The Legal Framework for Venture Capital in Ukraine (CBR project)

Overview

Background

The potential role of venture capital (‘VC’) funding in supporting Ukraine’s post-conflict reconstruction is high on the policy-making agenda. Prior to the conflict with Russia, Ukraine had already established a thriving innovation ‘eco-system’, with a significant number of university-industry collaborations, and a high rate of VC funding by comparison to other countries in central and eastern Europe. Since the summer of 2022 a number of VC partnerships based in London and New York have announced new funds to support early-stage investment in Ukrainian companies, and the Ukrainian government has prioritised VC in its plans for post-war reconstruction. The Ukraine Venture Capital and Private Equity Association (UVCA) has issued a Redevelopment Plan, which was discussed at the Davos World Economic Forum of January 2023.

With the focus on VC funding as a part of Ukraine’s reconstruction, it is relevant to consider how far Ukraine’s legal framework supports VC. It is generally recognised that the legal framework for VC financing is an important variable in explaining its incidence and effects across countries. Law-and-economics analysis, drawing on transaction cost economics, understands VC funds as acting as information intermediaries, linking ultimate investors (ranging from pension funds, mutual funds and wealthy individuals) to startups. By pooling expertise, VC funds can help overcome agency costs and learning externalities, and diffuse risks associated with innovation. There are features of the legal framework in Ukraine which may require particular attention from the point of view of encouraging an indigenous VC sector. The Ukrainian civil code lacks an exact equivalent to the limited partnership form. An overseas investor can enter into a joint venture with a Ukrainian partner through a ‘joint activity agreement’, but there are complexities associated with the process through which joint ventures are registered with the Ukrainian tax authorities. In principle, a distinct tax regime applies to VC funds, with zero tax payable on capital gains; however, in practice, Ukrainian VC fund structures are often used as tax evasion devices. Additional issues arise from the rigid legal form of the ‘joint activity agreement’: participation rights cannot circulate freely, as any change to membership creates legal complexities, and it is difficult to organise management, as there is no established template for board membership or the operation of the board’s powers of oversight and control. These difficulties can be avoided in practice through the incorporation of funds under a foreign jurisdiction, for example US or English law. As of 2021, Ukrainian law allows a foreign law to be chosen for a shareholder agreement, if at least one of the parties is non-resident. Allowing this option has increased the attractiveness of investment in Ukraine-focused funds, but it poses the question of how far returns from successful startups will eventually flow out of the country.

Aims and objectives

Given the need for research on the role of commercial and company law in supporting Ukraine’s reconstruction, the project will address the following questions:

1. What, in general, is the optimal legal and transactional framework for venture capital?
2. What are the current legal obstacles to venture capital in Ukraine?
3. What changes should be made to the law and to transactional structures to promote venture capital in post-conflict Ukraine?

Methods

Research on VC illustrates a ‘considerable divergence between the law and practical reality’ (Armour, 2002) that can only be overcome through empirical research. We therefore propose an empirical project to examine the interaction of law and practice in Ukrainian VC funding.

To understand the macro-level rules governing VC, we will conduct a review of relevant laws and regulations. We will use the Cambridge Leximetric Datasets (Deakin et al, 2016) to benchmark Ukrainian laws in the areas of shareholder, creditor and worker protection. This will enable us to get an initial measure, based on formal law or ‘law in the books’, of how far the Ukrainian legal environment is conducive to VC funding, following the approach of Armour and Cumming (2006) and Cumming and Johan (2014). The Cambridge datasets provide a method for ‘leximetric’ data coding which has been widely adopted and used in similar studies. Ukraine’s labour law has recently been coded up to 2022 as part of a recent update to the labour regulation index. A new coding of Ukraine’s shareholder and creditor protection laws will be carried out, enabling Ukraine’s laws to be compared to those of other European countries in the current version of the Cambridge dataset (several other central and eastern European countries have recently now coded up to 2022 as part of the current update).

At the micro level of transactional structures, we will conduct a literature review, using online sources, of relevant materials on the types of contractual and other arrangements made in VC agreements. A number of national venture capital associations make standard form agreements available for public use. Where it is not possible to derive standard forms from online sources we will directly approach the relevant bodies.

To get a deeper appreciation of how VC funds operate in practice we will conduct interview-based fieldwork with relevant stakeholders. We anticipate conducting around 20 interviews across a range of potential respondents: industry associations, ultimate investors, VC funds, law firms with VC expertise, and investee companies, with a focus on the IT sector, which is sizable in Ukraine. Around 10 of the interviews will focus on the experience of Ukrainian funds, with 10 focusing on the experience of British and US-based funds by way of comparison. Where British-based funds and other specialists are interviewed, we anticipate being able to conduct interviews in person. For US-based and Ukraine-based interviewees, the interviews will be conducted by Zoom (currently, most Ukraine-orientated funds are based outside the country, predominantly in London or New York).

Progress

By the early summer of 2024 we had conducted 30 interviews and carried out data analysis, focusing on statistical measures of the rule of law and changes in company and labour law in Ukraine and neighbouring countries. A draft report was presented at a workshop in Cambridge in July attended by stakeholders including policy makers, VC funds, law firms and startups from Ukraine. Together with colleagues from Cambridge Judge Business School we also organised a VC ‘speed dating’ event linking startups with VC funds. Following the workshop, a draft version of the report was published on the website of the Ukraine Venture Capital Association.

The final report, The Legal Framework for Venture Capital in Ukraine by Simon Deakin, Francesca Farrington and Hanna Sitchenko, was published in December 2024. Two working papers were subsequently completed: one on the concept of venture capital as a commons, for a forthcoming edited collection on Governing Corporate Knowledge Commons (edited by David Gindis, CUP, forthcoming); the second on the institutional environment and rule of law in Ukraine, currently under review with a peer-reviewed journal.

Findings

The main report assesses how far Ukraine possesses a legal and institutional framework which is conducive for VC growth and development. In common with other countries in Europe and around the world, Ukraine has made a number of legal changes with a view to encouraging VC and enterprise-based innovation more generally. These include a new bankruptcy law from 2019, reforms to the joint stock company law in 2021, and a significant liberalisation of employment law with effect from 2022. In addition, a special legal regime for IT-focused startups, the Diia City free zone, provides for many of the transactional devices thought to be important for VC development, including non-disclosure agreements, non-competes, convertible loan notes, option agreements, and representations and warranties, as well as VC-supporting tax and employment law rules. Potential legal obstacles to the VC sector nonetheless remain. There is a degree of uncertainty over how far transactional structures characteristic of VC, such as convertible debt, can be made to work in the wider context of Ukrainian corporate and commercial law. Shareholder agreements, similarly, may not be straightforwardly enforceable where they depart from companies’ articles of association and mandatory provisions of corporate law.

In practice, any shortcomings of domestic Ukrainian law may be alleviated by the use of foreign law to underpin corporate and financial arrangements. It is normal for Ukraine-based startups to incorporate in the US state of Delaware or to be controlled via a US-based holding company. The cross-border structure of VC is familiar to legal practitioners and has been successfully used in other European countries to help develop local VC ecosystems.

The wider institutional environment in Ukraine remains an obstacle to the development of a domestic VC sector. Progress towards the rule of law has been slower than elsewhere in east central Europe over the past decade. VC-friendly legal structures, designed to promote innovation, have been used as tax avoidance devices in non-innovating sectors, such as real estate, and to conceal corporate ownership.

The report concludes that, in the short term, reliance on foreign law to organise VC may be a practical option for Ukraine, as it has been elsewhere in Europe. In the medium to long term, building a viable VC ecosystem capable of generating knowledge spillovers will require the onshoring of legal and professional services. Reliance on workarounds and carveouts to support VC carries the risk that these structures will be used for ulterior ends. Exempting VC from general rules of law may run counter to the goal of enhancing trust in the legal system.

The first working paper explores the legal and transactional governance of venture capital (VC) from the viewpoint of the theory of the firm as a knowledge commons. At first sight, venture capital seems far removed from any notion of a commons, if that is taken to mean a shared resource constituted by emergent rules of conduct based on interactions between multiple stakeholders. Bright line rules favouring the interests of capital holders over those of producers and communities dominate the orthodox legal account of VC, which stresses the importance of US-style transactional flexibility in managing investment risks. On closer inspection, however, VC systems have many commons-like aspects, involving risk-sharing, information pooling, and the braiding of formal and informal rules. The public benefits of VC depend on the positive externalities generated by knowledge spillovers, which cannot be fully captured by private ordering. Understanding these features of VC through Masahiko Aoki’s theory of the firm as embedded cognition, and drawing on interviews with mostly Europe-based VC funds, entrepreneurs and legal advisers, we argue that the governance of VC should be concerned with maximizing the net social return from innovation, taking into account the multiple interests involved in knowledge creation and preservation.

The second working paper contributes to the literature on the institutional determinants of venture capital investment. In particular, the paper focuses on the influence of substantive legal rules and institutions of governance and enforcement on Ukraine’s venture capital activity and the potential role of venture capital in supporting Ukraine’s post-conflict reconstruction. Even if Ukrainian law is reformed to bring it into line with the content of foreign legal systems which have proved supportive of VC (mainly US and English law), a major obstacle remains in the form of the governance and enforcement environment within Ukraine. From our interviews, we can see that perceptions and incidences of corruption appear to be a persistent problem in Ukraine, alongside inefficiencies in civil justice. Concern over corruption appeared to be two-fold, encompassing the direct cost implications of firms making side-payments to powerful actors, and the impact of corruption on effective enforcement. Our analysis of corruption and rule of law indices shows that since 1990, Ukraine has failed to make significant gains in institutional quality, with those gains made in the last 10 years still leaving Ukraine below its highest score of 0.45 in 1990 on the V-Dem Rule of Law Index. As such, before contemplating legal reform, we would recommend that significant investments are made in tackling corruption and improving the quality of rule of law. Overall, we suggest that corruption is a greater obstacle to Ukraine’s post-war development than the state of the law as such. Legal reforms should be undertaken with a view to building trust in institutions within Ukraine. An approach which emphasises the use of foreign laws to structure commercial transactions, and provides VC funds and investors with workarounds from local laws which other actors do not benefit from, may help to foster VC investments in the short run, but will fall short of providing the institutional framework needed to develop a viable VC ecosystem within Ukraine.