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Don’t Waste Your Money Overthinking Where to Create Your Holding Company

We just read a tweet by a well-intentioned Latin founder announcing triumphantly that he had avoided using Delaware as the jurisdiction for his holding company.  “Good,” we thought, until we read that he had hired a large law firm and a large accounting firm who after an in-depth (and we suspect costly) analysis recommended a U.K. holding company.   

This entrepreneur could have avoided that time and expense had he read just one line from a June 2020 post from Y Combinator: 

“We [Y Combinator] invest in US, Cayman, Singapore, and Canada corporations.” (https://www.ycombinator.com/deal/)

[Little practice tip: unless you have been part of Y Combinator’s program don’t refer to Y Combinator as “YC”.  Sounds as if you are trying too hard.]

Venture capital funds love innovation in business models. VCs do not want to spend any time trying to rethink the legal structures of companies they invest in. 

Of the 600+ Latin founders and their companies we at PAG law have represented, approximately 75% have opted to create a Delaware holding company, 24% have created the “Cayman/LLC Sandwich” and fewer than 1% have successfully used any other jurisdiction. 

When Y Combinator publicly chose those four jurisdictions, it gave the whole VC industry in the United States a reason to shut the door on making investments into holding companies in any other jurisdictions (like the U.K., BVI, Panama, Luxembourg, etc.). 

Of the 600+ Latin founders and their companies we at PAG law have represented, approximately 75% have opted to create a Delaware holding company, 24% have created the “Cayman/LLC Sandwich” and fewer than 1% have successfully used any other jurisdiction.  (Brazilian founders trend a bit more towards the Cayman/LLC structure.)  

In short: if you want to raise money from US-based VCs, please don’t misspend your time and money focusing on any jurisdictions other than Delaware or the Cayman Islands (or perhaps Canada).

Click here for a summary of the pros & cons of Delaware vs. the Cayman/LLC Sandwich for holding companies of Latin tech-enabled businesses. 

Don’t Let Your US Lawyer Scare You From Using the Cayman Islands

Here’s a little secret–US lawyers don’t make as much money when a Latin founder creates their holding company in the Cayman Islands.  We regularly see US lawyers pushing their Latin clients away from a Cayman Islands holding company structure and towards a Delaware holding company structure by noting that in 2020 the Cayman Islands was put on the EU “Blacklist”.  These lawyers often fail to mention that the Cayman Islands was subsequently taken off this Blacklist.  (Click here for more background on Cayman and the EU Blacklist.)

This caused many Latin founders who wanted to avoid the Delaware C-Corp to consider alternatives to the Cayman/LLC Sandwich. 

Other than a few Brazilian companies, we have not seen many Canadian holding companies being used by Latin founders as an alternative to Delaware or the Cayman Islands. Our layman’s understanding is that Canada has a “participation” exemption for Canadian companies that own interests in non-Canadian operating subsidiaries—similar to the Spanish ETVE regime.  This means that generally, the income of Latin operating companies will not be subject to Canadian tax.  

However, there are at least two issues that have made using Canadian holding companies not popular for Latin founders and their businesses.

First, dividends paid from the Canadian holding company to its shareholders will likely be subject to Canadian taxes (similar to the US).

Second, and more problematic, is that Canada disfavors outbound transfers of a Canadian holding company.  The reality is that a large percentage of our clients with non-US holding companies need to redomicile to Delaware when they are doing their C-rounds/raising over US$100M, at the insistence of their new large Silicon Valley fund investors (who view the US as the center of the world).  So a successful Canadian holding company raising a large amount of money might find itself pressured to redomicile to Delaware.  That redomicile may be subject to Canadian taxes. 

Thus, the Cayman/LLC Sandwich continues to be the structure of choice for Latin founders looking for a more efficient tax structure for their holding company, while needing to choose a “VC friendly” jurisdiction. 

Don’t Pay for a “Flip & Freeze”: It will only Freeze Your Company from Raising Capital

If you have no idea what a “flip & freeze” is, congratulations! You may have avoided a problem that nags many founders from LatAm. A “flip &freeze” is the solution that US lawyers love to propose to their Latin clients after those entrepreneurs realize that a Delaware C-Corp is often a terribly inefficient structure for non-US founders whose business doesn’t sell primarily to customers in the United States.  

Of course the “flip & freeze” is the proposed solution usually at the end of a long (largely unreadable) tax memorandum that a tax lawyer charging US$1,000+ an hour repackaged for a “lucky” Latin client.  We have never seen one of these tax memos cost the client less than US$15,000.  We also have almost never seen a company that has undertaken a “flip & freeze” successfully raise capital from a major VC fund.  

The sad fact is the Delaware C-Corp is like the Hotel California, where “you can check out any time you like but you can never leave,” as the Eagles’ song says. The redomicile of a Delaware C-Corporation to a more tax-efficient jurisdiction like the Cayman Islands will be treated as if the assets in the Delaware C-Corporation were being sold, and thus the re-domiciliation will trigger US taxes. 

The reason that the “flip & freeze” likely makes the company unfinanceable by a VC fund is simple.  A “flip & freeze” might sound great on paper, but in practice, it is generally untenable.

The idea with a “flip & freeze” sounds simple. Create a parallel holding company structure.  So the Latin entrepreneur leaves the current Delaware C-Corporation in place.  And he/she creates a new holding company structure say in the Cayman Islands (this is the “flip”). The concept is the “new value creation” will take place outside of the Delaware C-Corporation.  The current value of the business will be “frozen” in the Delaware C-Corp.  

The reason that the “flip & freeze” likely makes the company unfinanceable by a VC fund is simple.  A “flip & freeze” might sound great on paper, but in practice, it is generally untenable.  The company is essentially creating a whole new parallel corporate structure to the current Delaware structure.  That current Delaware structure already owns the operating subsidiaries in Latin America.  If you try to move those subsidiaries from the Delaware C-Corp to the new, say, Cayman holding company, you may trigger US taxes, as there has not been a “freeze”.  

This leads to lots of complicated “inter-company” valuation/transfer pricing issues that need to be addressed; with a double structure, there is always a risk the IRS will collapse the structure or challenge it. A future VC fund investor may simply see a mess, and in our experience, VC funds likely won’t want to spend the brainpower to figure out if the “freeze” is likely to stand up to an IRS challenge.   VC funds don’t want to invest in a problem. 

This article is not meant to provide legal or tax advice. It should be understood as a provocative, simplified overview to allow the reader to better consult its legal and tax advisors. Every individual, every company, and every situation is different.  There is no “one size fits all” solution. Also, we are not tax advisors or tax experts, and do not offer tax advice.