Choosing the right legal environment for your startup

Due to the topic’s complexity we also spoke to Christof Strasser of 42law, one of the few legal practitioners admitted to practice in Austria, the UK and the US. He and his team have advised approx. 200 startups on matters from choice of jurisdiction to the first shareholders’ agreement and employee incentive schemes. His valuable expertise is included in this blogpost.

The majority of founders we talk to on a daily basis at capital300 have either a tech or business background, but have little legal experience. Thus, many approach us to ask about establishing a UK Ltd or US (Delaware) Inc.

A lot of “housekeeping” issues that startups experience at an early stage, such as bad accounting practices, loopholes in employment or freelancer agreements, or even IP ownership, can still be fixed later, e.g., at the time of the seed financing. By contrast, the decision of incorporation cannot be changed easily. However, it is important when it comes to attracting VC money from the US or UK.

British or American jurisdictions – superior to continental Europe?

Fundraising in the US and the UK is certainly easier if your company is set up in these jurisdictions. While US and UK investors are increasingly willing to look at continental-European companies, which they considered too exotic just a few years ago, we still hear from VC funds, especially those focusing on early stage investments, that they outright limit their portfolio to startups from their home countries.

Christof of 42law would not call the British or American jurisdictions superior to continental Europe (aka “civil law”-countries) in all respects. As he points out, the question whether the UK/US regime of corporate governance is more beneficial – leaving aside any non-legal considerations – ultimately is a question of what your role in the corporate context turns out to be in the longer run. Without going into detail, most economists and lawyers argue that the UK and US are more shareholder-centric, i.e., they better protect investors against rogue management. (Some leading scholars argue the opposite, it’s an interesting academic debate.)

Why good drafting matters when it comes to employee incentivisation

Many founders believe that only in a UK or US entity there are means to incentivize and bind employees through, e.g., ESOP. Our 42law-legal expert agrees with this in principle but emphasizes “shades of grey”.

The first of two underlying issues is that a US/UK corporation and a “classic” continental-European corporation are different animals entirely. A German GmbH, or a South-Eastern European d.o.o., for example, are simply not meant to let someone become a shareholder simply because he/she is working for the company, without contributing actual capital. The good news is that contracts allow you to overcome this limitation: it’s not trivial, but good drafting can let employees participate in a “liquidation event”, be it dividend payments or the sale of the company, almost the same way as real shareholders. “Almost”, because the contractual instruments employed here, often referred to as virtual or phantom shares, can never put you in a position identical to shareholders. But for all practical purposes, this first limitation inherent in the law can be overcome.

The second point weighs heavier, and that’s taxes. When the company is ultimately sold, the way phantom shares are structured, any payouts the employees receive will be classified as salary. Unfortunately, most countries tax work salaries at a progressive and, effectively, much higher rate than capital gains.

Is the US really a tax haven?

Of course, there are also drawbacks of US/UK holding structures. If a pure holding structure is effectively an empty shell with no operative connection to the US or UK whatsoever, the associated risks are not grave, but also not entirely insignificant.

According to 42law, one aspect to consider is the tax doctrine called “substance over form”. This effectively means that if the business is run from somewhere else, you don’t have a staffed office and no business on the ground, your US or UK entity will be entirely disregarded for tax purposes. This applies to business contracts, employment and freelancer agreements, but also to shareholders. If you’re not making any money anyway, and noone is selling their shares at a profit, this will have limited effect. But if things turn out well, money is about to be made and the tax office takes an interest, then a shell company in the US or UK can be a can of worms that you don’t want to wait to open until 8 weeks prior to the exit.

On the flip side, your home jurisdiction, which is often the obvious alternative to choosing the US for incorporation, could really be significantly more attractive tax-wise. Many, especially Eastern-European countries have enthusiastically joined the race to lower corporate income and capital gains taxes in recent years, whereas the US is not at all tax haven, particularly, if you consider federal and state level taxes together. In this light, no founder should underestimate the severe challenges of freeing yourself from the reach of the IRS (aka the U.S. tax office) once you’ve registered there.

A mere U.S. shell to sell your self-service SaaS software to U.S. customers doesn’t make any sense. However, direct sales definitely benefit from a locally incorporated sales unit and with an actual team of sales reps on the ground, you can demonstrate all the substance needed, so that no one gets in trouble tax-wise.

Coming back to fundraising, as already described above many US and UK investors limit their investments to companies incorporated in their own respective home jurisdiction. While there are various legal differences to consider, one major reason for choosing such an investment approach is simply that their home jurisdiction is the one they know well and the continental European regulations are exotic to them. Capital300 aims to bridge the gap between the US and Europe by not only providing European startups access to capital from US top VCs but we also help our fellows across the pond to better understand what is going on in Europe.