Expanding Foreign Business to the U.S. Markets

As a business lawyer, I’m constantly focused on business growth and liquidity, with a healthy respect for compliance and risk mitigation. Lately, I have been on the road a lot, both here at home in the U.S. and abroad, attending conferences and meetings, where I have been hearing and answering questions on how entrepreneurs and small to mid-sized foreign businesses can enter global markets? This is a key concern for my business and for my clients.

It’s also the key topic in a conference I will be attending this week in Milan sponsored by the International Bar Association Committee on Small International Business. It was the basic theme of the U.S. Department of Commerce’s “Select USA” program that I attended in Washington last month with 2,500 foreign business owners hearing promotions from 44 states and the Feds on why a foreign business should invest and employ workers in the U.S. Earlier this year, I spoke at a techUK.org meeting to UK tech businesses about expanding their operations in the U.S.

Let me share with you what I have learned and the questions every business needs to ask itself when expanding across borders:

What are your business objectives? First, consider the type of local activity: manufacturing, distribution, sales, R&D, shared services? By determining your requirements for a new operation, you can develop criteria for evaluating locations. This will help focus on the essential local operations. For smaller companies, a U.S.sales office might be the first opportunity by generating new revenues at marginal cost. For larger companies, toehold acquisitions achieve an instant workforce, manufacturing capability, installed customer base and local management. For all, localization improves branding and the quality of the customer experience.

Second, conduct a “cluster analysis.” At an early stage, you will want to identify the “clusters” of talent pools, markets, customers, customer influencers, supply chains, logistics and other local service providers. The U.S. Department of Commerce has developed a “cluster” database that can help identify clusters by industry, such as information technology, data services, automotive, pharmaceuticals, new technologies, manufacturing and business services.

Third, consider the balance between up-front capital investment costs and anticipated operating revenues and cost savings. You’ll need a financial analysis that gives you a model for identifying and optimizing return on investment (“ROI”). If you have a web-based SaaS platform, your marginal capital expenses can still be significant, but you can cut them using shared work spaces (e.g., Regus, WeWork) and incubators, a mobile workforce, Cloud-based infrastructure and virtual operations. 

Fourth, research the availability of incentives, grants and tax credits from local, state and federal governments and balance them against tax liabilities. The Select USA program identifies a list of 10 reasons to invest in a particular state. The states are both competitive and collaborative. Incentives can include income tax holidays (e.g., “Startup New York”), tax credits, abatements or rebates, project grants for capital investment or R&D, incentives for hiring and training local employees, abatements or rebates of property taxes, electricity costs, and eco-incentives (e.g., energy savings, pollution control).

Fifth, consider alternative sources of capital. Few foreigners understand the uses of the EB-5 employment-based visa as a source of investment capital. This federal immigration law permits you to finance a U.S. business by capital investment from other foreigners. You can reduce your cost of capital, but you must meet eligibility requirements for both the project and the foreign investors. For each investor, you’ll need to guarantee 10 full-time jobs. Each investor will need to invest at least $1.0 million (reduced to $500,000 if coordinated through a “regional center” for EB-5 visas).

Sixth, plan the legal structure. An effective legal structure will start simple but must follow certain rules of the game to limit unnecessary liabilities for taxes, regulatory compliance, employment practices, contractual obligations and supply chain risks. In my experience, foreign companies all want a Delaware corporation. Yes, that’s often an essential part of the puzzle. But there are other considerations, such as where intellectual property will be created, licensed and used, so that you might need a separate IP operation elsewhere. And for foreign startups, access to U.S. VC funding may require a new U.S. holding company and perhaps even a new U.S. operating company. A dual structure can also be essential for planning acquisitions in the U.S. And don’t forget to “tie the bow” with appropriate intercompany agreements on financing, services, licensing, sales and administration.

Finally, get the right people. Many foreign companies start their U.S. operations with foreign expatriates. That might be necessary for U.S. subsidiaries that will need to build upon a unique business model, mission, culture or operating structure. In my experience, foreign expats are generally essential for starting new U.S. operations, but over time talent can come from many sources. Americans today are more multicultural and globally oriented than 20 or 30 years ago, so hiring local talent with multilingual skills may be down the road for you.

I’ve seen some smart solutions by foreigners. Big American consulting companies often hire well-paid employees to work mostly at home and “on the road.” Like Americans, they might choose to have a small (or virtual) a corporate office or a shared showroom in a big town and keep other functions in lower-cost locales in the US or abroad. We had one foreign client that organized a US holding company, got funding in California, paid its foreign staff from the US funding and had only two US employees, in sales, in a city with their core customers. I was not surprised when they sold to a Japanese strategic acquirer at a multi-million company valuation after 8 years of innovation, growth and “globalization.”

Derivative Startups: Building Ecosystems of Innovation

We hear more and more about the success stories of Uber (or Lyft) and Airbnb.  I can personally vouch for both the nice ride and the nice lodging.    What is also happening, on the side, is that a new #DerivativeStartup business model has sprung up.  In a “derivative startup,”  entrepreneurs are building  new businesses  that are ancillary to another startup’s business.   For example, while Uber and Lyft offer rides to passengers, Breeze and HyreCar offer car leasing to drivers who want to provide such rides under an Uber or Lyft mobile platform.  And Guesty helps Airbnb manage its real estate properties. 

This piggybacking approach reflects the development of add-ins or complementary, non-competing technologies and services in support of a “host” successful startup.   Thus, #DerivativeStartups are second-generation startups that provide goods and services to larger startups.  http://on.wsj.com/1BlMD2y (“Piggybacks”, Wall St. Journal, Feb. 19, 2015).   

Whether these #DerivativeStartups become successful depends on a number of factors.  Certainly, as a business model, derivative startups face higher risks of failure.  Either the “host” startup might fail or it might become a competitor.   Or the derivative startup might face other competition or an inability to meet market demand.  Yet this dual risk also creates an opportunity for a double success.  For this reason, derivative startups may attract investors who regret having missed an opportunity to invest in the “host” startup.

Lessons can be learned from studying key performance indicators for other ecosystem business models used by public companies and private equity.  Traditionally, public companies use carve-outs and spin-offs to exit a line of business that no longer fits the company’s core mission.   In a carve-out, the public company transfers shares in the “carved-out” stand-alone business to existing shareholders for no cash, or it sells them to a private equity group.  The public company facilitates the spinoff’s operations by providing a transitional services agreement for a year to enable the spinoff to keep operating smoothly.    Also, private equity uses consolidation (“roll-up”) strategies to combine core lines of business with some ancillary “feeder” business lines, for a bundle to be sold off.

Like any small company feeding its “mother ship”, a derivative startup can avoid conflict and competition by developing a product or service that the “mother ship” / “host” startup cannot easily provide.  By changing the “SWOT” landscape for the “host” startup, it must also discourage the “host” startup from entering the derivative startup’s own line of business.

• Incentives for Collaboration; Disincentives for Competition.   The derivative startup must avoid being merely a supplier of “generic” products that could be copied or sourced from other suppliers.  It should strive to be a “unique” supplier.  The key is to offer incentives for collaboration, whether financial or otherwise, to the “host” startup, which in turn would discourage the “host” startup from competition. To achieve such a lasting alignment, the derivative startup’s management must identify commercial, financial, legal, intellectual property and regulatory frameworks that discourage the “host” startup from entering the derivative startup’s line of business. 
• Intellectual Property.  Many startups are created by individuals who leave another startup due to disagreements over business strategy or opportunities.   A derivative startup could face claims of misappropriation of intellectual property or trade secrets in such situations.  A successful defense will involve proof that the “information” is actually not confidential and not proprietary.
• Non-Competition Covenants.  Similarly, non-competition covenants could inhibit “look-alike” startups.   For the protection of both sides, it is therefore essential to define clearly the scope of the “host” startup’s business to avoid confusion and potential needless litigation.
• Type of Relationship with “Host” Startup.  Before approaching the “host” startup, the derivative startup should decide whether it wants any funding, intellectual property, services or other value from the “host” startup, as well as what the derivative offers to the host.  The host might offer to invest in the derivative, creating a “cross-ownership.”   Such arrangements can create inherent tensions that can exacerbate existing competitive risks.
• Exit Strategy.   The exit strategy for a derivative startup is limited since its raison d’etre is based on the host startup.  To avoid having a depressed price or being forced into an early exit, the derivative startup should remain focused on a business model of independent management and operations even as it seeks to ride the wave created by the host startup.  Additionally, it should seek other possible clients should the “host” startup fail.

High-risk, high reward derivative startups may be here to stay.  Derivative startups can improve their odds for success by taking some pages from mature multinationals and private equity tools of “carve-outs,” “spin-offs” and roll-up consolidation plays.
                                  

Redesigning the U.S. Business Workforce by Obama Fiat

If you thought Obama’s recent fiat on immigration only on focuses on Hispanic families and other illegal aliens, you are wrong. It targets business growth across the size, maturity and territorial footprint of a wide array of US businesses.

On November 20, 2014, President Barack Obama announced an Executive Order changing the legality of current illegal residents, creating  a path to regularization and amnesty for some 4 million to 5 million illegal aliens who have been in the United States for over 5 years, are not felons and will pay taxes.  But the real economic impact of his governing by “national interest waiver” and “parole” of foreigners into the U.S. will be felt more broadly, in startups, technology-based businesses and outsourcing services.

His proposal is to govern not by enforcing law, but by waiving enforcement and announcing it as an executive fiat rather than by legislative reform.  For politicians, this will potentially expose his waiver policy to judicial scrutiny and political contests in Congress, so much so that I believe that true legislative reform is highly unlikely in the next two years.

The political impetus was humanitarian aid to foreign parents of U.S. citizen children.   The economic impact will be felt broadly, not only in industries (such as restaurants, food processing, farming, landscaping and small business) that have traditionally employed illegal foreign workers.  Indeed, the greater impact will be felt across broad sectors involving STEM technology, startups, venture capital, outsourcing, global consulting and multinational companies.

• Domestic business owners will face increased costs of compliance with new administrative regulations. Those businesses that have relied upon illegal foreign workers will likely have to increase wages because the newly protected illegal foreign workers will have new portability of their work at one employer as a basis for adjustment of status to lawful permanent resident.  The new rules for the “Deferred Action for Childhood Arrivals” (DACA) program will impact every U.S. employer who will need to adopt new employment eligibility reviews, on terms to be defined under future regulations.

• Startup Mania.

• Foreign-owned startups won’t need to worry about H1-B’s.  They will benefit either by “national interest waivers” or (on a case-by-case basis for “urgent humanitarian reasons or significant public benefit”) by “parole.”  For foreign inventors, researchers and founders of start-up enterprises, the Obama administration has set an agenda to “clarify the standard by which a national interest waiver may be granted to benefit the U.S economy.”  Under individual decisions on to “parole” a foreigner, the USCIS will evaluate and grant individual requests for admission from abroad or even extend the right to “stay in place” in the United States.  According to USCIS, waivers and paroles will be granted to “eligible inventors, researchers and founders of start-up enterprises who might not yet qualify for a national interest waiver,” but who (i) have been awarded “substantial U.S. investor financing”; or (ii) “otherwise hold the promise of innovation and job creation through the development of new technologies or the pursuit of cutting-edge research.”  http://www.uscis.gov/immigrationaction/. 
• Startup Investors.  The US government estimates that this will benefit about 400,000 highly skilled foreign workers.  U.S. angel investors, venture capitalists, startup incubators and their operational supporters will be overjoyed, though the details remain to be seen. 
• Domestic startups will probably have greater access to foreign inventors, researchers and co-founders.

• Foreign investors in US companies, global consulting companies and foreign outsourcing companies dodged a bullet.  Foreign outsourcers will probably be able to continue to send large numbers of skilled foreign workers to fill gaps in the US workforce.    However, I suspect that new regulations will be drafted to adopt (tacitly or explicitly) the restrictions and additional governmental scrutiny under the draft Border Security, Economic Opportunity and Immigration Modernization Act, see S. Rept. 113-40 (113th Cong., 1st Sess.), as passed by the Senate in mid-2013.  Thus, H1-B skilled worker dependent employers would likely need to take good faith steps to recruit U.S. workers first, advertise H1-B jobs on a U.S. Department of Labor website and offer the job to a any U.S. worker who applies and is equally if not better qualified than a potential H1-B skilled worker.

• Foreign spouses of H1-B skilled foreign workers will get the right to work. This will bring additional foreign skills and competition to the American labor market.  But Indian and other foreign outsourcing companies were disappointed not to get an increase in the current 65,000 ceiling on H1-B visas, though they must accept that such an increase would take a new law, not a new “waiver” or “parole.”

• Foreign students will likely get increased access to work in the U.S. after U.S. university training under an expanded and extended definition of “optional practical training.”

• Foreign skilled workers who entered the country legally and are in limbo waiting for green cards (lawful permanent residency) will have new flexibility to change jobs without getting sent to the back of the queue for green cards.  This newfound job mobility will give them higher, more competitive salaries and thus less likelihood of being abused as “cheap labor.”

• U.S. labor unions, Obama’s core supporters, have kept their mouths shut.  They probably will be happy to see higher wages for H1-B’s due to portability and no increase in the 65,000 H1-B cap.   They can’t complain about humanitarian waivers and parole for family unification under the DACA program.

• Governing without a legislature.  In the short term, Obama’s executive order to waive the application of the law on a wholesale basis is good for business (especially high-tech, e-business and startups).  As a political gesture, it is probably bad for the incoming Republican-controlled Congress and the constitutional balance of power.  Thus, it will unlikely be overturned legislatively until a new Congress in 2016.

Not only illegal aliens, but businesses of all sizes, universities, startups, venture capital, business angels, tech-based operations can rejoice.   Of course, the devil’s in the details. 

Bringing Phoenix Value to Failed Startups

Entrepreneurship is strewn with startup corpses.  Dynamically, the world’s entrepreneurs, investors, governments, business schools (and their supporters like attorneys, accountants, incubators, consultants and advisors) have created millions of new startups in the last few years.   But startups have a high failure rate.  Yet few commentators discuss the painful process of what happens to failed startups. 

Like political questions, a “startup failure” depends on how you define it.  About three-quarters of venture-backed firms in the U.S. don't return investors' capital, according to a Wall Street Journal report on the research of Shikhar Ghosh, a Harvard Business School senior lecturer.   For him, “failure” means 0% ROI.  The same article cited more optimistic venture capitalists’ estimates that 30% to 40% of startups “fail completely” while another 30-40% return the original investment, and only 10% or 20% yield substantial returns. 

“Startup corpses” have “Phoenix Value.”   A “loser” is any project with 0% ROI.  Starting with the “Dot Bomb” bust in 2003,  some are purely domestic, like the web developers who offered new social “community” business models in 2003 for $500,000 that today would cost $5,000 to $20,000.  Others involve cross-border startups (and more mature enterprises) entering the U.S. markets seeking customers, funding, talent and sometimes a new home.  For example, this category includes “pet robots,” web analytics software and online video editing. 

A “winner” is a successful traveler from the Gulf of Nothingness to the radiant shores of Exitness.  Steps could include incorporation to “friends and family” funding, to VC rounds 1 and 2, to bridge loans where the founders mortgaged their souls (and shares), to sale of non-strategic assets, refinancing, generation of strong customer relationships and highly profitable exit sale.

However, don’t think that failed startups are always lost causes. Professionals can resuscitate, reutilize and reintroduce the lost value from startup corpses.  To help recover value from the startup crematory, an ecosystem of “Phoenix Value hunters” has arisen.   They consist of attorneys, restructuring experts, valuation advisers, investment bankers, stable businesses looking to fill tech gaps and “Phoenix Value” investors. 

Here are a few lessons learned from the trenches.

• Founders and early-stage investors in startups want to ensure the legal entity owns the intellectual property, trade secrets and, to the extent possible, the people doing the innovation. 

• VC investors want a preference in liquidation.  This means not only a preferred payment (ahead of common stockholders) but also a preferred return (the “liquidation preference” multiple of invested capital).

• VC investors need the right to fire the founder from management roles.

• Founders can leave failing startups and build anew, but the manner, timing and perceptions about their departures will impact their ability to raise capital in the future.

•  “Phoenix Value” investors can make good money by buying distress assets from a failing or failed startup.  They don’t anticipate any more “funding rounds.” “Phoenix Value” investors create Phoenix Value for transformation of “dead” or “useless” innovation into productive assets in a sustainable, well-funded business.

• Proper foresight in management and administration of intellectual property (as well as the people who create and manage it) can reduce losses, increase gains and avoid surprises that can kill or delay prospective acquisitions.

• Some bankrupt companies in one country might reappear in the markets of other countries, thanks to Phoenix-stage investors finding and generating new value from the ashes.

 So, when considering a startup or a new product development plan, keep planning for both success and failure.   Understanding how failures can be used to retrieve and revive a “sunk cost” can make a big difference in your personal and professional success.

New Tax Planning for Your Digital Business

Two recent developments in the news should get you thinking about what if….

Domestically, the U.S. Internet Tax Freedom Act (“ITFA”) will expire on December 11, 2014, unless Congress passes another extension.   ITFA, enacted in 1998 to encourage the growth of internet access and e-commerce, has already been extended three times, the last time in 2007.  It essentially prohibits any new direct taxation by state and local governments on internet access, multiple taxes on internet transactions (can’t be taxed twice by different jurisdictions) and discriminatory taxes (same tax rate must apply for both online and its physical counterpart) on online transactions.  A permanent ITFA was passed by the House in July, 2014, but has been held up in the Senate, politics being what it is.  ITFA was due to expire November 1, 2014, just prior to Election Day, but was kindly extended by Congress to December 11 for obvious reasons. 

So what if it is not extended or made permanent:

1)    Consumers and businesses alike would be hit by higher taxes in its usage and access to the internet.
2)    Higher taxes may restrict the ability of (moderate to lower income) consumers to access the internet, thereby reducing e-business sales and profits, affecting the nationwide economy.  Dissemination of information on the internet would suffer as well from lack of access.
3)    Services, such as e-mail, may be subject to taxes, taking a bigger bite of everyone’s budget.

Although it is likely to be extended, e-businesses need to be prepared for the possibility of higher taxes, going forward.

Internationally, on October 29, 2014, the OECD and G20 countries endorsed a new standard for the automatic intergovernmental exchange of financial and tax information, which will usher a new era of international financial transparency, beginning in 2017.  As one of the policies to prevent “artificial” “base erosion and profit shifting” (BEPS), the standard follows the US model of adopting information exchange treaties to identify all financial transactions of its citizens globally, where foreign governments become the willing enforcement mechanism for U.S. tax law.   See http://www.oecd.org/ctp/beps-2014-deliverables-explanatory-statement.pdf.  and recent press release by oecd.

…, [I]t is also recognised that the business models and key features of the digital economy exacerbate BEPS risks and therefore must be addressed. It is expected that the other actions will address these risks but at the same time a number of specific issues have been identified which must be taken into account when doing the work (permanent establishment issues, importance of intangibles and use of data and possible need to adapt CFC rules and transfer pricing rules to the digital economy). A number of broader direct tax challenges have also been analysed, such as the ability of a company to have a significant digital presence in the economy of another country without being liable to taxation due to the lack of nexus and further work will be carried out to evaluate their scope and urgency and potential options to address them. Finally, challenges in the area of indirect taxes in relation to business to consumer transactions have also been identified and will be addressed by 2015.  OECD, BEPS report, p. 8 (see above).

And Ireland has bowed to international pressure to eliminate the “Double Irish” corporate tax loophole, which allows an Irish-registered subsidiary to send royalty payments for intellectual property to another that resides for tax purposes in a country with no corporate income taxes (such as Bermuda).

So, what should the ordinary e-business do to simplify business and minimize compliance problems?

    First, you can’t hide.  As an “ultimate beneficial owner” (“UBO”), you should forget any hope of confidentiality of your ownership interests in any legal entity.  While American corporate laws do not require reporting of ownership to local Secretaries of State, tax laws do.  Under the OECD/G20 standard, you can’t hide behind a foreign holding company.  

    Second, develop strategies for workforce deployment and outsourcing.  Learn about “form vs. substance” and the principles of what constitutes a taxable nexus.  Anticipate that transferring intellectual property to a tax-favored holding company might not work unless it is in the same jurisdiction as your innovative employees who create the IP.  This principle will encourage smaller companies to outsource new product development since outsourcers normally assign IP rights across borders without much tax complexity. 

    Third, refocus on transfer pricing and be reasonable.  The new rules invite governments to tax more.  As governments get more active in adopting a new template for country-by-country reporting and challenging transfer pricing, businesses can consider collective action through trade associations to define standards for transfer pricing levels.  (Of course, exchanging of pricing information smells of concerted monopolism, so this would need some care to avoid crossing the line into anti-competitive conduct).

    Fourth, ask your portfolio companies what they are doing and how they are adapting.     

    Finally, rethink your game plan for tax compliance and eventual tax audit.  Maybe your internal analysis on allocation of value-creation and taxable revenue streams could be programmed into a software model that you could sell on the market.  After all, compliance costs for everyone will only increase, and you could recover your investment. 

Every pain enables someone to gain.  No pain, no gain.