India / US company structure for SaaS companies based in India

[Based on a recent round table facilitated by Chintan @ CXOconnect I added some edits]

With the boom in SaaS companies in India that are selling to the US, I often get asked by fellow founders about what is the right structure to follow when setting up an India entity and a US entity i.e. what should be the relationship between them.

What follows is a summary based on my experience of going through the acquisition of Recruiterbox Inc. in 2017 / 2018 (a US company) and some recent research for setting up the structure of my new startup (Sprinto). By no means should you consider this expert advice. I am hoping this will help you get a founder perspective to all the legal aspects. The points below are applicable to founders who primarily live in India and want to setup cross border entities in US or otherwise.

There are essentially three Indian regulatory authorities you need to consider while thinking about any setup.

1. RBI (FEMA regulations)
2. Income tax
3. SEBI

I haven’t come across any SEBI rules applicable to startups. I might be unaware of its regulation or it might apply only to public markets. In any case, please ping me on twitter to suggest edits on this subject.

I have come across three possible corp structures.

1. India subsidiary, US parent.

This is not legal as per FEMA rules. This type of a set up makes the Indian entity a step down subsidiary and it is not allowed. There are workarounds (involving gifting of shares) that are at best grey area in my opinion. Most VC funded companies seem to use this workaround. By using the work around, you cannot file the creation of the US entity with RBI (ODI filing) which essentially means that you will not be able to receive the proceeds from sale of your company into your personal Indian bank account at the time of exit. Of course, if you had to leave India to setup your sales ops or something similar, you are no longer an Indian resident at the time of exit and things are less complicated. The fact that this company was setup at the time you were in India could still be a point of contention if you ever decide to move back to India and move the funds back to India but I am not sure about it — further research is necessary.

Income tax department also has problems with this setup since you are realising most revenue outside India but you have substantial presence here. I haven’t personally come across a fellow founder who had run into this kind of a situation so far but I do know that this is a point of contention if not illegal.

[Apparently, gifting of shares especially from loved ones (blood relatives) is not illegal. Same is true for earning shares as sweat equity in the US entity to the extent that you become a majority shareholder. However, in all these cases at the time of sale, the compliance department in a bank may decide to refer the transaction to RBI. When that happens, the individual opinion of the official at RBI on the matter becomes paramount. From what I heard, some such cases have been approved without trouble while RBI did send notices to a bunch of startups regarding this structure recently and even issued notices to some companies to unwind these kind of corp structures.]

2. India parent, US sub

Everything is clean from a regulatory standpoint in India as well as in the US. US entity will be what is called a pass through entity and it has zero double tax implications. However, if you want to raise funds from the US you might have some push back from VC’s / angels who haven’t dealt with Indian regulation and paper work. Obviously this comes down to how your company is doing and how badly the investor wants to invest in your company.

You can flip this into a US parent by registering a new US entity at any time given you can justify a sufficiently high valuation of this new US entity — like a new fund raise. This cleanest way to do this is by what is called a share swap where the new US entity acquires the Indian parent company in exchange for its shares and the old US pass through company becomes irrelevant (can be shutdown). It requires a merchant banker valuation of both companies and I heard that this is a bit pricey. Hopefully you are doing this when you are raising a new round of funds and the valuation justifies the hassle and cost involved. This flip is still not legal if all the founders are Indian residents at this time. Usually raising funds from the US also involves moving your base of operations closer to customers and new investors. This usually causes majority share holding to move to the US and the Indian entity may no longer be considered a step down subsidiary — I am not sure about whether majority shareholding is enough or not.

[1. Apparently, the terms offered to India vs US HQ companies are very different especially around founder indemnity, material breach of terms listed in SHA/SSA and events that lead to founders losing their equity at face value. All three of these are terms that don’t appear in term sheets but make their way into SHA/SSA. These are virtually non existent for US hq companies but they are very onerous in India hq companies. Some of these can put not just me but my family at risk, and in my personal opinion, you should carefully consider what you are signing. Of course, a venture capital institution cannot call upon these lightly since its a huge reputation risk for them.

2. In the round table we concluded that flipping is not very easy once you have raised institutional funds. When a US company acquires the India company in a share swap the way I suggested earlier, it triggers capital gains tax and it is undesirable for all parties. Something for the lawyers to answer — I wonder why the value at which the share swap happens should not happen at or close to the last fundraise value triggering minimal capital gains.

3. When the flip happens, for the founders who are in India they are still in violation of FEMA regulation but I think it should be possible for them to receive RBI approval for the same — by this time, I am assuming there is reasonable business in the US and enough shareholding is outside of India.

4. In the round table, some of the founders who did quite a bit of research on flipping have concluded that there is no material advantage to flipping except for fundraising advantages and a whole lot of paperwork. As described in point 1 of the edits, I would add terms to the list.]

3. India and US company have a transfer pricing agreement

This is legal as per FEMA rules as long as you make an ODI filing. However, this structure is still not ok for Income tax department due to substantial presence problem I described earlier. Also, if you have investors, they have issues with investing in a US entity that technically holds all IP but all the employees and all work is happening from the Indian entity.

Additional notes if you are bootstrapped company.

I have seen legal advisors (CA’s and lawyers alike) claiming all options are viable. Based on my experience, all options are viable until one of the authorities decides to investigate further and the amount of money involved is considered high. RBI has a very small bar (a few tens of lakhs) on what it considers large money. As per my understanding, a lot of money laundering happens via model 1 or Model 3 or a close relative of those models. If you are bootstrapped company with marginal success it looks very suspicious in the eyes of RBI especially at the time of exit. From an outsider perspective, it looks like you invested a few hundred dollars during the initial setup and in a few years time you are bringing back hundreds of multiples of that money back — a money laundering operation would look very similar. To avoid any issues during a moment of success, I highly recommend that you get your paper work regarding ODI and other RBI filings water tight before you enter into an exit agreement.