The Delaware Flip: A Smart Move for European Companies?
By Jan J.H. Joosten, partner at FisherBroyles, LLP in New York
Many European companies try to raise capital in the U.S., often to fund their U.S. expansion plans. Some American investors will only invest if the European company first consummates a “Delaware flip”. This article will explain what a Delaware flip is and will discuss some advantages and disadvantages of a Delaware flip.
As many readers of this article are expected to be based in the Netherlands, this article will focus on Dutch companies that consider a Delaware flip. However, many of the considerations discussed below will also apply to other European companies considering a Delaware flip.
What is a Delaware flip?
A Delaware flip is the process of changing the corporate structure of a Dutch (or other non-U.S.) company by creating a new top holding company in Delaware and turning the original Dutch company into a wholly-owned subsidiary of the Delaware corporation.
Dutch startups and other privately held companies are typically organized as a B.V. (a private company with limited liability). Their investors will hold shares in the Dutch B.V., and there will be a shareholders agreement governed by Dutch law.
In order to do a Delaware flip, the current shareholders will have to exchange their shares in the Dutch B.V. for a proportionate number of shares in a newly established Delaware corporation. Their existing shareholders agreement will have to be replaced with U.S.-style agreements, often following the models published by the National Venture Capital Association.
A Delaware flip is a major corporate undertaking that requires the cooperation of the founders and the existing investors, as well as the assistance of sophisticated legal and tax advisors.
In the U.S., corporate law is governed by individual states. The State of Delaware has developed one of the most sophisticated, comprehensive, and well-regarded bodies of corporate law in the U.S. Many, if not most, U.S. investors prefer to invest in a corporation or other entity organized under Delaware law. Indeed, the model agreements published by the National Venture Capital Association are tailored for Delaware corporations.
Some advantages of a Delaware flip
The main argument for a Delaware flip is that a company will obtain improved access to U.S. investors. Some U.S. investors may not be permitted to invest in non-U.S. companies, and other U.S. investors may simply prefer to invest in U.S. companies. However, many U.S. investors may be willing to invest in a Dutch company, in which case a Delaware flip will not be necessary. Given the significant cost of implementing a Delaware flip and the near impossibility of reversing a Delaware flip, it is generally advisable to hold off on doing a Delaware flip until it is clear that it is absolutely necessary to do so.
Some observers believe that doing a Delaware flip will result in a higher valuation and better exit options (whether through an M&A transaction or through an IPO on the Nasdaq or the New York Stock Exchange).
Another advantage of doing a Delaware flip is that U.S. investors and U.S. employees will be able to take advantage of certain tax advantages, such as the Qualified Small Business Stock exemption. This exemption is not available if the top holding company is a Dutch B.V.
Some disadvantages of a Delaware flip
As mentioned above, a Delaware flip is a complicated corporate transaction that will require the assistance of sophisticated legal and tax advisors, resulting in significant out-of-pocket expenses. A Dutch company should generally not incur the significant expense of executing a Delaware flip unless there is a high level of confidence that the flip will result in one or more U.S. investors investing a significant amount in the company. We would generally advise Dutch companies to convey to potential investors in the term sheet phase that they are willing to consummate a Delaware flip—but that they will do so only immediately prior to the closing of the investment transaction.
Through the Delaware flip, the Dutch founders and investors will become shareholders in a Delaware corporation. Some of them may become directors and officers of a Delaware corporation. This will require them to become familiar with Delaware law, which adds some complexity to the company’s operations and may result in additional legal expenses. Typically, unless the Delaware corporation holds substantial U.S. real estate investments, the Dutch shareholders will not be subject to U.S. income tax except with respect to dividends received from the Delaware corporation. Capital gain from the disposition of the shares in the Delaware corporation would generally be exempt from U.S. income tax. On the other hand, shares of the Delaware corporation would constitute U.S. situs property for U.S. estate tax purposes, so additional planning is required to minimize potential U.S. estate tax exposure. From a Dutch tax perspective, the flip may impose additional tax costs on Dutch investors and founders due to the fact that dividends paid by the Dutch BV will – post-flip – be subject to a 15% Dutch withholding tax when paid to the Delaware parent, whereas prior to the flip dividends could be paid to the Dutch investors and founders free of Dutch tax.
Another potential disadvantage of doing a Delaware flip is that it is generally a one-way transaction. Because of U.S. tax rules, it may be very expensive tax-wise to reverse a Delaware flip.
If there is no investor pushing for a Delaware flip, Dutch companies should consider whether just setting up a Delaware subsidiary will be sufficient to help the company obtain a foothold in the U.S. For example, if a Dutch company merely needs to hire U.S. employees or sell its products in the U.S., having a Delaware subsidiary is often an adequate solution.
Is a Delaware flip enough?
Merely doing a Delaware flip is often not enough to attract U.S. investors. Typically, a U.S. investor will expect to see significant traction in the U.S. market. In many cases, a U.S. investor will expect one or more of the founders to move to the U.S. (As a side note, a founder should carefully consider the tax aspects of moving to the U.S. well in advance of the actual moving date.)
A Delaware flip is a major corporate undertaking and requires a significant investment of time and money. However, if a Dutch company has a high level of confidence that a flip will result in one or more U.S. investors investing a significant amount in the company, it would certainly be a smart move to consider a Delaware flip.
Participate in the Roundtable ‘The Delaware Flip’ on October 10 and 11, 2023, in Eindhoven and Amsterdam, the Netherlands — more information and registration.
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