Delaware flips are becoming more common locally. We, at Balogun Harold, estimate that up to 70% of the tech startups that have raised seed financing – or are looking to raise seed financing – in Nigeria have had to incorporate offshore holding companies in Delaware, Mauritius, or other jurisdictions considered to be investor-friendly[1]. This statistic is evident of a prevalent trend in early stage technology M&A transactions where Venture Capitalists[2], mostly non-residents, require that tech companies seeking VC investment must set up an offshore holding company as a precondition 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 holding company is probably the smartest way to go for a tech startup with limited financing options locally
The answer to the question of whether founders should establish an offshore holding company 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:
- Answering that question accurately may be the difference between a bad deal and a good deal from an investor standpoint.
- The decision to flip should be driven by the economics and control terms of each deal, the long-term objectives of the founders, and should be based on a clear understanding of the legal framework applicable to local investment and the operation of offshore entities.
In certain instances, it may be counterintuitive for founders to insist that investors invest directly. Yet, under certain conditions, the operating company and its shareholders may be exposed to greater legal risk and cost overruns where they decide to establish an offshore holding company early-on.
The decision to establish an offshore holding company therefore requires careful consideration, and it is important for founders and their investors to be able to accurately assess the limitations or advantages of an offshore holding company structure early-on.
Here are a few takeaways to bear in mind for your next financing round:
Why Are We Flipping?
There are a number of reasons why a VC may prefer an offshore holding company structure as a vehicle for investment into a start-up. One of the more prominent reasons is the prospect of minimising 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 obligations that may arise at the point of exit. Sometimes, VCs may simply prefer a familiar jurisdiction because they are 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 holding company 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 those are all legitimate reasons, we find that the underlying concern really is the perception of ‘high risk’ 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 fall back on a familiar offshore parent structure, even though these structures may sometimes be bad for the long-term interests of the operating company.
Therefore, it helps to make an effort to understand and have open discussions around the exact reason why a VC prefers an offshore holding company, because sometimes an investor concern might be adequately addressed, with the benefit of a detailed legal opinion from local counsel on the risk factors peculiar to a transaction, and how to create workable structures around these identified risks.
A number of regulatory 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 in startups are generally exempted from capital gains taxation.
Cross Border Taxation
If you decide to establish an offshore holding company, you should bear in mind that one of the direct implications of having one is to bring founders and investors within the tax net of a foreign 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 holding company, which may not be obvious at the point of negotiation.
Amongst other considerations, there will often be a different tax treatment for Nigerian shareholders and non-Nigerian shareholders in an offshore holding company, and the offshore holding company may still be liable to capital gains taxes under Nigerian law, 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 operating company intends to, at some point, sell its products or services in other African countries; where it becomes necessary to transfer relevant intellectual property and other key assets such as contracts and employees to the offshore holding company as part of a flip – or in the case of operating companies that have raised prior financing, where the holding company needs to reissue any existing convertible securities to holders or fulfil consent requirements.
An offshore flip will usually involve a situation that allows founders swap their shares for an equivalent number of shares in the holding company, with the effect that the operating company will be wholly owned by the holding company after 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 ensure that the share swap does not trigger additional tax obligations in an offshore or local jurisdiction as the case maybe.
Governing Law Clause and 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 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 operation of the operating company.
More often than not, term sheets that require the incorporation of an offshore holding company will stipulate that the governing law be the laws of the jurisdiction where the holding company is domiciled. While this is a fairly standard provision now, here are two points for founders to note:
- Founders will, in addition to retaining legal counsel in Nigeria, have to retain the services of a law firm qualified to practice in the proposed jurisdiction to negotiate and to advice on the efficacy of the rights of the founders in the term sheet and the definitive agreements.
- Founders and the operating company 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 operating company and among themselves, will typically be determined by foreign law. This may have implications. For example, Delaware corporate law is a significant departure and improvement from Nigerian corporate law. 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 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 powers by the operating company’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 also 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 an hourly basis, may completely jeopardise the interests of founders in a dispute scenario, especially where investors exercise a veto to block the release of the operating company’s funds to fund a court action.
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.
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 Stripe Atlas may often lead to 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 take into consideration the initial and continuing costs that the operating company and its founders will bear, when negotiating the economic 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.
