To Flip or Not to Flip? Further Reflections on the “Delaware Flip”

 This is a guest blog created by Robert Mollen from Fried Frank – a NYC based international law firm.  This is reprinted with permission of Robert Mollen.

In spring 2015 I co-authored a blog with Dan Glazer for Notion Capital on whether non-US companies should “flip” their corporate structures under Delaware holding companies in order to secure early stage US venture capital investment. The pressure to flip has come from certain US early stage VC’s who would only invest in a non-US start-up if it moved its holding company to the US. Additionally, certain US accelerators, such as Y-Combinator, have insisted on a flip as a condition of participation in their program, although others, such as Techstars, now take a broader view.

So what are the current considerations?

Negative Effects of a Flip

As we noted in 2015, for a variety of reasons, the flip may have negative tax and other effects for the company:

  • US corporate income tax rates are significantly higher than most other jurisdictions.

  • The US corporate income tax system is complex, particularly in the way that it treats non-US source income.

  • The flip may result in the loss of home country grants and tax benefits (although UK businesses, for example, may be able to retain many of these benefits, such as those under the Seed Enterprise Investment Scheme and Enterprise Investment Scheme, even after a flip if they take appropriate actions)

  • On exit, US multinationals may be willing to pay more for a non-US holding company than a US holding company in order to be able to use cash that would be subject to US tax if they remit it to the US

President-elect Trump has indicated an intention to change some of the US corporate income tax provisions described above. We’ll see …

Defer the Flip if You Can

It makes sense for non-US companies to defer any flip to the US unless and until a US VC who is critical to the company’s business insists on it as a condition of investment. The one exception to this general principle would be where the company thinks that a flip is highly likely down the road; and either:

  • the company has a key shareholder (or shareholders) for whom any flip will be a taxable transaction when it takes place (and consequently it is in the shareholder’s interest for the flip to occur earlier while the valuation is lower); or

  • less likely, the company itself will be subject to home country tax charges on the flip.

So why delay?

  • If the company needs to reverse course later, flipping out of the US will be a taxable transaction for the company (and if IP has been moved into the US, moving the IP out of the US separately is taxable).

  • If the company fails to secure US VC investment, it is very likely to find that its Delaware holding company is a negative factor in securing, e.g., European investment. I have now seen this problem in a number of cases. This is particularly troubling where a company has flipped into the US to secure a relatively small amount of investment (e.g., from an accelerator, business angel or crowd-funding) and then finds it has no real prospect of follow-on US investment.

  • Some potential trade sale acquirors (particularly non-US acquirors) may not want to acquire a US holding company (and, as noted above, US acquirors may actually pay more for a non-US holding company).

  • East Coast early stage VC’s, and larger West Coast VC’s, are increasingly willing to consider investing in non-US holding companies formed in certain jurisdictions (see below), so a flip may never be required even if US investment is important.

Note that this legal structure issue is separate from the question whether the US VC will find the business to be investible in the first place – that investment decision at early stage is likely to be substantially based on US traction, a US business plan, and founder proximity to the VC.  However, all of these can be achieved by expanding the business through a US subsidiary rather than flipping to a US holding company.

A Flip to the UK or Ireland May be Necessary

While a US flip may not be required, continental European companies may well find that they need to flip into a UK (or Irish) holding company structure in order to secure UK and US early stage investment. I have found US and UK early stage investors to be less comfortable investing in continental European corporate vehicles.

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This discussion is not intended to provide legal advice, and no legal or business decision should be based on its contents. If you have any questions or comments, feel free to contact robert.mollen@friedfrank.com or via LinkedIn here.
You will find Bob’s other weekly blogs for emerging and growth companies on US issues, international expansion and early stage financing here: http://bit.ly/2lP5uMP