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Undoubtedly, Nigeria is Africa’s most popular tech Start-up investment destination and has raked in billions of dollars in funding over the years. According to Disrupt Africa, Nigerian startups have collectively raised over $2,000,000,000.00[i] (Two Billion Dollars) between January 2015 and August 2022.
Ordinarily, one would instinctively give the literal meaning to the tag “Nigerian Start-ups” and assume they are incorporated in Nigeria. In contrast, this is not the case, as a large number of Nigerian startups are incorporated outside Nigeria, including many heavily funded and popular Nigerian startups like Flutterwave, Cowrywise, Paystack, Andela, ULesson, and Kuda, amongst others.
These Startups look out for investor-friendly countries to establish their Company in. Delaware in the United States of America and Mauritius have proved to be the most preferred countries for most of the Startups. As of 2020, Disrupt Africa reported that around seventy percent of Startups that were incorporated outside of Africa choose Delaware in the United States of America[ii]. The decision to establish a parent company abroad is a very strategic decision for most Start-up founders.
This article will highlight why most Startups register in Delaware and provide useful information for Startups who intend to set up a parent company in Delaware.
Why Exactly are these Companies registering in Delaware?
In Nigeria, banks represent the most common source of funding. The drawback to this traditional type of investor is that banks are not primarily allowed to pool resources to finance an uncertain venture like a Start-up, as the risk involved will not allow them to put the public funds at risk. They are more attuned to providing credit facilities with a high-interest rate for a specific duration. In contrast, America has been described as having the deepest capital pool in the world. As of 2022, the U.S. venture capital industry has a market size of $63 billion[iii]. Start-up founders who have not made their money from the sale or acquisition of their Startups have turned to venture capitalists for funding. Due to the availability of funds in the US, founders understand that they have to strategically position their Start-up to benefit from the vast pool of funds.
It is not uncommon for VC firms to request that a Start-up seeking equity financing be incorporated in a country outside the shores of Africa. Most often, it is a condition precedent to funding (usually contained in Term Sheets) that an offshore holding company is incorporated in an investor-friendly jurisdiction like Delaware. The rationale for this hinges largely on the fact that wise investors understand that investment only thrives where there are predictable government policies and are equally aware of the risks associated with an unstable business environment or unfavorable governmental policies that exist. For instance, the implementation of the Lagos State Transport Reform Law of 2018, which necessitated the ban on the use of motorcycles, resulted in the failure of e-hailing Startups like Go-Kada and Maxng.
This requirement is not restricted to VC firms only, as some incubators and accelerators have been known to make such requests. An excerpt from Y Combinators[iv], FAQs[v] on its website states that;
“If your company is already incorporated somewhere other than the United States, Canada, Singapore or the Cayman Islands, in order to participate in YC you will need to create a parent company that is in one of those jurisdictions. The existing company will then become a subsidiary of the new United States, Canada, Singapore or Cayman parent company.”
While these incubators do not give funding, acceptance into their community indicates a validation that strengthens investors’ opinion toward the Start-up.
Delaware has a distinctive pro-corporation legal structure. Over time, the Delaware Court of Chancery, which is the state’s sole Corporate Court, has established precedents, particularly in business-related cases. Business owners gravitate toward the state because they want it to be effective and predictable in the event of litigation. In contrast to Courts and statutes in other jurisdictions, the Court of Chancery and the laws of Delaware tend to be more favorable to companies. Many Business Managers are drawn to Delaware mostly for this very factor.
Officers’ and directors’ names do not need to be disclosed, and corporate and board structure flexibility is often mentioned as an advantage. While these may be relevant in some cases, this should however be compared with the conditions offered in the state or states where the business will operate.
INCORPORATING A PARENT COMPANY IN DELAWARE
Delaware offers a variety of company structures, such as; Limited Liability Companies (LLC), Series LLCs, Sub Chapter S Corporation, Public Benefit Corporation, Partnerships, Non-Profit Corporation, and C Corporation. Among the afore-listed, most Startups incorporate as a C-Corporation. This is the same structure used by Apple, Google, and the majority of the large companies in the United States.
The C Corporation is separate from its shareholders; therefore, C-corporations offer limited liability protection to Directors and shareholders. In addition, C-Corporation differs from other corporations in taxation and ability to raise investor capital.[vi]
Delaware operates a free-market economy; as such, there are no restrictions to foreigners wholly owning and operating companies in the country. This corporation may be incorporated with a single director and a single shareholder of any nationality. Additionally, companies are not required to have a resident director or a physical location in order to operate in Delaware, nor is there a minimum capital requirement to form a corporation.
To incorporate a C-corporation in Delaware, the applicant is required to;
To maintain a corporation in Delaware, the organization should have a structure with these features[vii]:
A corporation in Delaware must draft corporate bylaws. These should be in line with Delaware state laws and should regulate all aspects of the corporation’s activities, including the following[viii]:
While Delaware is not a “tax haven,” it is a low-tax jurisdiction, and there can be some tax advantages to being incorporated there. Delaware is a low-tax jurisdiction; therefore, newly registered corporations and companies who conduct their businesses outside Delaware are not required to pay state income taxes. Furthermore, shares of stock owned by non-residents are not subject to Delaware taxes.
Although a Start-up need not pay income tax in Delaware, it will have to pay the Delaware franchise tax based on the shares’ value. This is generally minimal for small businesses, but it will increase as the number of shares increases, and the share value goes up.
CONCLUSION
As a general rule, unless the company is planning to get external funding from investors at some point, it is usually not worth incorporating or forming a legal entity in Delaware. For small businesses or fully-owned subsidiaries of international companies who do not plan to raise funds from external investors, the added cost and complexity of setting up the business in Delaware and registering it in the state where it operates will normally not be justified[ix].
Indeed, establishing a parent company abroad is a very strategic decision for most Start-up founders; even those who did not initially register in Delaware have transferred incorporation through what is known as the “Delaware Flip”.
The Nigerian government is not oblivious to this trend; as such, the Nigerian Start-up Act recently assented to an innovative solution to this trend. While this will not totally diminish the need to incorporate abroad, its provisions are tailored to enhance the way of doing business for Startups in Nigeria.
REFERENCES
[i] The Nigerian Startup Ecosystem Report 2022 & Full Startup List from Disrupt Africa https://disruptafrica.gumroad.com/l/rflav
[ii] Jackson Tom, “Why African tech startups are increasingly domiciling overseas https://disrupt-africa.com/2020/03/10/why-african-tech-startups-are-increasingly-domiciling-overseas/
[iii] https://www.zippia.com/advice/largest-venture-capital-firms/
[iv] A popular American accelerator that focuses on seed investments to start-up companies.
[v] https://www.ycombinator.com/faq
[vi] Harvard Business Services https://www.delawareinc.com/what-is-a-c-corporation/
[vii] https://www.upcounsel.com/delaware-c-corporation#requirements-for-maintaining-a-c-corporation-in-delaware
[viii] Ibid.
[ix] https://www.markentryusa.com/en/incorporate-in-delaware-myths-realities-and-the-delaware-flip/
Written by Chiamaka Ogbonannya for The Trusted Advisors
Email us: info@cms.trustedadvisorslaw.com