As the global economy continues to rebound from the recession and M&A markets become increasingly crowded, U.S. investors are opening foreign offices and foreign funds to make cross-border transactions. The VC industry is expected to increase its presence in emerging markets, with more local activity and a shift of LP allocations to those markets. Private equity investors, too, are increasingly emboldened by bright prospects in Asia and South America. This leaves some investors wishing they had a Beijing office, or a billion-dollar fund solely dedicated to cross-border opportunities. While there is no genie for this, there are best practices and concepts to use when preparing for private investments abroad. Investors looking at new deals and investing from the U.S. should consider some key principles before finalizing a transaction.
Transaction costs are always higher when investing cross border. Among other things, this can be the result of travel and related expenses of investment personnel, the need to have U.S. counsel as well as local counsel in the jurisdiction of investment, and the other issues highlighted below that can cause additional drag. It is a good idea to build in extra wiggle room when considering how transaction costs will impact your investment returns.
The concept of information sharing can be inherently cultural. In the U.S., we are accustomed to finely detailed due diligence. U.S. investors are often faced with some level of “culture shock” when making investments abroad. In some cases, cultural differences lead to hurt feelings when a U.S. investor attempts to carry out what, in any other transaction, would be considered standard procedures. In other cases, local entrepreneurs may try to hide behind cultural differences as a means of securing capital without being subjected to unwanted oversight. As with any investment, assessing the people behind the business is of principal importance, and in some cases, those people may need to adopt new information sharing practices if they are going to be good business partners for a U.S. investor. This is especially true in this day and age, where U.S. investors are subject to heightened tax compliance obligations with respect to foreign investments. Access to information is imperative –if you can’t open the spigot, it may not be a good investment.
Minimizing tax-related surprises is of utmost importance. For example, in the U.S. we are accustomed to the concept that only residents are taxed on the sale of intangibles, such as corporate stock. As a result, foreigners often feel that they can invest freely in U.S. equities. However, this rule of thumb does not apply in all other countries. In some cases, an unsuspecting investor may be taxed in a foreign country on the sale of shares. The foreign taxes may exceed U.S. tax rates, especially with respect to tax-exempt investors, which may not be recognized as such outside of the U.S. In addition, a number of foreign countries have favorable local tax regimes that seek to encourage venture capital investments. These regimes often require prior registration and tax rulings, and the process can be time consuming, expensive and political. There may also be benefits under existing double tax treaties between the U.S. and other countries. Again, these issues may impact investment returns by increasing expenses of the fund and changing the effective tax rate. Consider the local tax issues before you circulate a term sheet to be sure you understand how local taxes will impact your investment returns.
Intellectual property laws differ in every jurisdiction. Be sure that appropriate procedures have been established to protect your investment in its country of residence and other countries where it does business. Also, if you are investing on behalf of a fund or other formal organization, consider whether steps to protect your own intellectual property rights, such as your trade name, should be taken.
Consider the rights of founders and other key personnel, including vesting of equity, enforcement of non-compete obligations and ownership of developments. Also consider local labor law issues, including potential liabilities of employers, mandatory leave and vacation policies and other cultural and legal issues that can impact expectations and liabilities of employers and employees.
In the U.S., the concept of exchange controls is essentially unknown. Exchange controls are rules that govern the purchase or sale of foreign currencies, and for our purposes, can result in restricting the import or export of currency. Exchange controls can negatively impact U.S. investors investing abroad by hindering the repatriation of investment returns to the U.S.
Likewise, the U.S. is fairly permissive in the freedom of enterprises to engage in mergers and acquisitions. There are often more restrictive antitrust or merger review procedures in foreign countries that can potentially result in restrictions on the ability to liquidate an investment through a sale, especially to a strategic buyer.
In the U.S., the concept of “par value” is largely antiquated. This is not the same in other countries, many of which impose minimum capital requirements on their resident companies. In some cases, all shareholders may be liable for satisfying minimum capital requirements, even those shareholders who have tendered the full purchase price for their own shares. The possibility of being held liable for capital contributions beyond an investor’s initial investment is, well, foreign, to most U.S. investors.
Many of the above considerations can lead to investment structures that differ from the equity investment structures to which U.S. investors are accustomed. For example, in some jurisdictions it is common to address certain concerns by investing in convertible debt or other hybrid instruments that achieve equity-like economics while being treated as debt under local law. It is important to have a good understanding of these instruments (from a foreign perspective and a U.S. perspective) and the circumstances under which they are indicated long before a term sheet is prepared.
In many cases, these sorts of issues should be disclosed to investors before a fund is raised. In the case of a fund with a domestic focus that is considering an opportunistic foreign investment, there may be a judgment call as to whether additional disclosure and/or consent should be solicited, and whether this should be done formally or informally. Depending on the circumstances, it may also be desirable to structure the investment in a standalone fund that is offered to existing investors as a co-investment.
Daniel L. Gottfried works on cross-border deals and tax law with Rogin Nassau LLC in Hartford, Connecticut. He can be reached here. The opinions expressed here are entirely his own, and should not be construed to represent the opinions of Rogin Nassau LLC or any of its clients.