July 25, 2017
Delaware flips are now increasingly common locally. We estimate that up to 70% of the tech start-ups that have raised seed financing or looking to raise seed financing in Nigeria have had to incorporate offshore holding companies (HoldCos) in Delaware, Mauritius or other jurisdictions considered to be investor-friendly[1]. This statistic is evidence of a prevalent trend in early stage technology M&A whereby Venture Capitalists (VC)[2] – mostly non-resident/foreign VCs, require that tech companies seeking VC investment must set up an offshore HoldCo as a pre-condition for investment[3]. If one considers the fact that the current Nigerian VC pool in the technology patch is predominantly contributed by foreign funds[4], mostly U.S. based, establishing an offshore HoldCo is probably the smartest way to go for a tech start-up with limited financing options locally. Increasingly a topical issue in Nigeria’s emergent technology industry, the answer to the question whether founders should establish an offshore HoldCo in advance of financing or flip their existing businesses for say, a 100k round isn’t a straight yes or no answer. What is clear however is that (a) answering that question accurately may be the difference between a bad deal and a good deal from an investor standpoint (b) the decision to flip should be driven by the economics and governance/control terms of each deal, the long term objectives of the founders and based on a clear understanding of the legal framework applicable to (i) investments in tech companies locally (ii) the set up and maintenance of offshore entities. In certain instances, it may be counter-logical for founders to insist that investors invest directly. Yet, under certain conditions, the start-up/operating company (OpCo) and its shareholders may be exposed to greater legal risk and cost overruns where they decide to establish an offshore HoldCo early-on. The decision to establish an offshore HoldCo, at what point in the course of a company’s trajectory to establish an offshore HoldCo and the jurisdiction to settle for, thus requires careful consideration and should not be glossed over. Overall, it is important for founders and their investors to be able to accurately assess the limitations and or advantages of an offshore – or onshore- HoldCo structure early-on.
Here are a few takeaways to bear in mind for your next financing round.
Why Are We Flipping?
Founders should try to understand ‘why’. There are a number of reasons why a VC may prefer an offshore Holdco structure as a vehicle for investment into an OpCo. One of the more prominent reasons is the prospect of minimizing or avoiding capital gains tax. Capital gains tax is more often, but not always, a source based taxation. Since financial investors principally invest based on the expectation that there will be capital accretion within the holding period, it does make sense to make an effort to avoid tax on capital gains by investing through an entity domiciled in a jurisdiction where there is minimal or no tax on capital gains or in a jurisdiction that has signed a favourable double taxation agreement with the domicile of the target company. A VC may also want minimal regulatory oversight in terms of ongoing regulatory oversight or in terms of regulatory approvals and or compliance obligations that may arise at the point of exit. Sometimes VCs may simply prefer a familiar jurisdiction because they are generally more comfortable with that jurisdiction and may be averse to a new set of rules or compliance obligations. A VC may also take the view that an offshore HoldCo may better its chances of exiting to a trade buyer. The contractual obligations of some VCs under limited partnership agreements may also prohibit them from investing directly in local tech companies. Whilst these are all legitimate reasons, we find that the underlying concern really is the perception of ‘high risk’ flowing from the notion of an unpredictable and unstable legal framework, which is often associated with the investing in Africa narrative. We find, in a majority of instances, that because many foreign investors are unfamiliar with the dynamics of local tax and regulatory framework, they reflexively, – understandably so, fall back on a US/offshore parent structure with which they are comfortable, even though, these structures may sometimes be against the long-term best interests of the OpCo. Therefore, it helps to make an effort to understand and have open discussions around the exact reason why a VC prefers an offshore HoldCo because sometimes an investor concern might be adequately addressed, with the benefit a detailed legal opinion from local counsel on the risk factors peculiar to a transaction and how to create workable structures around such identified risks. A number of regulatory developments/reforms that have been initiated by the Nigerian Government to encourage FDI investments in Nigeria have the effect of mitigating, or in some situations extinguishing certain risk factors like excessive/double taxation, restrictions on repatriation of profits, intellectual property protection issues and unjustifiable disclosure/approval requirements. Nigeria has recently initiated an aggressive Ease of Doing Business Initiative. Relative to other African countries, there exists significant protection for minority VC shareholders under Nigerian corporate law and investors disposing their shares are exempted from capital gains taxation. Nigeria’s companies’ regulator is also finalizing the introduction of a new Part D to the Companies and Allied Matters Act to allow businesses to operate as limited partnerships and limited liability partnerships.[5] It does appear that within the current framework, investors and founders can creatively structure their transactions to maximize and create long term value and depending on the structures adopted, direct investments and onshore HoldCo structures may be more beneficial under certain circumstances.
Cross Border Taxation
If you decide to establish an offshore HoldCo, you should bear in mind that one of the direct implications of having an offshore HoldCo is to bring founders and investors within the tax net of a foreign/offshore jurisdiction. Although, it is often generally assumed that an offshore incorporation equals favourable tax terms, this is not always the case especially for founders and there may be significant tax burden on local founders arising from a careless offshore flip. While, individuals are taxed based on their worldwide income in both US and in Nigeria for instance, the rules on outbound and inbound transactions in both countries vary significantly. On this basis, it is extremely important that founders and VCs receive independent cross border legal advice on the tax implications of incorporating an offshore HoldCo as there may be negative tax consequences which may not be immediately obvious without proper analysis, at the point of deal negotiation. Amongst other considerations, there will often be a different tax treatment for Nigerian shareholders and non-Nigerian shareholders in an offshore HoldCo and an offshore HoldCo may still be liable to capital gains taxes under Nigerian law under certain circumstances, notwithstanding that the sale or disposal of the assets in question is carried out in an offshore jurisdiction. There are a number of other situations that can create additional tax implications. For instance, where the OpCo intends to, at some point, sell its products or services in other African countries; where it becomes necessary to transfer relevant intellectual property, other key assets, like, contracts and employees to the Offshore HoldCo as part of a flip or in the case of OpCos that have raised prior financing or have revenue contracts, where the HoldCo needs to reissue any existing convertible securities to holders or fulfil consent requirements. An offshore flip will usually involve a share swap that allows founders swap their shares for an equivalent number of shares in the HoldCo with the effect that the OpCo will be wholly owned by the HoldCo, post completion. Given that cash will not typically exchange hands with a swap transaction, founders and investors will need to be clear on how the swap will be recorded for accounting and tax purposes and also assure that the share swap does not trigger additional tax obligations in an offshore or local jurisdiction as the case maybe.
Governing Law Clause & Jurisdiction Clause
A governing law clause enables investors and founders to specify the system of law that will apply to the interpretation of an agreement and the rights and obligations of the investors and founders amongst themselves and in relation to the OpCo if a dispute arises. On the other hand, a jurisdiction clause is a dispute resolution clause which identifies which court will hear a dispute that arises between founders and investors in relation to the management and or operation of the OpCo. More often than not, term sheets that require the incorporation of an offshore HoldCo will stipulate that the governing law be the laws of the jurisdiction where the HoldCo is domiciled. Whilst this is a fairly standard provision now, here are a few points for founders to note. First, founders will, in addition to retaining legal counsel in Nigeria to advice on a financing round, have to retain the services of a law firm qualified to practice in the proposed jurisdiction to negotiate and to advice on the efficacy or otherwise of the rights of the founders vis-a-vis that of the investors and the OpCo in the term sheet and in other transaction documents. Founders and the OpCo will also require ongoing legal support from foreign counsel because, with a foreign governing law clause, the rights of the investors and founders as shareholders in relation to the OpCo and among themselves will typically be determined by foreign law. Although Delaware courts , – which rank as one of the corporate and business law tribunals in the world – and similar to Nigerian courts, follow a common law approach in the adjudication of disputes, American corporate law is a significant departure and improvement from Nigerian corporate law. For instance, at the heart of Delaware corporate law is the notion of freedom of parties to contract in terms of regulating their internal matters relating to voting/management decisions, meetings, classes of shares, veto rights and so forth. The laissez-faire approach can be severely disadvantageous for local founders who do not have the benefit of legal advice from foreign counsel. If not properly handled, a foreign governing law clause may create avoidable complications in relation to the exercise of management and decision making powers by the OpCo’s shareholders. In addition to stipulating a preference for foreign governing law, a term sheet may also stipulate a foreign jurisdiction clause. In this case, founders will have to retain foreign legal counsel in a dispute scenario. Inability to raise funds for prosecuting disputes in a foreign jurisdiction, where billing for legal services is usually on a hourly basis, may completely jeopardize the interests of founders in a dispute scenario especially where investors exercise a veto to block the release of the OpCo’s funds to fund a litigation. The issue around foreign law and foreign dispute resolution clauses is also a critical point of reflection for foreign VCs because Nigerian courts do not always honour foreign governing law or dispute resolution clauses and will not treat them as conclusive under certain circumstances. VCs need to consider the position of Nigerian courts in drafting governing law/dispute resolution clauses and in the overall structure of offshore HoldCo investment structures.
Overall, founders need not be under pressure to flip their businesses. Not everybody is flipping and as outlined above, flipping may not be ideal in certain situations. The ease of registering an offshore entity through DIY approaches or online platforms like StripeAtlas may often a costly simplification of serious business considerations that are typical with cross border venture capital transactions. Admittedly, a flip might be the pragmatic course of action to take under certain circumstances; where this is the case, it will be important for founders to bear in mind the initial and continuing costs that the OpCo and/or its founders will bear and to take this into consideration when negotiating the economic and control terms in a term sheet. Every part of a term sheet is an adjustable movable. Legal costs can always be creatively managed and win-win negotiations are a reality.
[1] We are aware of and advised a tech company whose investors favoured Singapore as a jurisdiction of choice based on a reasoned cross border tax analysis
[2] Venture Capitalists as used in this update excludes private equity firms/funds but includes angel investors, incubators or accelerators, early-stage VCs/growth funds and the pool of investors interested in early-stage investments
[3] Some US- based accelerators or incubators or funding programs require U.S. incorporation in order to access funding
[4] We estimate that domestic capital pools constitute less than 5% of the total venture capital invested in technology in Nigeria annually.
[5] Individuals have been allowed to carry on business in Lagos State as Limited Partnerships as far back as 2009
