Delaware Flip for Foreign Startups: Corporate & Tax Considerations

By Bobby Gojuangco

For foreign startups seeking U.S. venture capital, entity structure can become a threshold issue. U.S. venture investors generally prefer Delaware corporations, a preference that often requires a foreign startup to reorganize before closing a financing. A common solution is the “Delaware flip,” in which the existing shareholders exchange their interests in the foreign company for stock of a newly formed Delaware parent. Structured properly, the exchange is tax-free for U.S. federal purposes, and the Delaware parent’s new stock can qualify as qualified small business stock (“QSBS”).

The corporate and U.S. federal tax considerations become more complex with each layer of ownership, from a startup owned by its founders, to one with preferred equity, to a group with operating subsidiaries in several countries. The home country rules (exit tax, rollover relief, stamp duty) matter just as much, but they differ in every jurisdiction and require local counsel, so they appear here only where they affect the U.S. analysis.[1]

Structuring the Flip

A Delaware flip generally involves forming a new Delaware parent company and exchanging the foreign company’s existing shares for stock of that parent, leaving the foreign company as a wholly owned subsidiary. Most of the legal work involves recreating the cap table at the parent level to mirror the foreign company’s existing ownership and rights. Existing share classes and investor rights generally need to be recreated at the Delaware parent level, while outstanding Safes, convertible notes, and employee options must also be addressed as part of the reorganization.[2]

Because the exchange transfers shares rather than assets, the foreign company remains the operating company, and the business avoids having to reassign contracts, licenses, employee arrangements, or IP. Key agreements should still be reviewed for change of control provisions, which can be triggered by the exchange. The exchange may also require separate class consents under the foreign company’s governing documents.

Most U.S. venture financings are governed by Delaware law and documented using the National Venture Capital Association (“NVCA”) model forms. A Delaware parent allows VCs to invest on those familiar terms without the tax exposure that comes with directly holding stock of a foreign company.

The Common Stock Flip

The most straightforward scenario is a company owned by its founders and early employees, with any outside capital raised through Safes or convertible notes. The shareholders contribute their ordinary shares to the new Delaware parent in exchange for common stock, and no gain is recognized so long as they control the parent immediately after the exchange.[3]

The exchange has two principal U.S. tax consequences. The foreign company becomes a controlled foreign corporation (“CFC”) of the Delaware parent, which changes its ongoing U.S. tax treatment. Unlike later shares issued to investors or acquired through option exercises, exchanged shares are generally not QSBS because they are issued for foreign company stock rather than money, other property, or services.[4] A Safe or note that still converts into shares of the foreign subsidiary after the flip, rather than the parent, is a drafting mistake that leaves the holder outside the Delaware cap table.[5]

The Preferred Stock Flip

For companies that have already raised a priced round, the flip must also account for the rights attached to the existing preferred stock. Investors in the foreign round negotiated for specific rights, such as dividend and liquidation preferences, anti-dilution protection, board seats, and veto rights, but those rights do not automatically transfer to the Delaware parent. They have to be recreated in the parent’s certificate of incorporation and stockholder agreements (the NVCA model investor rights, voting, and right of first refusal and co-sale agreements).[6] Standard economic terms should carry over unchanged unless the parties renegotiate them (e.g., an 8% noncumulative dividend and a 1x non-participating liquidation preference).

More difficult questions arise when the foreign shares include rights with no equivalent in the NVCA documents. The parties must then decide whether to recreate those rights in the Delaware documents or negotiate their removal.

Because those rights often include protective provisions or other blocking rights, the flip may also require investor approval. However, investors generally consent where the reorganization is a condition to the company’s next financing.

The Multi-Entity Holding Company

The most complex structure involves a foreign holding company with operating subsidiaries in several countries. A common approach is a reorganization in four steps:

1. The new Delaware parent is formed, along with a Delaware subsidiary and a merger LLC.
2. The foreign holding company merges with the merger LLC, and its shareholders exchange their shares for stock of the Delaware parent.[7]
3. The Delaware parent contributes the foreign holding company down to the Delaware subsidiary.[8]
4. The foreign holding company is liquidated, leaving its operating subsidiaries held directly under the Delaware group.[9]

The reorganization can generally be completed tax-free, but accumulated earnings in the foreign holding company can become taxable U.S. income when it is liquidated.[10] Most venture-backed startups have no accumulated earnings after years of losses, but the analysis should be confirmed before closing.

What Determines the Outcome

The tax treatment of a Delaware flip depends on the company’s existing structure and capitalization. Accumulated earnings, entity classification, outstanding convertibles, and the location of key assets can all affect the result.

For U.S. investors, the Delaware structure generally eliminates the complications associated with directly holding stock of a foreign startup, including potential PFIC exposure.[11] The Delaware stock they purchase for cash can also qualify as QSBS.[12] U.S. employees may similarly acquire QSBS-eligible stock through the company’s equity plan.

The flip also causes the foreign subsidiaries to become CFCs because they are now owned by the Delaware parent. This creates additional U.S. tax reporting obligations and may subject certain subsidiary income to current U.S. taxation.[13]

Foreign stockholders generally receive less U.S. tax benefit from the flip. A non-U.S. holder typically is not subject to U.S. tax on gain from the sale of stock in the first place, while dividends from the Delaware parent may be subject to U.S. withholding.[14]

The timing of certain steps can also affect the tax result. An entity classification election must be effective before the exchange to potentially preserve QSBS eligibility for the founders, and the flip can affect the group’s eligibility under the $75M gross-assets test.

About the Author(s)

Bobby Gojuangco

Bobby Gojuangco is an attorney at Vela Wood. He focuses his practice in the areas of venture financing, M&A, and taxation.

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