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Doing the Delaware Flip: The Basics of Re-incorporating in the U.S.

Timothy Corbett of Hale & Dorr London


The following article was previously published in Full Ratchet(TM), the Trans-Atlantic Venture Capital Review, which is published by Hale and Dorr LLP. If you would like to receive future issues of Full Ratchet, please send an e-mail to chris.grew@haledorr.com.

For many non-U.S. technology companies, the United States remains the principal source of venture capital, as well as the location of some of the world's premier stock markets. A stock exchange listing on NASDAQ or a trade sale to a U.S. acquirer is often seen as an ideal potential exit. Operating through a U.S. holding company may ease each of these processes.

An increasing number of English companies are choosing to form new Delaware holding company structures in connection with venture capital financing rounds, including companies currently having minimal or no operations in the U.S. This article examines some of the key considerations involved in "flipping" an English company into a Delaware holding company structure.

Why choose a U.S. entity?

Over the years, VCs in the U.S. have devoted substantial time and effort to developing standards for the complex web of documentation involved in a venture capital investment. VCs in the U.S. generally feel most comfortable with the corporate mechanics available in a U.S. entity-for example, they understand and are comfortable with the way in which the rights of preferred stock can be structured under U.S. corporate law. In addition, many VCs believe that a U.S. entity will offer more advantageous opportunities for an "exit", either through a trade sale or a public offering, because:

  • There is a good chance that a potential acquirer will be based in the U.S., and will be based in the U.S., and will be more comfortable dealing with the corporate mechanics and structuring of the acquisition of a U.S. target.
  • The public markets in the U.S. remain attractive to investors. Although non-U.S. companies can list on U.S. markets, the process can be expensive and cumbersome. In addition, some U.S. institutional investors are prohibited by their charters from buying the securities of non-U.S. companies. Further, technology investment bankers and VCs often argue that a listing on NASDAQ of a U.S. entity can result in numerous benefits to the company and its investors, including a higher valuation and increased liquidity (which in turn enable VCs to exit the company without adverse trading consequences). Some investment bankers believe that this may be a primary reason for the lower investment returns of European VC funds compared with those of their U.S. counterparts.

Why a Delaware corporation?

In the U.S., corporate law is generally governed by the individual states, not by the federal government. Over the past century, the State of Delaware has developed one of the most sophisticated, comprehensive and well-regarded bodies of corporate law. This has made Delaware one of the favoured jurisdictions for business people seeking predictability and certainty in complex transactions. Many of the best-known U.S. companies are incorporated in Delaware.

Certain provisions of Delaware corporate law make it easier to manage both the day-to-day operations of a company and its significant corporate events. For example:

  • the stockholders of a Delaware corporation may act by written consent with only a simple majority vote, while many other jurisdictions require unanimous or super-majority consent
  • under Delaware law it is possible to effect a statutory merger with another company with the consent of a simple majority of stockholders. The certainty of being able to eliminate an unhappy minority may make a Delaware target more attractive to a potential acquirer.

Most significantly, Delaware companies and their investors can draw upon a substantial body of experience in structuring complex financing and corporate governance arrangements-for example, the terms of preferred stock and the voting rights of investors-with great predictability and certainty.

Effecting a "flip" from an English limited company

The "flip" from an English company to a Delaware corporation is usually effected by a share-for-share exchange between the newly formed Delaware company and the existing shareholders of the English company. After effecting this exchange, the shareholdings of the Delaware corporation will mirror the pre-existing shareholdings of the English company, and the English company will be a wholly owned subsidiary of the Delaware corporation. In addition, any outstanding options to purchase shares of the English company will be exchanged for new options to purchase shares of the new Delaware parent company.

Tax considerations

The potential tax consequences of a "flip" are very complex and must be analysed and considered carefully. Detailed tax advice should be sought from the tax advisers for both the company and its shareholders prior to effecting a "flip".

In the U.K., a properly structured "flip" should generally be tax neutral (other than with respect to stamp duty, as described below) to both the English company and its existing shareholders (and optionholders), and the existing tax benefits enjoyed by the English company and its shareholders (and optionholders) should generally be preserved (such as the "carry over" of the holding periods and original cost bases for capital gains tax purposes). In particular, the exchange should not give rise to any U.K. tax on chargeable gains for U.K.-resident persons (provided, among other things, that the transfer is carried out for bona fide commercial reasons and does not form part of a scheme to avoid capital gains tax or corporation tax).

If the English company is a "qualifying company" for purposes of Enterprise Investment Scheme (EIS) and/or Venture Capital Trust (VCT) relief, confirmation should be obtained from the Inland Revenue that the new Delaware corporation will be a qualifying company for purposes of EIS and/or VCT relief. Similarly, if the English company has an Enterprise Management Incentives (EMI) share option scheme, confirmation should be obtained from the Inland Revenue that the Delaware corporation will also qualify for EMI treatment.

Stamp duty will be payable in the U.K. on the transfer of shares in connection with the "flip" at a rate of 0.5% of the value of the Delaware corporation (which should generally be equal to the value of the English limited company). Generally, the value of the shares involved is likely to increase over time, and so the amount of stamp duty payable is likely to be higher if a "flip" is effected later rather than sooner.

Tax residence of the U.S. corporation

Following a "flip", the Delaware corporation will be a holding company with no operations. Its sole asset (at least initially) will be 100% of the share capital of the English limited company. Over the course of time, the group will likely find it advantageous to conduct any non-U.K. operations either directly through the Delaware parent or through a new non-U.K. subsidiary of the parent, so as to minimize the amount of non-U.K. source income of the group that will be subject to tax in the U.K.

There may be advantages in preventing the Delaware corporation from becoming tax resident in the U.K. To avoid U.K. tax residence, it is necessary to ensure that the Delaware corporation is not "centrally managed and controlled" in the U.K. There is no bright-line test for determining where a company is centrally managed and controlled, but criteria such as the physical location of board meetings, the residence of directors, the location of offices and similar matters could be taken into account by the tax authorities. These criteria are complex and should be reviewed in detail. It should be noted that if the Delaware corporation does become tax resident in the U.K., and wishes at a later date to move its tax residency out of the U.K., it may face a substantial "exit charge" at such time.

Possible disadvantages

Although there are a number of potential benefits to a Delaware holding company structure, there are also a number of potential pitfalls:

  • The tax implications of the "flip" are complex and require detailed analysis. Any failure to comply with the very specific rules and requirements could result in the loss of valuable tax benefits or other adverse consequences.
  • By forming an ultimate parent company in Delaware, the company may become exposed to the risk of litigation in the U.S. at an earlier point in time than would otherwise be the case. With no presence in the U.S., the risk of litigation in the U.S. could otherwise be remote.
  • If the company ultimately chooses to list on a non-U.S. stock exchange and not to list in the U.S., the creation of a Delaware holding company structure may make legal compliance matters much more complex. In particular, the corporation will be subject to the U.S. securities laws and will only be able to issue securities pursuant to an effective registration statement on file with the U.S. Securities and Exchange Commission or pursuant to an exemption from such registration requirement.

To "flip" or not to "flip"?

Forming a new Delaware holding company structure is a major corporate undertaking and requires significant investment of management and shareholder time, as well as input from legal, accounting and tax advisors. The process grows more complex later in the life of a business, as the capital structure and commercial relationships of a company become more complicated. The management of a company would do well to consider whether a "flip" makes sense for the company in the early stages of its financing lifecycle. Despite the hurdles, the "flip" may provide a promising route to new financing and increased shareholder value over the long term.

Timothy Corbett (timothy.corbett@haledorr.com) is a Junior Partner at Hale and Dorr in London.