Three more complex and overlooked issues in startup funding (especially in South-east Asia)
Fundraising – always a “fun” activity whether you are doling out cash (making a wise investment) or receiving those doles of cash (channeling it for the growth of the company). Active participants in the fundraising scene more or less know the key terms to look out for in an investment. Valuation, anti-dilution, rights of first refusal etc. – a simple google search will generally yield pretty decent commentary on what to look out for, so, do some homework and read up.
Outside of the term sheet though, there are three other issues I’ve seen become quite a hassle somewhere down the road – these are often less well-discussed, largely because of the intricacies of different laws in different countries. Both founders and investors will do well to have these issues in mind, and a plan on how to deal with them, prior to concluding any investment round.
1. Capital appreciation tax
It’s a happy problem to consider – the valuation of the Company has increased, and you’re looking to exit. However, founders and employees may find themselves subject to capital appreciation tax, depending on which tax jurisdiction they are subject to. This can be significant, especially for early shareholders (read: Founders, initial employees), who enjoy the greatest upside. Employees who are awarded shares as part of the Company’s share option plans may also find themselves out of pocket if they are made to pay tax for equity granted previously which has vested and appreciated in value.
To deal with this, parties should consider (1) using a different class of shares; (2) executing a share swop prior to exit; (3) having shares owned by offshore entities in tax-friendly jurisdiction. Under (1) and (2), the intent is to be able to “match” the exit price of the shares with new shares obtained by a holder, either through conversion or a swop. Under (3), any upside will have to be extracted out of offshore entities by other means – in other words, some tax planning and structuring.
2. Foreign ownership restrictions
A number of countries impose foreign ownership restrictions, where a certain percentage of the company must be owned by local citizens/residents (also depending on the type of business being conducted) – for example, Indonesia and Thailand. Having a holding company in a non-restricted jurisdiction may not also work since these foreign ownership restrictions are on a “see-through” basis and apply to holding companies as well.
This issue can be resolved at the start by having nominee shareholders, as well as respective trust/call options put in place to ensure control. However, some of these mechanisms may not be in compliance with local laws. For example, shares “held on trust” for a foreigner are not accounted for in certain countries in calculating whether local ownership requirements have been met. Complications may also arise if there are conversions at a later stage which may affect shareholding percentages.
To deal with this, parties should consider the myriad of options available, and really, the end commercial intent. If control is the issue, issuing a different class of shares with super voting rights may work as a solution. If economic distribution is an issue, consider the various control measures that can be put in place (for example, pre-signed share transfer forms) in order to mitigate any risk. Ultimately though, this will require a bit more alignment with the state of local laws, so the key point is really to have this in mind when dealing with different jurisdictions.
3. Re-domiciliation and future investors
Last but not least, parties should consider carefully which entity (in the group structure) investors are investing in, and its country of incorporation, especially in consideration of future investors. A number of funds/accelerators prefer having a holding company set up in their local jurisdictions. While there is nothing wrong with this, some thought needs to be given for future rounds, future investors and their tax obligations, and ultimately, the Company’s key region of operation. Issues 1 and 2 above are extremely relevant for the choice of jurisdiction for the investment entity, and founders may find themselves requiring to go through a complex re-structuring exercise in order to accommodate future rounds or prior to an exit if these issues have not been clearly thought out.
To deal with this, well, no easy answer here. If incorporating in a “foreign” jurisdiction is a strict requirement, parties have to strongly consider whether it would be prudent to invest some time in preparing for “unwinding” arrangements beforehand, usually in the form of share swops or back to back put and call options. While none of the above issues are severely crippling in the grander scheme of things, having an idea on how to deal with this will save parties a great deal of time in the future, especially if the proper arrangements have been put in place right from the start.
I’m on a journey to try to make knowledge and education more accessible and affordable, and to sieve out the noise in an age saturated with information. Practicing lawyer by day (I specialize in working with clients in the technology industry), and aspiring technology educator by night. I’ve advised both companies and venture capital funds in their investment rounds with a combined total transaction value of more than US$500m. I am also an active limited partner in a venture capital fund, and sit as an advisor to various startups.