing the agreement and closing the deal.
Emerging growth businesses have an inbuilt competitive edge by being able to make decisions in an agile and streamlined manner therefore care should be taken when agreeing to these kinds of pre-completion restrictions. If care is not taken, business growth and expansion could be slowed whilst waiting for buyers to approve even relatively routine corporate actions (for example entering into contracts, acquiring assets or hiring new employees).
Depending on the pricing structure of the transaction and particularly where there is a price adjustment on closing (for example for actual levels debt, cash and working capital) this friction can impact a founder's bottom line on exit. Therefore, as a general rule sellers should look to agree financial thresholds on approvals to figures that would be material to the overall value of the business (for example approval is only required on agreeing to terminate employees paid over $X amount).
Protect future upside
As a result of continued valuation uncertainty in the Middle East following the peak of the pandemic, we are frequently seeing the use of earn-outs (i.e. additional or deferred value paid for the business based on its performance after the sale) on technology sale transactions in the region. Earn-outs are attractive to (a) buyers because they can leverage a founder's belief in their business' growth whilst paying less for a business up front, and (b) sellers who, being confident in the business' potential, can receive a higher upside later down the line if this potential is realised.
When agreeing to these terms however sellers should not forget to include a robust set of protections in the sale agreement which regulate how the buyer runs the business during the relevant period to the earn-out. For example, if a founder has agreed an earn-out whereby they will receive additional funds if a specific profit multiple is achieved in a particular future year, then the agreement should restrict the buyer (who will control the business at that time) from artificially increasing company costs or diverting revenue from the business to elsewhere in its group to artificially deflate the profit figures. Sellers should also ensure they negotiate appropriate information rights so they can monitor performance during the relevant financial period.
Frequently deferred payments are also structured in the form of the grant of an option to sellers who retain a minority stake in the business allowing them to sell their remaining shares to the buyer after a particular period of time (usually 1-2 years depending on the buyer's view of the seller's importance to the business' transition). These are commonly described as Put Options (i.e. a seller's right to put the shares to the buyer). In the Middle East region, these structures can cause difficulty as it is practically difficult to compel an individual to buy shares against their will (i.e. because of notarial requirements). It is also questionable as to whether put options are enforceable under the principles of Shariah law. Therefore, in jurisdictions where an onshore court ruling would be required to enforce the option (for example in the KSA, onshore in the UAE and in free zones (other than the ADGM and DIFC), sellers should not accept the grant of a Put Option as part of deal structure. Instead, as suggested above, a ADGM or DIFC holding company should be put in place above the operating company and an option granted over that entity's shares (on the basis that the legal framework of these jurisdictions is generally based on English law where Put Options are enforceable).
In summary, the M&A environment in the Middle East, not unlike other markets, has some unique challenges when negotiating and structuring exits; however, these challenges can be navigated with proper planning and the appointment of experienced regional legal and financial advisors who can guide sellers through the sale process and help alleviate some of the pain points.