Coming to America — A Founders’ Quick Guide to the Legal Process
You’ve worked hard to become familiar with the UK legal process. Then you take investment from US investors and suddenly you’re exposed to the US legal process and market standards.
Here is a quick guide to some of the most common questions we’ve heard from our portfolio companies who have been through this process. With thanks to our good friends at WSGR and Dentons.
Does my company need to flip to the USA?
This decision will be for the company to weigh up. On one hand (i) the drivers for the flip coming from the ‘new’ investor base and, on the other (ii) the cost, expense and tax impact as to whether this is a sensible decision for the Company.
There may be compelling reasons for a US-based investor to require a flip to a US-based corporate entity. A couple of such reasons include:
- Tax Benefits — The US federal tax code provides very favorable tax treatment (no federal tax if certain conditions are satisfied) upon the sale of Qualified Small Business Stock (“QSBS”). One of the requirements of QSBS tax treatment is that the stock be issued by a corporation formed under US law.
- Structuring Complexity — An investment in a foreign entity may require the US fund to structure the investment through an offshore investment vehicle (adding to more time and cost for the investor).
- Transaction Fees — Investing in a foreign entity is more expensive than investing in a US entity (need for US and foreign counsel). Such a fee structure is cost prohibitive for many smaller, early stage funds.
It may also be the case that it’s a governing provision in the fund formation documents of the US fund that they only invest in US companies (or even more narrowly, only in Delaware companies).
In addition, most U.S. venture funds are prohibited in investing in tax pass-through entities such as limited liability companies or partnerships, so the preferred vehicle is a corporation. A C Corporation, which is a U.S. tax designation, is a non pass-through entity for U.S. tax purposes (unlike an S Corporation, which is taxed like a partnership).
From a practical standpoint, the US funds may simply have limited experience with non-US parent companies (legal documents, reporting obligations, director duties and other legal obligations) and may feel more comfortable investing in entities that they are familiar and comfortable with.
On the other hand, there are certainly US investors out there who are happy to invest in foreign topcos so whilst a Company should seek to understand the motivational factors behind the investor request, they should also carefully consider their own position.
See further information here.
Why are there so many documents?
Multiple documents are used to segment out the participants and signatories to those documents. There are typically five core documents:
- (1) Purchase Agreement — this is simple bill of sale for sales. It generally is a single event document which does not survive after closing (think subscription agreement in the UK)
- (2) Charter — this contains all rights specific to the securities no matter who owns them (think Articles of Association in the UK)
- (3) Investor Rights Agreement — this is an incremental document that grants specific rights to investors such as rights to information and registration rights for future public offerings, and pre-emption rights. The registration rights in this document are intended to survive an IPO until the investors no longer need them, so this document remains a separate document that survives and is often publicly filed as an exhibit to a U.S. registration statement for an IPO
- (4) Right of First Refusal and Co-Sale Agreement — this is separate because the key obligants are the founders and the common stockholders, and the rights holders are the preferred investors. This usually terminates on an IPO or sale, so it is good to have as a separate document so it can easily be discarded
- (5) Voting Agreement — this also typically terminates on an IPO or sale but sets out the rules for how each class of shares will vote with respect to Board of Directors composition and a sale of the company (the items addressed in documents 3–5 are found within a shareholders’ agreement and Articles of Association in the UK)
Why can’t specific parties (e.g. an investor) have named rights in the Certificate of Incorporation?
They can, but it’s usually simpler to keep this in the financing agreements and better for confidentiality reasons (as the certificate of incorporation is public filing, while the financing agreements related to the round are not).
If they are heavily specific, the Secretary of State of the jurisdiction of formation (usually Delaware) may refuse to accept the Certificate of Incorporation as not sufficiently clear on its face to securities holders.
Why doesn’t the liquidation preference explicitly refer to a “sale”?
A Deemed Liquidation Event generally includes a merger, in which case stockholders are getting settled out in cash or stock. A stock sale may often result in the entity surviving and the individual stockholders selling.
What is, rightly, not caught within this concept, is the sale of shares by an individual shareholder holding some, not all, of the shares in the Company. This is a third-party transaction where the proceeds should not be run through the liquidation preference waterfall.
Instead, what may happen in this scenario, is that rights of first refusal and co-sale rights are triggered to protect other investors.
Why do only “major” investors benefit from pre-emption rights?
It is customary in the US to have pre-emption rights only benefitting those investors who have put sizeable cash amounts into the business and have the real firepower to keep following their funds. Similarly, in financing situations it is quite common that the company wants to move fast and does not want to have to reach out to a large group of investors to see if they are taking up their pre-emption.
This is not yet market in the UK although we are seeing it appear in some documents.
What’s the difference between warranties and reps? Is an indemnity basis of claim common?
In the US, the distinction between reps and warranties is typically not relevant for risk mitigation purposes. Both are generally a means of diligence/disclosure in a VC deal to ensure that companies reveal the true state of their businesses at the time of investment. Indemnity claims are infrequent since it would involve a VC pursuing a claim against a company that the VC has funded (and effectively going against its own money).
In situations where there are issues discovered in the diligence process including via the representations/warranties by the company, it is sometimes common for the parties to “re-price” the financing round (i.e., lower the pre-money valuation for the round, thereby increasing the equity stake of the investors).
Do I (founder) need to give warranties/reps?
This depends upon the (i) company’s stage of development (ii) the macro financing environment and (iii) who has the ‘upper hand’ in the deal.
You may see requests for founders to make limited representations/warranties in seed stage deals (before the company has raised significant outside capital), but this is only really seen in a minority of deals.
Founders often view the request for founder representations/warranties (and the additional liability exposure associated therewith) as a “deal killer”, so you would be far less likely to encounter such a request in a competitive financing environment (as we are experiencing now) or if the deal is ‘hot’.
In subsequent financing rounds (A, B, C, etc.), it’s unusual to encounter a request for founder representations/warranties, since the company is likely to have more dispersed ownership and a professionally managed Board/governance structure.
Do I (founder) need to be subject to good/bad leaver events and what happens if I was to leave?
Employment in the US is at will, so leaving is very easy. The big questions surround the amount of severance a founder may be entitled to when they leave a business and more importantly, whether you want to accelerate the vesting on any equity awarded.
It is important to note that, as part of the investment transaction, the founders may have had a portion of their shares subject to reverse vesting (where the founders’ equity is taken away and then essentially earned back over time).
In addition to this, at the outset you should consider what should happen to unvested equity — where you (founder) do not yet fully own all of the stock you may have been awarded and you leave.
As founder — your ideal scenario will be that if you are terminated from your employment (without any good reason or where there is ‘no cause’), all of your unvested equity immediately vests. In the same way, you would want this to happen if your company is sold. This is known as “single trigger acceleration” but is not common in early-stage companies.
Most commonly, what is known as “double trigger acceleration” governs your unvested equity. This means that both your unvested equity will accelerate and vest only when both your company is sold and you are terminated as an employee.
Here, it is important to think at the outset as to what sort of vesting you are willing to agree to in the context of the long term role you/the founder intends to have.
Do I (founder) need to give non-competes?
This is again deal dependent and we have had responses from counsel which suggests that sometimes this is completely accepted (as in the UK) but oftentimes, it is not required other than in connection with the complete sale of the business.
Where non-competes are required, they are in addition to covenants regarding confidentiality and assignment of inventions/IP (which all employees are generally subject to) and founders, executives and key employees are typically required to agree to (i) a non-competition covenant (no competition with the company during employment and 1 year thereafter), and (ii) a non-solicitation covenant (won’t solicit company employees during employment and for 1 year thereafter). This is not the case in California however where they are against public policy and therefore generally unenforceable except in connection with the sale of a business.
Talk me through disclosure on US deals? It’s different to what I’m used to.
Yes — it is much more detailed with very explicit questions, but this should be seen as akin to a due diligence questionnaire (from a UK perspective) — it is all driving diligence for the investor.
What should I expect to happen at closing? It seems less “formal” than in Europe and do I face any risk as a result?
It is far less formal. Typically signing and closing coincide, the restated Charter is filed on the morning of the closing, and then closing occurs. If anything, signing and closing at the same time reduces risk for founders as it is a done deal without any additional conditions to closing and this is all typically done electronically.
Why Delaware law?!
The U.S. does not have a national corporation format, and each of the fifty states has separate corporate codes. Over time, Delaware has evolved as the most commonly accepted jurisdiction for U.S. corporations. The Delaware General Corporation Law is modern and flexible, constantly updated and improved by the state legislature, and interpreted and enforced by Delaware’s highly respected state court system, which has particular specialization in corporate law. As such, this law has become the “national” corporate law for many lawyers across the US who like its accessibility, predictability, and well-developed case law. Skilled venture lawyers across the US (regardless of state) are presumed to be well-versed with it. The model venture financing documents published by the National Venture Capital Association (which are used in a number of US deals and the equivalent of the BVCA across the pond) are drafted assuming that the company is incorporated in Delaware. The corporation is the preferred choice of entity for venture capital. A majority of VC funds will require the re-domicile into Delaware of an entity formed in other US jurisdictions as a condition to making an investment.
Entrepreneur’s Relief — is there a risk I lose this moving overseas?
Technically, the individual never loses the right to claim this by moving overseas — where you are based isn’t one of the conditions to this tax relief so, in theory, you can always make this claim if you meet the other conditions (holding shares in a trading company, being an officer or employee of the company and holding at least 5% of the ordinary shares and voting powers in that company for at least a year prior to the share sale).
It is only worth an individual making an Entrepreneur’s Relief claim however if they have a UK capital gains tax liability (which they may not have if they are no longer considered a UK tax resident — see below!)
Don’t forget, the bigger question is really — what is the IRS going to try and tax me on now that I am in the US (which is where your capital gain treatment can suffer).
When do I get treated as a non-UK tax resident?
Whilst there is lots of detail which could be captured here, at a high level, a person will be treated as non-UK resident for capital gains tax purposes, and not be liable to pay UK capital gains tax, if they:
- Spent 45 days or less in UK in relevant tax year AND were not resident in UK in any of the three previous tax years;
- Spent 15 days or less in UK in relevant tax year AND were resident in UK in one or more of the three previous tax years; or
- Are working full-time overseas and spent less than 91 days in the UK in the relevant tax year and do not work in the UK for 3 hours or more on more than 30 days.
Side note — if the gain arises during a period of ‘temporary non-residence’ then the individual will pay UK capital gains tax when they become UK resident again. Temporary non-residence is complicated but it may be helpful to know that if someone is non-resident in the UK for 5 years and 1 day or longer, then they won’t be temporarily non-resident.
With thanks again to our friends at WSGR and Dentons. While this advice is thorough and professionally informed, it is of course not intended as a replacement for legal advice from your US counsel. Similarly, with the tax queries, always consult a tax adviser who can talk to your US and UK tax position.
