Key Legal Considerations for Venture Capitalists Investing in Malaysian Startups

Introduction 

Venture capital (VC) plays a critical role in the growth of startups, and Malaysia's dynamic startup ecosystem presents promising opportunities for investors. Sectors such as fintech, e-commerce, and healthcare are expanding rapidly, drawing interest from both local and international venture capitalists[1]. Enabler policies have also been implemented by the Government for the purpose of fostering a more dynamic startup ecosystem and this is evidenced by the Government’s commitment to invest RM90billion in the New Industrial Master Plan 2030[2]. However, investing in startups involves navigating several venture capital legal considerations. To ensure that your investment is secure and profitable, understanding the legal framework for venture capital in Malaysia is essential. This article outlines the key legal steps that venture capitalists must take when investing in Malaysian startups.

1. Due Diligence: Assessing the Startup’s Legal Health

Conducting thorough venture capital due diligence in Malaysia is critical before committing to any investment. Legal due diligence helps investors assess the startup’s legal standing by reviewing its corporate governance, intellectual property (IP) and employment agreements. Key areas of concern would be the startup’s material commitments via financing arrangements or key contracts entered into by it and pending litigation matters (if any).

Case Study:

Our Firm was recently engaged by a VC in relation to a proposed investment. Our scope of works included conducting a legal due diligence exercise on the target startup. Searches conducted at public domains seemed to suggest that the startup was in good shape. However, upon the review of the startup contracts and documents, it was found that the startup was operating in an unfavourable position as there were multiple potential contract breaches and key contracts contained lopsided terms. The employment agreements entered into between the startup and its employees were also not in compliance with the amended Employment Act 1955. Our VC client was still desirous of pursuing the investment due to the startup’s potential but the findings paved a way for (i) further negotiation on the valuation of the startup and; (ii) remedial measures to be put in place prior to closing the deal.

Pertinently, venture capitalists must also ensure the startup owns its intellectual property, as unresolved IP disputes in Malaysia could derail future growth. By conducting comprehensive legal due diligence, venture capitalists reduce risks and ensure they are making well-informed decisions about their investments.

2. Structuring the Investment: Equity vs. Convertible Instruments

One of the primary venture capital legal considerations in Malaysia is deciding how to structure the investment. Venture capitalists can choose between direct equity investments or using convertible equity instruments like redeemable convertible preference shares (RCPS). Equity investments provide immediate ownership in the startup, giving investors voting rights and a say in decision-making processes. However, convertible instruments offer flexibility by allowing venture capitalists to convert their investment into equity at a later stage, typically after the next fundraising round.

A potential legal and regulatory update clarifying the use of Simple Agreement for Future Equity (‘SAFE Agreement’) within the Malaysian startup ecosystem is also on the horizon. SAFE notes, along with convertible notes, are commonly used by investors and venture capitalists for early-stage financing, especially in Silicon Valley, with firms like Y Combinator frequently employing them. These agreements postpone equity dilution by allowing the investor's funding to convert into shares at a future date. We look forward to writing more on this once the proposed amendment takes effect.

When structuring investments, venture capitalists must ensure compliance with Malaysian laws, including the Companies Act 2016 and Contracts Act 1950, to avoid complications in future funding rounds. Proper structuring not only protects investor interests but also sets up the startup for long-term success.

3. Shareholders’ Agreements and Investor Protections

A well-drafted shareholders' agreement in Malaysia is crucial to safeguard venture capitalist interests. The shareholders' agreement (SHA) sets out the rights and obligations of both the startup founders and investors. Clauses such as anti-dilution provisions, pre-emptive rights, and drag-along/tag-along rights are often included to protect investors from future equity dilution and ensure they have a say in key decisions.

‘Tag-along’ rights protect minority shareholders by ensuring that if a majority shareholder sells their shares to a third party, the minority shareholders have the right (but not the obligation) to join the sale under the same terms. This ensures that minority shareholders can exit the company on equal terms, avoiding situations where they are left behind with an unfavourable or unknown new majority shareholder.

Illustration:

·       Shareholder A holds 70% of the shares, while Shareholder B and Shareholder C hold 15% each.

·       If Shareholder A agrees to sell their 70% stake to a third party, Shareholders B and C can exercise their tag-along rights, requiring the buyer to also purchase their shares (15% each) on the same terms. This ensures that B and C can exit at the same valuation as A

‘Drag-along’ rights Drag-along rights allow majority shareholders to compel minority shareholders to join in the sale of shares if the majority shareholder finds a buyer for the entire company. This right is intended to facilitate a complete sale of the company and avoid minority shareholders blocking the deal.

Illustration:

• Using the same example where Shareholder A holds 70% and Shareholders B and C each hold 15%, if Shareholder A finds a buyer for 100% of the company, they can exercise their drag-along rights. This would force Shareholders B and C to sell their shares on the same terms as Shareholder A, ensuring the buyer acquires 100% ownership.

In recent times, it has been common for venture capitalists to negotiate for a board seat, giving them the ability to influence the startup’s strategic direction. Investor veto rights on major decisions—such as mergers, acquisitions, or issuance of new shares—further ensure that such venture capitalists maintain control over critical aspects of the business. Without an effective shareholders' agreement, venture capitalists risk losing influence and protection as the startup grows.

4. Regulatory and Compliance Considerations

Depending on the startup’s sector, additional regulatory approvals may be required. For example, fintech startups in Malaysia must comply with guidelines set by Bank Negara Malaysia (BNM) and the Securities Commission Malaysia (SC). Venture capitalists should ensure that startups they invest in comply with these regulatory frameworks to avoid future legal challenges.

Additionally, compliance with the Personal Data Protection Act 2010 (PDPA) is essential for startups handling personal data. Non-compliance could result in heavy fines and legal penalties, affecting the startup’s financial standing. Venture capitalists must ensure that the startup is aware of and complies with all applicable regulations to mitigate risks.

5. Exit Strategies: IPOs, Trade Sales, and Secondary Sales

Planning for a smooth exit is crucial for venture capitalists. Common venture capital exit strategies in Malaysia include initial public offerings (IPOs), trade sales (acquisition by another company), and secondary sales of shares. Each exit strategy comes with its own set of legal requirements.

For IPOs, the startup must comply with Bursa Malaysia listing requirements, including conducting a rigorous due diligence process and obtaining regulatory approvals. Trade sales may require navigating the legal complexities of acquisition agreements, share transfers, and consent from regulatory bodies. In the case of secondary sales, venture capitalists must ensure that their shareholders' agreement includes provisions that allow for smooth transfers of shares, protecting their right to exit at favorable terms.

6. Protecting Intellectual Property: A Key Legal Consideration

For many startups, especially in the technology sector, intellectual property in Malaysia is often the most valuable asset. Venture capitalists should ensure that the startup has solid protection for its IP by registering patents, trademarks, and copyrights[3] with MyIPO (Intellectual Property Corporation of Malaysia).

It’s also crucial to ensure that any IP created by employees or contractors is legally transferred to the startup. Without proper IP protection, venture capitalists risk investing in startups that are vulnerable to infringement claims, potentially derailing the startup’s growth prospects. IP issues should be addressed early in the due diligence process to avoid any costly surprises later on.

Conclusion

Investing in Malaysian startups requires navigating complex legal frameworks. Venture capital legal considerations in Malaysia include due diligence, investment structuring, robust shareholders' agreements, regulatory compliance, exit strategies, and IP protection. Without proper legal advice, venture capitalists risk exposing themselves to legal pitfalls that can affect both the investment and the startup’s long-term success.

Engaging an experienced corporate law firm is essential to help venture capitalists secure their investments and navigate the legal complexities of venture capital deals in Malaysia. At Rajvin Gill & Co we specialize in advising venture capitalists, ensuring that their investments are protected every step of the way, from due diligence to exit strategies. 

Contact Us

---

The content presented in this article is meant solely for offering general information and should not be considered as legal opinion or professional advice.

References:

[1] Malaysia Startup Ecosystem RoadMap 2021-2023, Ministry of Science, Technology and Innovation (MOSTI)

[2] In his Keynote Speech, SC Chairman, Dato’ Seri Dr. Awang Adek Hussin at the MVCA Malaysia Venture Forum 2023,

[3] Malaysia does not have a formal registration system for copyrights, as they are automatically granted. However, under Section 42 of the Copyright Act 1987, copyright owners can either prepare a Statutory Declaration to support their ownership claim or voluntarily notify MyIPO by depositing their copyrighted work