Recently, the founder of a US early stage company (previously London-based) described various problems he experienced in trying to implement a UK-US cross-border equity financing. Ultimately, he gave up on the UK piece of the deal and financed solely in the US.
Early stage cross-border financings do involve greater challenges, given the need to balance the company’s own objectives against investor groups with different expectations and motivations. Cross-border transactions also require legal and tax advice in multiple geographies.
However, we think that, if handled properly, combining US and UK investor groups can provide a very good (and potentially superior) base from which to build a global business. Investors don’t just bring their money, they bring their contacts and expertise; an international investor base provides access to advisers with a wider scope of background and skills, and a broader and more diverse network.
So – how to make this work? The discussion below is focused on the US and UK context, but the base principles have broader applicability to other geographies.
1. Choice of Holding Company
For reasons we have discussed previously, we think a UK holding company provides a better starting point for a global business than a Delaware corporation or other US company. Nonetheless, a cross-border financing can work equally well with a US holding company.
2. Role of Founders
Founders need to understand the cross-border financing structure, so they can communicate appropriately with potential investors. A capital structure that works for both UK and US investors will differ from what investors might expect in purely domestic financings. It is important that the respective investor groups not be surprised.
3. Legal and Tax Advisers
The company’s lead legal and tax advisers should understand all sides’ relevant expectations and motivations, so they can give balanced, sensible advice. Cross-border expertise and a willingness to look beyond a purely national perspective are critical. It is also helpful if all of the company’s advisers are in the same place, or at least within compatible time zones. Finally, the right team will include US-qualified advisers for US issues and UK- qualified advisers for UK issues.
4. Tax Differences are Critical
Differences between the UK and US tax systems are the key drivers of the need for different approaches.
A. SEIS and EIS Investors.
Early stage UK investors may well want to take advantage of the very substantial tax incentives offered by the Seed Enterprise Investment Scheme (SEIS) and Enterprise Investment Scheme (EIS) programmes. However, these programmes have a number of specific requirements, and UK investors will typically want tax clearance from the UK tax authority (HMRC) before proceeding. If a UK tax-qualified Enterprise Management Incentives (EMI) employee option program is being put in place, an additional clearance may need to be sought.
Securing the UK tax clearances will take time — you should allow at least a month, so don’t wait to get started!
You will also need to meet various substantive requirements. For example, the SEIS and EIS programmes have limitations based on the types of business and the nature of the securities being offered. The company will need to comply with certain ongoing restrictions on its business in order to retain SEIS and EIS qualified status. These include, for example, a requirement that the company itself maintain a permanent establishment in the UK for at least three years.
Note, however, that a company is not required to be a UK company in order to qualify for SEIS or EIS, so long as it has a permanent establishment in the UK.
Investors seeking SEIS or EIS benefits can only hold ordinary shares (common stock), not preference shares (preferred stock) or convertible debt. However, that does not prevent the company from including preference shares, or debt convertible into preference shares, in its capital structure, so long as it is not issued to investors seeking to qualify for SEIS or EIS. That point is critical for the reasons discussed below.
B. US and Other Investors.
US investors, in contrast, will expect to acquire convertible preferred stock, or a debt or equity instrument convertible into convertible preferred stock. The preference gives the investor a preferred position in the event of a liquidation, and sometimes other preferences as well. The convertible preferred stock is convertible into common stock.
The terms of these instruments are fairly well established, although there is some limited range for negotiation. UK investors who are not seeking SEIS or EIS treatment (as is the case with many venture capitalists, including UK VC’s) typically look for comparable terms.
C. Resulting Capital Structure
The combination of UK investors – often seeking SEIS or EIS treatment – and US and other investors seeking a preferred position, results in the latter having a senior position in the capital structure. SEIS and EIS investors hold the same subordinated equity security as the founders and employees, potentially with some additional rights, such as board representation. This is the price that the SEIS and EIS investors pay to get the SEIS and EIS tax benefits.
D. Tax Complexities
There are a few other tax complexities, but they are manageable. For example, US investors may look to avoid adverse treatment under US tax provisions relating to certain kinds of interests in non-US companies. Without appropriate planning, these broad provisions may inadvertently apply to investments in non-US early stage companies.
This may sound difficult, but it is actually not rocket science. The founders and the advisers need to know what they are doing and work in a coordinated way, and the investors need to understand the nature of their investment. With these cautions and caveats, cross-border financing can be a source of additional value for startups and investors.
In the second series of posts to this blog, starting in summer 2015, we will be looking more closely at how UK startups can make themselves more attractive to US investors.
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Want to learn more about how best to pursue US expansion or US investment? Feel free to get in touch with Daniel Glazer (firstname.lastname@example.org) or Robert Mollen (email@example.com).
1 – A good non-technical description of these terms can be found in Brad Feld and Jason Mendelson’s book, “Venture Deals: Be Smarter than Your Lawyer and Venture Capitalist.” The book provides a very clear description, written for entrepreneurs, about how venture funding works in the US.
Article produced in partnership with Daniel Glazer and Robert Mollen at Fried Frank Technology.