By Jason Stark*
You’ve built your operations in Latin America using funding from local friends and family and Angel investors and you are ready to raise a Series A round of financing (usually U.S.$1-3 million from institutional investors). First, congratulations. Just surviving as a startup in a region with a difficult and diverse regulatory environment (think Brazil), currency transfer restrictions (think Venezuela and Argentina) and fluctuating economic headwinds is an accomplishment and puts your company in a solid footing in the region, considering that any competitor will have to survive these same barriers to entry.
The U.S. remains the most active venture financing market in the world for technology and Internet companies, but U.S. venture funds generally will not invest into local operating companies in Latin America because of concerns regarding taxes, rule of law and contractual interpretation. To close a financing round, it is wise (and often required by the investor), to restructure your business entities to create an international holding company into which the Series A investors will invest, which are commonly structured as a U.S. corporation or U.S. limited liability company (“LLC”) that owns the local operating companies, or a Cayman Islands holding company that owns a U.S. LLC that owns the local operating companies.
Below is a cost/benefit analysis of the three legal structures described in the prior paragraph that work well for Latin America based startups, and the restructuring that may need to occur prior to creating the new structure.
Restructuring the Latin American entities
A venture capital fund or investor will require that the holding company into which it will invest owns 100% of the equity of the local operating companies (or 99% for jurisdictions which require two shareholders), and 100% of the assets and intellectual property of the operating companies.
Forming companies in multiple Latin American jurisdictions often is difficult and costly. For that reason, and as a result of being a startup needing to keep costs low, perhaps your legal structure is a bit informal (e.g., the founders own intellectual property, and the various entities do not have the same ownership percentages).
Restructuring the various operating companies into an international holding structure often is resolved fairly easily. Restructuring the ownership of the various entities usually is accomplished with a simple exchange agreement (permuta) whereby each company’s shareholders agree to transfer their shares in the local operating company to the new holding company in exchange for shares in the new holding company. Local counsel would revise based on local requirements and file any documents required by the local jurisdiction. The exchange agreement method works in conjunction with any of the three alternatives below.
Three Holding Company Structures
The U.S. (Delaware) corporation would own all other entities in the group. This is the classic, most well-known and understood structure.
- U.S. venture capital funds and investors are comfortable with Delaware corporations. No explanations are needed with venture capital funds.
- Unlike an LLC, there is no “phantom income” on the corporation’s profits for shareholders, meaning that until the corporation makes a distribution, undergoes a taxable event (such as a merger or asset sale) or the shareholder sells his shares, there is no tax to the shareholder.
- A U.S. corporation is a taxable entity, and this results in “double tax” (worldwide earnings will be subject to U.S. corporate income and U.S. dividend withholding tax). If the company is profitable, those profits are taxed (highest effective corporate rate is 35%) and then the shareholders are taxed again upon sale. For a profitable company, this tax treatment will result in a significant tax burden upon sale of the company.
- Delaware corporations are subject to Delaware franchise tax, which may be as low as $175 and may be as high as (in very unusual circumstances) $180,000. Typically, it is under $1,000, and it is tied to par value of the corporation’s shares (for this reason, shares should be issued with a very low par value).
- Potential acquirers (think strategic acquirers of the entire business rather than a venture capital fund acquiring a minority ownership interest) may insist on purchasing the local operating companies to avoid acquiring a U.S. taxable entity, and in such event, the shareholders at the holding company may be required to pay taxes on the sale of the operating companies (pursuant to what is known as a liquidating distribution) or when the cash is distributed.
U.S. Limited Liability Company (“LLC”)
The Delaware LLC would own all other entities in the group.
- A U.S. LLC is not a taxable entity, and the profits are instead taxable at the member level.
- A U.S. LLC may operate less formally than a corporation and are subject to less formal documentation (e.g., no requirement for an annual meeting or bylaws and more flexibility over governance and how to define the rights of its members).
- The investment documentation usually is simpler as well – the investment documents for a corporation (the “West Coast” documents adopted under the National Venture Capital Association’s model Series A round legal documents) traditionally are broken into the purchase agreement and four other primary documents governing the relationship among the shareholders, while an LLC only requires the purchase agreement and an LLC agreement.
- The U.S. members are permitted to deduct their pro rata share of the losses the LLC generates against their current U.S. income, subject to limitations such as the passive activity loss rules.
- The LLC holding company may sell the operating subsidiaries without any capital gains to the non-U.S. members, and for the benefit of the acquirer, the LLC holding company may re-domicile outside of the U.S. in the future without triggering additional tax, except in unusual situations.
- LLC’s are subject to what is known as “phantom income”, meaning that income is taxable to its members in a given year whether or not the profits are distributed to such members (although this is not an issue for non-U.S. persons because non-U.S. persons do not pay capital gains tax).
- Many U.S. venture capital funds require that the company be a U.S. corporation (however, note that conversion to a corporation is usually a simple, inexpensive process).
- The non-U.S. members will be required to obtain a U.S. tax identification number for purposes of allowing the LLC to fulfill its U.S. tax reporting obligations.
Cayman Islands entity above U.S. LLC
A Cayman Islands entity would own a Delaware LLC, and the Delaware LLC would own all other entities in the group.
- No U.S. federal tax filings or reporting. The Delaware LLC, as a single member LLC wholly owned by the Cayman entity, is disregarded for U.S. tax purposes, and there will be nothing to pay other than an annual fee to Delaware (currently $300).
- May institutional investors are very comfortable with Cayman entities. Many venture capital funds either are domiciled in Cayman or have an “off shore” feeder fund in the Cayman Islands, and as a result, the fund is comfortable with Cayman Islands law, works with Cayman lawyers, etc.
- U.S. corporations and LLC’s are subject to U.S. reporting requirements that investors in a Cayman company may avoid. On an annual basis, the U.S. Corporation and the LLC need to file an annual tax return (for the LLC, individual IRS Form K-1’s are filed that includes the name of, and flow-through income to, its members). In addition, a Report of Foreign Bank and Financial Accounts (FBAR) may be required with respect to the non U.S. financial accounts, as well as the non-U.S. financial accounts of its subsidiaries if certain conditions are met, and disclosure forms with respect to ownership of non-U.S. companies, such as Form 5471 for the non-U.S. subsidiaries. In this structure, the Delaware LLC may be required to file the FBAR report and the Form 5471, but none of the annual tax filings will be required.
- There will be additional expense due to including an additional entity in the structure. Cayman entities have more corporate formalities to follow than Delaware corporations and are relatively expensive to form and maintain.
- Certain U.S. based funds may resist a “Cayman” based structure, as they are more comfortable with a U.S. (Delaware) Corporation.
In short, Latin American based startups have alternatives beyond creating a U.S. Corporation to support their Series A financing. A Cayman or U.S. LLC holding company may be acceptable to institutional investors, provide tax efficiency and work operationally for the Latin America based early stage company.
*Jason Stark is a partner at the Private Advising Group, a law firm in Miami. Jason is an attorney (and also is a certified public accountant) who advises emerging and growth companies. He can be reached at Jason@private-advising.com
[The information in this article is provided for informational purposes only and does not constitute legal advice. You should not act or rely on any information contained in this article without first seeking the advice of an attorney.]
Original source, featured image