India and other developing countries in the past decade have witnessed considerable developments in terms of Venture Capital (“VC“) funding for their start ups; however, the United States (“US”) still remains on top of the list, by a considerable margin in terms of venture capital backing. This has given rise to the “flip” trend, pursued by a large number of Indian start-ups.
A concept which has been gaining popularity in the VC circles; a Delaware Flip Transaction is the creation of a company in the US with the intent of making it the holding company of an international subsidiary (in this case, the subsidiary would be Indian). The term “Delaware flip” gained popularity because Delaware, United States has been known to have a comparatively comprehensive and structured set of corporate laws that makes both incorporation and operations a smooth affair. However, start-ups may pursue a “flip” with any country, provided local regulations for the same are conducive.This article would explore the furtherance of a flip” transaction in India, in the backdrop of its legal governance and compliance.
FLIP MECHANICS:
The Indian promoters incorporate an international holding company (“holding company”) (either in Delaware or any other state/country that allows such incorporation), whose securities they subscribe to by offering shares in its Indian counterpart on a share swap basis. As a result, the holding company would hold 100% paid up capital of the Indian company and the Indian promoters shall in turn hold 100% stake in the holding company.
Essentially, the structure creates a buffer company incorporated abroad, between the promoters and the Indian company i.e. the promoters, instead of directly holding shares in the Indian company, would be doing so through the holding company.
Illustration: Company A is a start up with Indian promoters who seek venture capital funding but are unable to tap the market through their India based company. They incorporate Company B in Delaware, United Estates in which they are the promoters and hold controlling interest.
Company B and the Promoters now enter into a “share swap” agreement whereby Company B purchases all shares in Company A from the promoters and in exchange issues its shares i.e. Company B’s shares to the promoters.
Share Swap: In order to give effect to the flip, the Indian company would have to issue shares to their proposed international “holding company” in exchange for shares in the holding company issued to Indian promoters.
FEMA[1] on Share Swap: Direct investment outside India in a Joint Venture/Wholly Owned Subsidiary by way of share swap arrangement is allowed under the automatic route[2] provided the valuation of such shares is done by a Category I Merchant Banker registered with SEBI or an Investment Banker outside India registered with the appropriate Regulatory Authority of the host country. It may be noted that all share swap transactions require the prior approval of the Foreign Investment Promotion Board (FIPB) for the inward leg of the investment.
Issue of Shares: On completion of the “Flip”, any further funding received by the start up is generally routed through the international holding company. The holding company thereafter introduces such funds into the Indian company either by way of equity or loan.
FOREIGN COMPANY
The Companies Act, 2013 (“Act”) has defined a foreign company as one which has a place of business in India, either physically, through an agent, or through electronic mode AND conducts any business activity in India. Chapter XXII of the Act would be applicable to all foreign companies, 50% or more of whose equity/preference share capital is held by one or more citizens of India[3].
The effect of the above results in a fair amount of compliance issues for the holding company which has set up business operations in India through its Indian subsidiary and would have to follow the local regulations of the country it was incorporated in as well those prescribed under Chapter XXII of the Act. Compliance includes filing of its charter documents, annual reports etc. Further, all provisions of the Act pertaining to the issue of debentures, books of accounts, registration of charges and power of the Registrar of Companies to inspect, inquire and investigate would apply to a foreign company as if it were an Indian company.
CONCLUSION:
A flip transaction is a lucrative option for all companies looking to make their businesses more attractive for investors as well as have the flexibility of splitting its operations between two countries. Further, despite strong possibilities of an Indian start up receiving funding, setting up a tried and tested U.S. start up in tune with the prevalent VC terms could lead to increased valuation for the start up and better returns.
However, a prime disadvantage of a “flip” structure is analysing the taxation laws applicable to it, which, due to its inherent structure and the application of two countries’ tax legislations, have proven to be complex. Failure to understand and comply with specific regulations prescribed by each country could not only lead to loss in tax benefits but also result in adverse consequences due to non-compliance. The deal would require consulting with taxation authorities well versed with the tax laws of both countries.
A “flip” transaction is ideal for a start up that has reached a growth point of being able to manage its business and tax structuring despite having a U.S. holding company and one that is confident of receiving VC funding from the country it has set up such holding company in.
(The Author was an Associate in the Corporate Team, Jayanth Pattanshetti Associates)
[1] Foreign Exchange Management Act, 1999
[2] Regulation 6(5)(b) of the Foreign Exchange Management (Transfer or Issue of any Foreign Security Regulations), 2004
[3] Section 379, Companies Act, 2013
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