As the UAE strengthens its position as a regional startup hub, convertible notes have become a widely used tool for early-stage fundraising. Their flexible structure and ease of execution make them an attractive alternative to traditional equity financing for both investors and entrepreneurs. However, despite their growing popularity, convertible notes carry legal complexities that require careful navigation within the UAE’s diverse legal landscape, including mainland UAE, the DIFC, and the ADGM.
Understanding Convertible Notes
A convertible note is essentially a hybrid instrument i.e. a debt that is intended to convert into equity upon the occurrence of specified trigger events, most commonly a subsequent financing round. Unlike conventional loans, convertible notes are not designed for repayment in cash; instead, they offer early-stage investors the opportunity to receive shares in the company at a future date, often at a discounted valuation. This mechanism allows startups to defer valuation discussions until a more mature funding round, when market forces can better determine the company’s worth.
This blog is a part of our Choosing the Right Investment Instrument for Startups Blogpost.
Key Terms to Know
Convertible notes are typically governed by a set of negotiated terms that determine how and when the debt converts into equity. Among the most important of these is the principal amount, representing the capital provided by the investor. This amount usually accrues interest, which may be paid in cash or converted into equity alongside the principal. The maturity date marks the end of the note’s term, at which point the investor may be entitled to repayment or conversion, depending on the circumstances.
Another key term is the conversion discount, which gives the investor the right to convert their debt into equity at a reduced price compared to new investors in the qualifying round. This discount typically ranges between 10% and 30%, rewarding the investor for taking early risk. Many convertible notes also include a valuation cap, setting an upper limit on the valuation at which the note can convert. This ensures that early investors are not excessively diluted in high-valuation future rounds.
Common Conversion Triggers
The most typical conversion trigger is a qualified financing round, in which the company raises a threshold amount of capital (usually defined in the note agreement) from new investors. Upon this event, the outstanding principal and accrued interest are converted into equity under the terms specified. If the company raises a smaller amount which is often referred to as a non-qualified financing then the note may provide the investor with the option (but not the obligation) to convert.
Conversion can also occur at the maturity date if no financing round has taken place. In such cases, the investor may choose to convert into equity at a predetermined valuation or request repayment. Another trigger is a liquidity event, such as a sale of the company or an initial public offering (IPO). Convertible notes often contain provisions that allow for conversion immediately prior to such events, or alternatively, entitle the investor to a payout that reflects the value of their investment plus a premium.
UAE Legal and Regulatory Considerations
The legal treatment of convertible notes in the UAE depends significantly on the company’s jurisdiction of incorporation. Companies established in the DIFC (Dubai International Financial Centre) or ADGM (Abu Dhabi Global Market) benefit from common law systems and a well-defined legal framework for investment instruments. These jurisdictions allow for greater contractual freedom and are generally more conducive to investor-friendly convertible note structures.
In contrast, companies incorporated in mainland UAE are governed by the Federal Commercial Companies Law and the UAE Civil Code, which are based on civil law principles. These laws may impose restrictions on the issuance of debt instruments and the conversion of debt into equity, especially in limited liability companies (LLCs). In such cases, careful structuring and alignment with corporate governance requirements such as shareholder approvals and capital increase formalities are essential.
Companies must also consider foreign ownership restrictions, especially in regulated or strategic sectors where full foreign ownership may not be permitted. Although recent reforms have relaxed these rules for many activities, convertible note conversions resulting in equity ownership should be reviewed for compliance with local licensing and ownership laws. Additionally, where Shariah compliance is relevant (such as in family-owned businesses or Islamic investment funds), convertible notes may need to be restructured using Islamic finance equivalents like mudarabah or musharakah contracts.
Legal Risks and Challenges
Despite their appeal, convertible notes can pose several legal risks. Ambiguity in drafting, particularly around conversion mechanics and valuation, can lead to disputes between founders and investors. For instance, if a note lacks clarity on whether interest converts into equity, or how the valuation cap interacts with a discount, the conversion process may become contentious. This is especially critical in the event of a down round or early exit.
Another risk arises from insolvency scenarios. Since convertible note holders are often unsecured creditors prior to conversion, they may face significant losses if the startup fails before reaching a financing or liquidity event. In free zones like the DIFC and ADGM, security interests may be registered to mitigate this risk, but such mechanisms are more limited in mainland jurisdictions.
Investors must also ensure they obtain meaningful shareholder rights upon conversion, including voting rights, pre-emption rights, and anti-dilution protections. These rights must be incorporated either in the shareholders’ agreement or through company constitutional documents post-conversion. Finally, convertible notes that convert just before an acquisition or IPO may raise exit complications, particularly if the acquiring entity challenges the note’s enforceability or treatment in the capitalization table.
Conclusion
Convertible notes offer a compelling alternative to equity funding for startups and early investors in the UAE. However, their enforceability and commercial success depend on a clear understanding of the legal frameworks, jurisdictional nuances, and potential risks involved. Both founders and investors must seek professional legal guidance to ensure that the terms are properly negotiated, documented, and implemented in accordance with applicable UAE laws.
