In a recent article by Quartz Africa on “Why Africa is defying global trends in VC funding”, Kenya alone attracted more venture funding in the first three months of 2022 ($482 million) than it did in all of 2021 ($412 million).
In another report on venture capital by the African Private Equity and Venture Capital Association, 2021 was record-breaking for Africa, with the value of venture funding exceeding that of the last seven years combined.
According to African Private Equity and Venture Capital Association, in 2021, there were about 86 deals in Kenya with a reported value of $225 million (about Sh20 billion).
One of the notable deals in the $50 million investment in Twiga Foods, a business-to-business marketplace platform that sources produce directly from farmers and delivers it to customers in urban areas (CrunchBase).
It is also quite telling that some of the Big Tech Companies such as Amazon and Microsoft have either set up shop or are in the process of setting up shop here in Kenya.
There is a possibility that some of these Big Tech companies will seek to make strategic acquisitions of Kenyan technology companies as part of setting up and/or expanding their operations in the East African market.
It is no secret that there is a huge amount of venture capital funding in Kenya looking for a suitable bride to marry. Innovative Kenyan startups that are solving real problems for consumers and are commercially viable are strong candidates for venture funding.
Yet a key phase of venture capital funding is the carrying out of due diligence on the potential businesses by the to-be investors. Just as one does a background check on the title to land before purchasing it, or on a person before employing them, Investors also conduct a health check on a startup before risking their money.
While the startup would most likely not get a 100 percent green check, the due diligence enables an investor to identify the issues and based on their risk appetite, decide on whether to invest.
If the investor decides to proceed with the investment despite the issues identified, they would generally either require that the issue is addressed before the close of the deal (generally only the fundamental ones) or enter into an action plan with the startup for the issues to be eventually addressed over time. This is usually set out in the legal documents for the investment.
The due diligence process comprises legal, commercial and operational due diligence. Depending on the size and maturity of the business, and the preference of the investors, the due diligence could also include an in-depth tax health check on the startup.
However, considering that most startups would generally only have operated for a short period and possibly not generated substantial income (if any), a tax check may not be a big concern for an investor. This article will focus on legal due diligence.
Legal due diligence is almost always mandatory before an investment is made. It is therefore imperative for startups that intend to raise venture funding to have a prior understanding of the process and be prepared for it.
Seamless legal due diligence would not only further persuade an investor to invest in your startup but would also lessen the transaction period. Otherwise, a lack of preparation may stretch the diligence period to months.
Firstly, an Investor would want to understand the corporate structure of the startup being its registration status, its shareholders, directors and beneficial owners, any rights that may have been granted to any other person to acquire shares in the startup, and whether the startup has maintained all corporate records that it is required to maintain under the companies’ laws and identify any other formalities that may be required for the investment to be made.
As part of this process, an investor, through their lawyers, conducts a search at the companies’ registry to verify part of the corporate information provided by the start-up.
One of the major issues that may arise, is usually concerning the shareholding of the startup. It is not uncommon to have a startup where the co-founders and/or team members believe they have a certain shareholding in the company, which from a search of the company, turns out to be different from what they believed or agreed between themselves.
This could easily lead to a conflict in the shareholding, or uncertainty during the due diligence and pre-investment phase and likely push away potential investors.
It is thus prudent for a startup to be transparent from the beginning on their shareholding, ensure that its records at the companies’ registry are accurate and that any changes that should be filed with the registry are filed properly, and the filing records well maintained.
In addition, the startup should ensure that it maintains the statutory records required under the Kenyan company law, such as the registers of members, directors and beneficial owners.
While a startup should also maintain the minutes of their shareholder and board meetings as required under the law, it is also important that the founders document each of their meetings as part of best corporate governance practice.
This would enable an investor to have a view of the decision-making process of the startup.
While we have not seen the companies’ registry strictly enforce the maintenance of the records and whilst this may not prevent an investor from investing, having all the statutory records in place would certainly create a positive impression for potential investors.
Secondly, a key part of the legal due diligence is confirming compliance with the applicable regulatory requirements, that is, permits, licences and continuous obligations.
Most startups that do not operate in regulated sectors such as banking or insurance are only required to obtain operating permits and licences.
These include a business permit, a fire clearance certificate, a certificate of workplace registration, registration with the National Industrial Training Authority (NITA), National Health Insurance Fund (NHIF) and the National Social Security Fund (NSSF), data protection registration, MCSK licence and permit to use a standardisation mark from the Kenya Bureau of Standards (Kebs).
There are also certain continuous obligations of a business, including making statutory contributions in relation to the staff to NITA, NSSF and NHIF, and conducting a health and safety audit annually.
If a startup operates in a regulated industry such as banking or insurance, it would likely also be required to obtain a licence from the Central Bank of Kenya or the Insurance Regulatory Authority of Kenya or any other relevant regulator.
An investor would want to understand the regulatory requirements of the startup any breaches of those requirements including failure to obtain a licence or permit, the penalties that the breaches attract as well as the likelihood of enforcement.
Arnold Karanja is a data protection and privacy law practitioner, and Ndegwa Alex is a corporate and commercial lawyer.