What the 2020 Companies (Amendment) Ordinance means for startups

The past 18 months have unquestionably been big for the Pakistani startup scene: two companies with Pakistani founders and significant presence in the Pakistani market had blockbuster transactions, one a multibillion-dollar acquisition (Careem), and the second reaching a $1 billion private market valuation (Zameen.com). This on the heels of the Alibaba acquisition of Daraz and Airlift raising a $12 million Series A funding round – the largest ever in Pakistan – and there has never been a better time to be a startup in Pakistan.

But while many things have been going in favour of Pakistani startups, the nature of the law is not one of them. There are many aspects of the way company law is structured in Pakistan that make it abundantly clear that these laws were written with large manufacturing businesses in mind rather than small, nimble, asset and capital-light startups.

Both entrepreneurs and venture capitalists have been clamouring for a change in the law to recognise the nature of startups and for regulations to accommodate a variety of different factors such as the fact that startups tend to not have a lot of money for upfront expenses, and tend to like paying people in equity, etc.

In the 2020 Companies (Amendment) Ordinance, at least, it appears that part of the government has been listening to those concerns, with the Securities and Exchanges Commission of Pakistan (SECP) introducing a legislation that could address at least some of the concerns that Pakistan’s startup ecosystem had been expressing for at least the past two to three years.

There are four major changes that the new law would bring into effect. Firstly, the regulations allow for considerably greater leeway to issue equity compensation for employees. Secondly, many of the costly regulatory documentation requirements have been eased for startups. Thirdly, the definition of what constitutes a startup has been expanded considerably so that more companies will be able to benefit from these changes. And lastly, startups will be allowed to buy back their own stocks.

Let us examine each in detail and consider the implications of each of these.

1. Paying people in equity will become easier

One of the biggest changes in the new law ratified by the President on May 4, 2020 – and one that both venture capitalists and entrepreneurs had been eager to see – is the easing of rules around paying employees in equity. A whole host of rules around this matter are set to be relaxed under the ordinance and could significantly boost interest among young college graduates in working for startups.

The first change proposed is expanding which companies can issue equity compensation. In the previous law, only public limited companies (whether they be publicly listed or privately held) were allowed to issue employee stock options. Now, even private limited companies, especially companies classified as startups, will be able to offer such benefits as well.

“Sometimes when companies are young and new, they cannot afford to pay their employees market competitive salaries. In such cases, they issue employee stock options,” said Barrister Ahmed Uzair, a partner at AUC Law, a law firm based in Lahore. “With the new amendments, now even private companies may issue the same for their employees and may also do so without needing any further approval from SECP.”

Beyond simply allowing companies to issue stock options, however, the company has also made it easier for founders to consider the value of their ‘sweat equity’ – or the value of the work they put into the startup without cash compensation – in the valuation of the company.

“Strictly speaking it [considering sweat equity in valuing a company] was allowed but required valuation by the SECP which ultimately decided how much worth could be assigned to a resource’s worth,” said Uzair.

Under the current regulations, the value of sweat equity would be determined by an independent valuation advisor – typically the advisory arms of major accounting firms – and submitted to the SECP for approval before such valuations could be accepted. Under the proposed regulations, however, startups would be exempted from the requirement of that valuation exercise, which can be quite expensive and often end up costing hundreds of thousands of rupees in advisory fees.

Exempting startups from this requirement is likely to be seen as friendly towards startup founders, who are often the people most likely to have their stake in a company be measured in sweat equity. As a company determines its share count and ‘paid up capital’, founders will be able to put up their equity in the form of their own efforts and labour, rather than having to contribute cash. This, in turn, will allow them to retain more equity in the companies they create, incentivising more people to start companies in Pakistan.

2. Many costly regulatory requirements have been relaxed for startups

The proposed legislation also seeks to remove many other bureaucratic requirements that may seem minor but add to the headache and cost of running a startup. These include things like the specific time limit during which the company has to deposit the cash it needs for its startup capital, or having a chartered accountant from the very beginning.

The startup capital deposit requirement was one that was created as part of the 2017 Companies Act, and it stated that if a company had declared a certain amount as its paid-up capital, that amount would need to be deposited into a company-owned bank account within 30 days of registration. This requirement has now been relaxed for companies classified as startups.

However, it is not yet clear as to how long companies will now have to deposit the cash, merely that the SECP now has the discretion to allow for extensions in that deadline.

Another requirement that has now been relaxed is the one requiring a chartered accountant. Under the amended law, companies were required to have a chartered accountant – duly qualified and a member of the Institute of Chartered Accountants of Pakistan (ICAP) – sign off on their financial statements as an auditor.

That, in itself, seems like a reasonable regulation. However, combined with the artificial shortage of accountants in Pakistan created by ICAP, the expense of hiring a chartered accountant ends up being somewhat prohibitive for startups seeking to conserve their cash burn rates. An easing of that requirement, as expected, is welcomed by many entrepreneurs.

Then there are other minor regulations that have also been eased, such as the requirement to have a company seal on all documents that need to be signed by senior company executives.

3. The number of companies eligible for regulatory relaxations for startups has been increased

An important change in the proposed regulation has been an expansion in the definition of what constitutes a startup. Under current law, a company that has been in operation for five years or less is considered a startup, and there are few, if any, other ways to have a company be classified as such. Under the new regulations, however, companies that have been in existence for up to 10 years will be able to be classified as a startup.

In addition, there will now be other elements of the definition of a startup that will allow more companies to be classified as such. Companies with revenue of less than Rs500 million – or any other amount subsequently defined by the SECP – will also fall under that definition, as will companies that can demonstrate that they are “working towards the innovation, development or improvement of products or processes or services, or is a scalable business model with a high potential of employment generation or wealth creation.” In other words, innovative startups.

The expansion of the definition of a startup means that more companies will be able to take advantage of the regulatory relaxations that have been granted to startups under the proposed legislation. The goal of this provision appears to be to expand the scope of the startup ecosystem in Pakistan.

4. Startups will now be able to buy back shares from departing founders

This provision is likely to be especially useful for the investors and current management of Patari, where much of the founding team has been forced to depart the company owing to allegations of sexual harassment against one of the founders and allegations of aiding a cover up on the part of the others.

In such circumstances – or in situations where founders leave owing to disputes with each other or with investors – it can often create an awkward situation where the departing founder still owns a large chunk of the company’s equity but is no longer a contributing member of the management team. For startups, this is a very common scenario, and one that is made worse in Pakistan by the fact that, under the very recent law, only publicly listed companies were allowed to buy back their own shares.

Under the proposed legislation, startups will be able to buy back their own shares, in addition to all private limited companies. This allows for the amicable settlement of disputes between founders and does not require one founder or investor to buy out others, but rather have the company’s collective resources be made available to resolve such issues.

Limitations to the proposed changes

However, while the SECP – which is not controlled by the Civil Service of Pakistan – has a relatively citizen-serving orientation, the rest of the government does not. The SECP is by no means the only entity that startups have to deal with, and many of the others – most prominently the Federal Board of Revenue (FBR) – are nowhere near as polite and accommodating as the SECP.

So while the law would change many things that make life a little inconvenient for startups, it would do nothing to change the biggest bureaucratic hurdle facing all companies in Pakistan: how to comply with the byzantine paperwork requirements of filing tax returns with the FBR.

On that front, progress remains relatively unlikely. Despite repeated efforts by multiple governments over the past several decades, the FBR remains hopelessly mired in both corruption and extreme bureaucratic inefficiency.

And even the proposed regulations by the SECP do not uniformly ease regulations entirely. Among the proposed changes is a more stringent requirement for all companies to file their annual financial statements with the SECP, regardless of size.

This is part of the SECP’s drive to get more and more data about companies available to the government in line with how regulators operate in most European countries.

The SECP’s approach to regulation

There is some good news when it comes to the proposed legislation that the SECP has put forward: it represents a willingness by a regulator to propose amendments to a law that was already one of its biggest achievements in recent decades, the 2017 Companies Act, which was the biggest change to how businesses are regulated by the SECP since the preceding law, which was enacted in 1984.

And the 2017 Companies Act is widely considered to be a relatively well-written law. “When, in 2017, the Companies Act was reformed and re-enacted, it was by and large a new law altogether and a 21st century law. It incorporates technology and up-to-date systematic rules. It obviously isn’t perfect, but it is an up to date law,” said Uzair, the partner at AUC Law.

So for the SECP to be willing to undertake significant changes to its signature legislative accomplishment over the last two decades speaks well of the intellectual humility and service orientation of the institution, especially when one considers the fact that such changes are on behalf of not large businesses with significant clout, but instead small, cash-strapped startups armed with nothing but big dreams and interesting ideas.

Indeed, not only is the SECP willing to go through the process of drafting and advocating for these changes, but it is also willing to explain those changes to aspiring startups in a webinar conducted a few weeks ago, despite a pandemic halting most in-person interactions and generally slowing down the pace of business all over the world.

And the SECP appears willing to institutionalise the process of regulatory iteration in collaboration with startups, creating the “Regulatory Sandbox” – utilising a term used by software engineers to describe an environment where programmers can test their code – that would allow the SECP to try new ideas and examine which of its regulations need to be changed to better facilitate startups.

In short, the SECP is willing to become the kind of nimble, adaptive regulator that Pakistan will need if the economy is to have any hope of competing globally. Now, if only the rest of the government would cooperate…