Disclaimer: Reproduced with permission from Corporate Accountability Report, 24 CARE, 2/7/17. Copyright 2017 by The Bureau of National Affairs, Inc. (800-372-1033). BNA.com.
Co-authored by:
Edwin Thom Ruberger Jr., Partner, Foley & Lardner LLP
Hassan Sohbi, Partner, Taylor Wessing
The European startup ecosystem continues to forge ahead in advancing a digital economic makeover of old-world economies. While much of Europe has made great progress expanding the availability of seed and first institutional (Series A) financing—albeit notably seeded/supported by interested government players, particularly the Luxembourg-based European Investment Fund—the post-Series A capital needed for European startups to quickly expand is still not meeting the need. As such, U.S. venture investors remain a viable choice for the most ambitious of these European companies.
An Overview of the Current German and European Startup Landscape
Berlin has shaped into one the key hubs for forming and building a startup across Europe, arguably second only to London, which by all accounts has enjoyed quite a head start and continues to do well, even in the face of Brexit. Startup culture, however, is by no means limited to a few well-known international cities; new startups, accelerators, company builders and funds are continuing to launch across Western and Eastern Europe. For example, Munich, leveraging the advantage of being home to many of Germany’s leading VC funds, has continued its growth as a hotbed for technology startups. Frankfurt, the financial center of Germany and home to the European Central Bank and EU Insurance and Occupational Pensions Authority, as well as the national financial services and securities regulators, is beginning to share London’s reputation as a great market to launch and grow a financial technology (fintech) startup. Outside of Germany, Paris is known by savvy, early-stage European investors as having an excellent and deep engineering talent pool, who have expanded their focus far beyond the traditional fashion and retail startup scene. Likewise, startup culture has existed for some time in the Nordics but is now getting well-deserved recognition in such world-class cities as Amsterdam, Barcelona, Madrid and Milan, and has pushed east into the Baltics, Poland and even Russia and Ukraine.
A Challenging Opportunity for Startups
While much progress has been made—particularly over the past year—in not only seed, but also Series A financing sources and availability, growth capital nevertheless continues to be a challenge for ambitious European entrepreneurs with goals of expanding outside of their home country. The business models are proven, initial customer traction exists, smart entrepreneurial teams are at the helm and strong early-stage investors are already on board, but the availability of growth capital to expand rapidly and pursue business globally—currently obtainable by similarly situated Silicon Valley startups—is not currently matching the need.
What choices do these globally aspirational startup founders have beyond tapping into some of the newer pan-European or established, primarily London-based, venture firms, adventurous family offices and forward-thinking corporate investors? Representing what is still the vast majority of all global venture capital, U.S. venture investors are growing increasingly comfortable with European startup teams, recognizing their pure technical talent as well as their business acumen and the discipline that comes from business outliers who have learned to operate leanly and prioritize revenue, if not profitability, over market penetration at all costs.
Although a growing number of U.S.-based venture capital funds are willing to invest directly in European startups, the vast majority of U.S. investors don’t believe they are equipped to manage an overseas investment. Typically, U.S. investors require that a European startup’s primary operations, or at least key management, relocate to the U.S., preferably in close proximity to the decision-making venture fund partner.
Reading the stream of announcements of financing closings on leading U.S. tech blogs, European founders are enticed to make a Bay Area fundraising trip by the seemingly easy time their Silicon Valley counterparts appear to have in raising growth equity. However, taking the next plane from TXL to SFO, lining up some investor meetings on Sand Hill Road and closing quickly on an oversubscribed U.S. investor-led follow-on financing is unfortunately not the reality. To successfully raise funds in the U.S., there are some prerequisites. Obtaining U.S. market traction is the key first step. As noted previously, commitment by at least one, if not most, of the key co-founders to the U.S., including moving here, is also typically a requirement. Formally establishing a U.S. legal presence is also critical.
Completing a Delaware Flip
While forming a U.S. subsidiary or affiliate is an easier entry path for a more mature company’s initial sales efforts in the U.S., many U.S. investors will insist that the parent company “flip” from the original non-U.S. company to a newly established Delaware corporation. In particular, a common approach is forming and inserting a new U.S. holding company effectively above the existing non-U.S. company as the new parent entity, sometimes referred to as a “Delaware flip” or inversion transaction (i.e., “flipping” the original company’s shareholders out of the non-U.S. company and into a newly formed, often Delaware, corporation through a share-for-share exchange). It is, however, generally considered a major undertaking, with significant immediate and future consequences for the shareholders; in particular, many of the contemplated transactions stumble and sometimes are abandoned altogether due to a potentially significant exit tax owed by the shareholders in their home country. Additionally, once the new U.S. entity becomes the parent entity, any subsequent move out of the U.S. (and attempt to wind down the U.S. parent) becomes very difficult under U.S. tax laws.
Some of the key factors that a European startup team should consider when contemplating a U.S. restructuring include:
- Regarding the tax consequences to the shareholders—are the taxes significant, are they immediate or can they be deferred, and are the shareholders cash-strapped?
- Where is the company’s customer base, and where is it projected to be in the future? Is there any U.S. customer traction? Is the existing non-U.S. market traction significant?
- Does the company’s leadership plan to move to the U.S. (albeit likely leaving the engineering team intact in the home jurisdiction)?
- Is obtaining U.S. venture investment a primary goal and/or an immediate need?
- Could the flip transaction to the U.S. trigger or accelerate repayment obligations of home country government grants, loans or other similar benefits previously received to incentivize the company to establish operations in its home jurisdiction?
- Could the flip transaction result in the loss of future or recapture of certain advantageous tax benefits to the shareholders, including not only founders but investors (e.g., a U.K. company wishing to preserve the tax benefits already granted to its angel investors pursuant to the Enterprise Investment Scheme (EIS) tax relief program)?
Careful consideration of the questions posed above will help determine whether and when to undertake a U.S. relocation. In short, the complexities and ramifications of a cross-border migration should not be underestimated. Experienced advisors—legal, accounting and business—are critical. Advance planning will play a big role in the success of such an undertaking. The rewards, however, can be great. Once here, teams quickly realize that access to key business relationships, mentorship and A-team talent only add to the appeal.