What is a "Delaware flip"?

Here at SSM PC, one of the most frequent questions that we receive from our foreign entrepreneurs with businesses in their home countries is how to set up a US-based entity so that they can do business in the States.  

Are you seeking venture capital financing in the States?

One of the most important deciding factors in determining how to set up American operations is whether American venture capital funding is a predominant part of the equation.  

By way of example, when a startup from Europe who has received limited funding in its home country comes to the States to raise a more substantial round of funding from American investors, American venture capitalists might advise the startup to do what is colloquially called a “Delaware flip.”  

Conversely, if the foreign company is (1) not a traditional startup and/or is (2) not immediately receiving equity investment here in the States, it does not necessarily have to do a “Delaware flip.”  It can simply create a Delaware subsidiary of its foreign parent.  We generally recommend, due to cost constraints, that our early stage startup clientele only expend the legal and accounting fees when they receive a Term Sheet from an American investor requiring a flip, usually at the first priced round (i.e., Series Seed/A).

What is a Delaware flip?

In a Delaware flip, all of the shareholders who hold equity/shares in the foreign company exchange their equity/shares with the newly-formed Delaware C corporation, in order to receive equity/shares in the newly-formed Delaware C corporation.  The exchange may be on a 1:1 basis or other ratio depending on how many shares were authorized and issued in the foreign company.

When the exchange happens, the foreign company essentially becomes a wholly-owned subsidiary of the Delaware C corporation, as it now has a single owner, the Delaware C corporation.  The shareholders now own equity/shares in the Delaware C corporation.

Other ways to accomplish this process may include:

• ​If the startup abroad is nascent and IP development is still relatively green: Transferring the IP portfolio to the US entity at a CPA-determined fair market value (i.e., may likely require a formal IP valuation) via IP Transfer/Sale Agreement, setting up a similar ownership structure in the US Delaware C Corporation, and dissolving the abroad entity if there is no use for it.
• If the founders can afford it: Individually purchasing the IP outright from the abroad entity, presuming again that the IP is relatively green and the cost is not too high, and then contributing that IP as individuals when they pay for their common shares at incorporation of the DE C corporation.  The abroad entity may be dissolved after the IP is transferred if there is no use for it abroad.

[Caveat: In the cases of startups operating in regulated industries in the United States or startups coming from LatAm, it may also be wise to consider flipping into the Cayman Islands instead as a precursor.  This is often called a "Cayman's Sandwich."  The resulting structure may be that the foreign shareholders own the newly-formed Cayman’s entity, which then owns a Delaware entity in full, which then owns the abroad entity in full.]  

What happens after a Delaware flip is accomplished?

The foreign company continues its operations in the home country.  Frequently, American venture capitalists investing in the new Delaware C corporation ask the key C-suite level officers of the company (i.e., the CEO, for example) to immigrate to the US and manage the operations and team here in the States.  

The new funding received from American investors will be used predominantly to fund the Delaware C corporation’s operations in the United States, but may also be used to fund some expenses by the foreign corporation pursuant to an Intercompany Services Agreement.  There is usually a transfer pricing analysis accompanying the Intercompany Services Agreement, and that transfer pricing analysis is performed by an international tech transactions CPA firm.

Local laws permitting, there may be a sale/transfer of the IP/technology from the foreign entity to the new Delaware C corporation during this process as well, such that the new Delaware C corporation owns the technology previously created/owned by the foreign company, and then licenses it back to the foreign entity such that the foreign entity can sublicense the IP to its customers abroad.  The IP valuation and transfer pricing analysis for the licensing arrangement are handled by international technology transaction CPA firms who do this work.

What are some common considerations that accompany the Delaware flip?

Below are some questions that owners should consider in accomplishing a flip:

1. What are the consents required abroad to accomplish the flip transaction?  Third-party and investor consents must be obtained by the abroad entity before the flip can take place.
2. What are the tax implications resulting from how the technology will be either shared between the two entities or sold from one entity to the other via a licensing agreement or sale agreement, respectively?  
3. Is the foreign company now subject to taxes in the States?
4. Does the Delaware C corporation have liability insurance specific to its operations in the United States?  Does the foreign entity's insurance cover US operations, or is there a need for a US-specific policy?
5. Is the timing right?  Often, it is strategically more cost effective and advantageous to flip the ownership interests when the company is still young and in preparation for the first priced round raise.  Yet, this is an expensive process and absent a Term Sheet from an American VC, it might be premature.

An accountant that frequently works with clients who have cross-border transactions, or a tax lawyer familiar with international tax concerns may research and advise as to the answers to the first three questions.  

Oftentimes, the lawyer in the home country who previously set up or consulted with the foreign corporation to establish operations abroad is already familiar with the foreign entity’s legal documents.  He or she can advise as to the fourth question, as well as draft the necessary board consents for the foreign company to enter into the Delaware flip transaction.  Lawyers here in the States can set up the Delaware C corporation.  The home-country lawyer will work with American lawyers to accomplish the flip transaction.

SSM Law PC is available to answer any questions or concerns you may have regarding a Delaware flip.  

This blog does not constitute solicitation or provision of legal advice, and does not establish an attorney-client relationship. This blog should not be used as a substitute for obtaining legal advice from an attorney licensed or authorized to practice in your jurisdiction. You should always consult a suitably qualified attorney regarding any specific legal problem or matter in a timely manner, as statutes of limitations may bar your claim.