From Foreign Startup to a US Unicorn — Startup Guide
The founding of a company in the US, also known as incorporation, is usually recognized by foreign start-ups as an unpleasant and cumbersome process. This is mainly due to the different legal systems and ignorance of the local institutions. As a consequence, many entrepreneurs are slow to make this decision and thus delay the development of their activities.
In this article, we would like to introduce to the native entrepreneurs in an accessible way the subject of the correct establishment of the company and highlight the most important issues related to it. The following study in no way describes the issue in a comprehensive way, but we hope that it will be sufficiently informative to overcome the potential inhibitory effect that ignorance may have on the start-ups in this regard.
Selection of incorporation status
At the outset, it is worth noting that the commonly used term “American company” is misleading and imprecise, because there is simply no such entity as an American federal company. The United States is a federation; therefore, each state has its own separate rights and, consequently, its separate procedure for establishing a company. The first basic choice that must be made by a foreign entrepreneur heading west is, therefore, the selection of the state in which the incorporation will take place. The criteria to be considered are primarily the pro-business nature of a given state, the friendliness of its regulations for foreign entrepreneurs, local tax regulations, its reputation among investors and the presence of subsidies and additional tax breaks.
Anyone who is even a little interested in the subject of establishing a company in the United States had to have come across the slogan “Delaware”, because more than 50% US public companies and 60% Fortune 500 companies were founded there. Delaware’s reputation is well-deserved as it is a legal system trusted by investors and businessmen. What’s more, there is no company income tax (“CIT”) for companies established in Delaware which do not conduct business there; there is no sales tax for transactions carried out in this state; there exists no obligation to reside in Delaware for shareholders or directors of the company, as well as many other beneficial and pro-business solutions. While the incorporation state of choice is usually Delaware, other states are trying to compete with Delaware, as a result of which many small companies decide, for various reasons, to incorporate somewhere else. The states that may be considered include, among others, Nevada, which in principle continues the Delaware policy in the west and New York or California, which are particularly interesting for companies interested in the physical relocation and development of structures and activities in those regions due to interesting subsidies and aid schemes for small enterprises.
Choice of legal form
The question of the legal form of the company is inextricably linked with the question of selecting the state of incorporation. After rejecting forms obviously unsuitable for running a start-up such as Limited Partnership or S Corporation, one can state that the choice is limited in principle to Limited Liability Company (“LLC”) or C Corporation (“C Corp.”). We regularly repeat that it is not only inappropriate, but also often impossible to translate the American system and legal culture using terms belonging to the foreign system.
With the above reservation in mind, one can risk a statement that the C Corp. conceptually reminds one of the foreign limited company and LLC, of the limited liability company. Therefore, the choice of foreign entrepreneurs often falls on the LLC, because they are intuitively guided towards a familiar and informal structure devoid of the requirement of a significant minimum share capital of the company. At the same time, they try to escape from the form of a joint stock company that is not popular among start-ups.
In Delaware, however, there is no requirement of a minimum share capital and no equivalent of the National Court Register, which significantly speeds up the registration and functioning of companies and reduces many of the above-mentioned shortcomings connected with the joint-stock company in Europe and thus redefines the criteria for choosing the legal form. The main difference between the LLC and the C Corp., which falls to the disadvantage of the latter form, is that LLC is a tax-transparent entity, while C Corp. is taxed twice, at the stage of obtaining the company’s income and paying dividends. On the other hand, however, the C Corp. is not subject to the obligation to pay American social insurance and fees in conjunction with from Medicare, offers more opportunities to reward employees (restricted stock or options), and offers greater flexibility in the scope of ownership structure.
Due to the functionality of both entities, LLC companies are generally used by local enterprises with a small number of partners, while the C Corp. is suitable for running both medium and large companies, of international character, with many shareholders, an incentive system for employees and a complicated structure of ownership. C Corp. is also a legal form that will no doubt be required from the company in the context of co-financing by potential angels or institutional investors. In the light of the above comparison, we usually suggest foreign start-ups choose the form of C Corp.
The procedure for founding a C Corp. in the state of Delaware
Establishing a company in Delaware is relatively simple and with an efficient cooperation between a lawyer and an entrepreneur, it can be done even within a week. The first step is to choose a company name. The name of a C. Corp. must contain the word suggesting the legal form of the company. The most popular include “Incorporated”, “Corporation”, or their abbreviated form: “Inc.”, “Corp.” and Co. Before sending the founding certificate (articles of incorporation), please check the availability of the name on the website of the secretary of state of Delaware.
Formal establishment of a company in Delaware takes place by sending the signed founding certificate to the Secretary of State of Delaware and payment of the registration fee (in standard or accelerated mode, which allows the company to be set up on the same day). For non-US entrepreneurs, it is important to note that there is no need to send the original signed initial certificate and it is fully sufficient to send a copy of it. It is worth remembering that the founding certificate is not the equivalent of the non-US company agreement. At the initial stage, it can consist of only one page and does not contain much information, for example about the representation of the company or its shareholders. Therefore, to the disbelief of non-US lawyers, the data of the founder, board members and shareholders will not be made available anywhere.
After the Secretary of State of Delaware accepts the founding certificate, the company officially exists and can be found in the register. Incorporation on this, however, does not end, often contrary to the belief of entrepreneurs who are trying to set up a company in Delaware. It is necessary to perform a number of necessary actions to secure the interests of the company and its shareholders, including: select the board of directors, properly issue shares to shareholders, in some cases sign agreements between the founders, or apply for an American equivalent of NIP for the company.
The fees associated with incorporation in Delaware are relatively low. The company must pay $350 each year (basic amount, which may change as the company grows) under the registration tax (franchise tax) and pay once a year 150–200 dollars fees to the statutory registration agent who will receive the official correspondence of the company in Delaware.
Company profile and the basis of corporate governance at a C Corporation
Many entrepreneurs set up their company in Delaware and undergo the incorporation procedure without any idea of how to incorporate a new company in the future. This is partly understandable because the company is founded and operates not only according to foreign rules but also in a foreign language. Below we present the basic features of C Corp. and the main principles it functions on.
The initial capital structure of the company should be as simple as possible. A new company should have, as a rule, one class of common shares with no par value or a value of as low as possible, e.g. $0.00001. The founding certificate usually provides for the issuance of 10,000,000 such shares. They are marked as “authorized stock”, i.e. shares that can be subsequently issued by the decision of the board of directors, without changes to the founding certificate. They should be distinguished from the so-called “Issued stock” or shares already issued, which consist of shares held by shareholders and employees and shares owned by the company itself, which is, in contrast to the rules prevailing in non-US legal system, as a rule allowed.
The founders of the company should in practice embrace about 70–80% authorized stock and subject them to so-called vesting, which is gradually giving way to the right of repurchase of these shares by the company for the original purchase price. Vesting is a market standard used to bind key shareholders/founders with the company, which serves the interest of all founders and is usually required by investors. The remaining shares should be reserved for investors and future employees.
An issue that raises many doubts among non-US founders is the issue of recapitalization of the company when it is incorporated. Although in practice, shareholders bring in cash or non-cash contributions to the company, officially in Delaware there is no minimum share capital requirement. Therefore, a full-fledged C Corp. can be established without the need to pay a dollar to it. However, it should be remembered that the transfer of certain funds to the company may be important for other reasons, e.g. for reasons of immigration, for it is often one of the requirements necessary to obtain a nonimmigrant visa, for example, an investor visa (E-2).
The company is managed by the board of directors elected by the shareholders, which in the initial phase of activity is usually composed of one or three members. The board of directors manages the company’s operations, takes key business decisions and appoints officers of the company, which in turn have to deal with matters related to its daily operations. The most basic positions of officers are: chief executive officer, president, chief financial officer and secretary. The competences of the board of directors and individual officers are defined very generally in the certificate of incorporation, and in detail in the rules of the company’s operations (Bylaws), which should also be drawn up during incorporation.
It is worth remembering that the same person can (and usually does so in the first stages of the company’s activity) perform three roles, be a shareholder, a director and an officer of the company. Shareholders, directors and officers do not have to live in the States to perform their duties. Our experience, however, indicates that at least one person with the right to act on behalf of the company should permanently reside in the United States for pragmatic reasons.
Trading in securities
One of the most common mistakes made by non-US startups starting their operations in the United States is ignoring the securities law — the federal law (the “Securities Act of 1933”) and the state law (the so-called “Blue Sky laws”). These provisions require, among other things, full transparency in the presentation of the company’s situation to the buyer of its shares and registration of transactions in the government register or other forms of formalities before its finalization.
Ensuring that transactions comply with the US securities law is crucial because the purchaser of shares (i.e., an investor) could otherwise demand a refund in the future, claiming that his rights were violated in the above-mentioned case. Furthermore, civil and criminal sanctions are possible consequences for making false declarations and omissions by the company regarding the offering or sale of securities.
Some exceptions to the above registration and qualification requirements are usually available for offers and sales of shares in the context of the company’s founding, such as issuing shares to founders, selling shares in small and early financing rounds, or issuing employee shares. It should be remembered that the shares acquired under the above mentioned exceptions are subject, in addition to the typical contractual restrictions and limitations placed in Bylaws, to an additional restriction on their resale to third parties imposed by federal law.
Doing business outside the state of incorporation
In order to run a business in a state other than the state of incorporation, the company must register accordingly. First of all, it is problematic to determine what is actually classified as conducting such activity, mainly due to differences between legal systems of particular states as well as discretion and flexibility of criteria. In addition, there is a general trend extending the definition of doing business due to the fact that registration in a given state results in the obligation to pay local taxes, which makes the states have a financial interest in forcing companies to register.
Generally, it can be stated that the obligation to register a business activity in another state will arise, for example, if the company runs an office there, rents a warehouse, or employs employees who perform services other than acquisition only. This obligation will not, in principle, arise if the activity in another state is only incidental or transit, e.g. cars transporting the goods of companies to pass through its territory, or customers from this state benefit from the online service provided by the company.
Not registering activities in states where, according to local law, the company conducts business activity, may have consequences in the form of the imposition of fines or other financial penalties on the company, issuance of orders to take specific actions, and the company being deprived of the right to file suit in courts.
In order to obtain a business license, it is necessary to provide, in principle, documentation regarding the company, its operations, as well as pay the registration fee and establish a local registration agent for the company. The total cost of administrative fees associated with such an operation should not exceed $1,000.
Federal and state taxes
C Corp. is subject to CIT as a separate legal entity. In addition, C Corp. shareholders are taxed with personal income tax (“PIT”) if payment is made to them in the form of a dividend. The current federal corporate tax rate is a flat rate of 21%. For any dividends paid by C Corp., the company is responsible for 30% as withholding tax on behalf of the foreign parent company, unless the double taxation agreement provides for a lower rate.
The tax liability indicated above may be reduced by maintaining an appropriate debt-to-equity ratio and by characterizing the transfers of capital as debt repayments to the foreign parent company. It should be remembered, however, that the business relationship between the foreign subsidiaries and the United States must be correctly formulated, clearly defined and documented in order to preserve the separation of legal identity both for tax purposes and limitation of civil law liability.
It should also be remembered that frequent presence in the United States by entrepreneurs, regardless of the purpose of the trip, may result in the fulfillment of the premises of the so-called substantial presence test, being subject to the jurisdiction of the US tax office, i.e., the Internal Revenue Services (“IRS”) and, consequently, the need to file a PIT tax return also in the United States.
Most states impose CIT and sales tax on state-owned companies instead of the US value added tax (“VAT”). CIT is calculated separately in each state in which the company runs a business on the basis of income received there annually. In Delaware, it is 8.7%, in other states, it oscillates between 7–8 %.
The sales tax is calculated based on the sale price of the product or service. Since the buyer pays it, every seller is obliged to add it to the product/service price and submit it to the local tax office. Sales tax differs depending on the state, and discrepancies occur not only in its amount, which is normally between 5%. and 10 %. For example, the state of New York imposes sales tax on software license agreements, while the state of California exempts it from this obligation. Delaware is one of the 5 states that have decided not to introduce a sales tax at all.
Introducing a product to the US market usually requires the approval of a government agency whose statutory goal is to exercise control over a given field of activity. Procedures vary significantly and depend on the type of product or service, and therefore each situation must be analyzed separately.
In states, control is exercised by the Federal Trade Commission over consumer safety. Protection of public health is dealt with by the Federal Drug Administration, which in addition to medicines also regulates trade in food, nutrients and medical devices. A common mistake made by non-US start-ups is entering the market with products emitting radio waves without obtaining the proper permission of the Federal Communications Commission, which deals, among others, with radio, satellite and television devices.
The role of a lawyer - attention to conflict of interestMoving for "big water" should not be a dreaming venture and entrusting it to a good lawyer is definitely a guarantee for a quick passage of legal formalities. It should be remembered that the establishment of a new company, and in particular the transfer of a foreign company existing, is not an administrative act, but a sensitive business transaction, and it is inappropriate for the same lawyer to represent the interest of both the investor and the company founders in the company. This is due to the fact that transactions usually lead to potential or actual conflicts of interest between the company's founders and the investor, despite the lack of bad will. Also, several founders and shareholders of the company should not, as a rule, be represented by the same lawyer when transferring to the US, because their interests are not necessarily coincidental in this situation. If the "founders" want to take a risk for various reasons, they will have to sign the so-called "Waiver", in which they declare, among other things, that they are aware of a potential conflict of interest and accept all the consequences that could occur from them being represented by the same person.