For businesses that have been initially chartered in Europe, an early question is whether to set up a new holding entity in the United States.
Reorganising in the US is worth serious consideration for several reasons, initially access to venture capital for funding growth in the business.
Although not impossible, raising money from US investors as a foreign business is hard.
US venture capitalists generally only invest in US companies, where they are familiar with the legal and regulatory regimes and market norms.
Venture capital is not the only financial reason to reorganise in the US, as exit opportunities, whether through acquisition or the public market, may be more bountiful (and certainly also better understood by US investors).
We also observe that businesses coming from abroad might not have a choice – US investors and accelerator programs may issue an ultimatum – reorganise in the US as a Delaware corporation or we will not fund your company.
The good news: the “flip” itself can be done quickly and cost-effectively. Once accomplished, it becomes considerably easier as well to address important business needs including establishing a US bank account.
How to flip into the US
After a founder decides that a “flip” into a US corporate legal structure is best for the business, the next question is how to accomplish it.
A share exchange is the most common method for implementing a flip transaction and the preferred US company structure is a Delaware corporation.
A share exchange requires existing shareholders to tender their shares to the newly formed Delaware company in exchange for a like number of shares in the Delaware company.
This results in the foreign entity becoming a wholly-owned subsidiary of the Delaware company.
A critical issue for the existing shareholders will be to ensure that this share exchange is tax-free under relevant tax laws.
Much has been written on this topic, but in short entrepreneurs and investors favour Delaware due to its well-developed corporate law and the predictability it affords stakeholders.
It is important to note that the exact restructuring plan will be driven significantly by tax and legal considerations.
A share exchange may not be the best fit, however there are alternatives, such as an asset sale, which should be discussed with professional advisors.
Once the flip transaction is complete, the startup can begin conducting operations in the US through the new Delaware company while continuing to operate in Europe through the local entity (now a subsidiary).
Existing shareholder agreements will need to be terminated and corresponding agreements entered into among the US entity and existing shareholders. Legal terms in the prior shareholder agreements should mirror the legal terms in the new shareholder agreements to the extent reasonably practical.
As is the case with initial corporation formation documentation and seed financings, a core set of standard documents have been developed by leading law firms to accomplish a “plain vanilla” flip.
Beware of legal pitfalls
We encourage founders, before deciding whether to flip into the US, to consider, among other things, whether there any tax, intellectual property and business issues. These issues can be complex so line up experienced legal and tax advisors, both in the US and abroad.
Tax considerations are of the utmost important. The first question to ask is whether the flip transaction can be accomplished on a tax-free basis.
The answer will depend in part on the laws of the local jurisdiction and the composition of a shareholder base (note that if the company has existing investors, the tax analysis will be more complicated).
Some jurisdictions grant tax-free treatment for all share exchanges, while other countries require that the transferee entity be within the EU or impose other restrictions.
Second, it is key to develop a game plan for the company’s intellectual property. Key points to consider include determining which company will own intellectual property and how intellectual property (and other assets) will be shared between the US company and the subsidiaries.
US investors may insist on intellectual property residing in the US company but likely could get comfortable with a license arrangement between the two entities (where the US entity has the paid-up right to use these assets in its business).
The transfer of intellectual property or associated rights could also trigger adverse tax consequences if proper planning is neglected prior to the flip transaction (it really does all come back to tax).
Finally, consider whether any existing commercial agreements will require third-party consents or approvals. For example, real estate leases may contain a provision that allows a landlord to terminate a lease in the event of a reorganisation transaction.
All commercial agreements should be carefully reviewed in order to avoid inadvertently triggering a third-party termination right.
The legal issues associated with a flip transaction will only become more complex as a business grows, making it advisable to move forward with the flip early in the company’s life cycle.
With the right advisors in place, European founders should be able to accomplish a flip transaction quickly and efficiently to take advantage of the abundant financial opportunities in the US
Murray A. Indick is a partner in Morrison & Foerster’s San Francisco Office and is the co-chair of the firm’s Emerging Companies and Venture Capital practice group. He has more than 30 years of experience as a corporate lawyer, with expertise in venture capital, private equity, fund formation, M&A and corporate governance matters.
Jonathan O’Connell is an associate in Morrison & Foerster’s San Francisco Office. His practice focuses on the representation of technology startups in Silicon Valley and abroad.