As we highlighted in last week’s blog (The Differences between UK and US Early Stage Venture Deals), one of the major differences between the approach of a UK and a US venture capital investor is in their choice of holding company.
US venture capitalists historically insisted that they would only invest in an early stage UK or other non-US company if the company “flipped” its corporate structure and installed a US (typically Delaware) holding company above the startup’s existing top company. For a variety of reasons this historical view is changing. US investors are increasingly open to the idea of investing in UK and Irish-based companies without the “Delaware flip.”
What’s driving the investor mindshift to an accepted “non-flip” option?
US VC investors are becoming aware that the higher corporate tax rates in the US compared with the rest of the world, and the potential advantages of a non-US holding company on exit, argue against a “Delaware flip.” The US has one of the world’s highest corporate tax rates, approaching 40 percent (national plus state); by comparison, UK corporate tax rate is almost half that (approximately 20 percent). This means that a “Delaware flip” potentially subjects a larger share of the startup’s global profit to the higher rate of US tax, and adds greater tax complexity.
US VC investors have become more sensitive to the impact of these jurisdictional tax disparities due to the recent popularity (or infamy) of “inversion” transactions, which are structured to ensure that a parent company based in a lower-tax jurisdiction results from the merger of a US company with a non-US company. Well-known inversion transactions include US-based Burger King’s merger with Canada-based Tim Horton’s, and Pfizer’s aborted bid for AstraZeneca. While the US Government has taken steps to discourage inversion transactions, the controversy has focused US investor minds on the benefits of operating a global business through a non-US parent company.
Additionally, US companies are holding more than two trillion dollars in “trapped cash” profits (i.e., profits that will be subject to a US tax charge if repatriated to the US) outside the US. In this context, a number of large US companies such as Microsoft and Cisco increasingly have focused on non-US acquisitions. Indeed, the acquisition of a non-US company with a substantial US business permits the acquisition of US assets without incurring the repatriation tax charge.
As a result, US investors increasingly see value in a “UK parent-US subsidiary” corporate structure regardless whether their eventual exit is a sale or IPO. If a sale is preferred, potential US acquirers with offshore “trapped cash” have acknowledged the desirability of acquiring non-US holding companies. If an IPO is desired, the UK-based startup’s ability to pay less tax on non-US-source corporate profits should help boost valuation; a UK company establishes similar tax efficiencies in expanding to the US through a US subsidiary as a US company does when inverting out of it.
King Digital, one of 2014’s significant US tech IPOs, is a high-profile example; despite a strong US presence, King filed for its IPO through its non-US parent company.
However, UK startups need to recognize that some US institutional investors’ internal rules may prohibit them from investing in non-US companies (although this is increasingly unusual). Further, not all US VC investors are aware of the dynamics described above.
The argument for the Delaware flip
An argument we commonly hear in favor of a Delaware flip is that it avoids friction with potential US investors, especially those on the West Coast. Those investors are familiar with Delaware corporations and aren’t necessarily inclined to consider changing the model that has worked for them in the past, especially given the volume of homegrown US companies already competing for their capital.
In response, UK founders should keep in mind that, if ultimately necessary and with careful tax planning, a UK company can implement a Delaware flip later in its life cycle without incurring UK tax. Consequently, if the optimal US investor to lead your UK company’s Series A round insists on flipping, you can flip in connection with that fundraising transaction; there’s no need to do it at the preliminary discussion stage. If the US investor is willing to lead a Series A in a UK parent but is concerned about the willingness of other US investors to lead a future Series B, the decision to flip can be postponed and re-evaluated in anticipation of the Series B round. Until these scenarios arise, the UK company can maintain its tax-efficient structure and save the cost of the flip.
Other arguments we’ve heard in favor of a flip include (1) it’s easier for a US company to execute a US IPO, (2) US customers are less comfortable contracting with UK companies, and (3) US employees may be reluctant to take equity in a UK company. There are valid counter-arguments to each of these. On the other hand, additional reasons to avoid a flip include the potential adverse impact on UK Government grants and incentives intended for UK businesses.
Careful consideration should be taken before any decision is made
The question “to flip or not to flip” requires careful consideration of the relative advantages and disadvantages. It is important to have a thoughtful discussion with your US VC at the outset about these issues, and potentially to include your lawyers or other advisors. Many US VC investors simply are not yet familiar with transatlantic tax dynamics and reflexively fall back to the US parent structure with which they are comfortable, even if counter to their and the startup’s long-term best interests. Nonetheless, you need to be pragmatic and make a judgment call if your preferred US VC investor ultimately will not invest in anything other than a US company.
Next Week…. The Top Ten Tips for US Expansion
Interested in learning more about the support needed for potential US expansion or US investment? Feel free to get in touch with Daniel Glazer (firstname.lastname@example.org) or Robert Mollen (email@example.com)
Article produced in partnership with Daniel Glazer and Robert Mollen at Fried Frank Technology.