Blueprint to the legal entities of a high-tech startup

07 Dec, 2016 0 Author

At some point you want to make sure you cover the legal side of your startup. Set up the legal entities, split the equity over the team, sign that big customer or investment deal, and go conquer the world. A good legal and tax foundation will save you from a lot of headaches down the road. It pays off to study a bit of legal and tax matter before you incorporate your business.

This post creates a blueprint for a high-tech or software startup that is based on creating IP and needs external investment to pull that off. And not much more to keep things simple. No tax-evading Panamanian mailbox schemes here (“brievenbusfirma”). I’ll stay far away from these. Oh, and as (especially) tax rulings are different in every country and my experience does not cover the whole world, I’ll focus on The Netherlands. And use the Dutch terms in parentheses.

Intellectual Property (IP)
IP is of course an umbrella term for many different types of Intellectual Property rights, such as patents, trademarks, design rights, and copyrights. Even trade secrets, that only need to be kept secret, are in some way an IP right. For reasons of clarity I will use the umbrella term IP rights in this article.

Beware of the advisors!

In setting up a new venture, you need to make sure you are surrounded by a team of advisors. Yet as each covers their domain of expertise, you are the one that needs to pull it all together. At the risk you can’t see the wood for the trees.

How do the advisors help you?

  • Legal advisor – focuses on how to avoid claims, how to prepare for a divorce in your team and how to brace yourself for bankruptcy (while keeping the baby).
  • Tax advisor – focuses on how to avoid tax claims and how to avoid reporting a profit. 😉 An example is a construction to compensate a profit in one entity with the loss of another.
  • Notary public – just does (a little less than) what you pay them for. Save cost by keeping things simple and standard.
  • Accountant – focuses on keeping your accounting simple and therefore manageable.
  • Investor – may ask you for special legal setup that you must take into account, e.g. an investor may demand a separate holding protect the IP in case of a bankruptcy.

Note that the advice is often conflicting. For example, from an accountancy and tax viewpoint it may be lucrative to combine a holding and subsidiary into a single fiscal entity. Yet from a legal standpoint, that may be bad news if the subsidiary is confronted with a tax claim or bankruptcy.

Blueprint to legal entity bliss

The figure shows the rough setup. I’ll walk over the entities top-down.

legal_blueprint

1. Individual holdingsindividualholding

For many of the arguments below, it makes sense for each founder to have his/her own holding. Dividend paid and capital gains are not taxed as long as you have at least 5% share (“aanmerkelijk belang”) in the company.

No caveats here. Get an online accountant to keep things afloat and cheap.

Management fee

You can decide to work via your holding for the main company instead of being directly employed there. You then become the single employee (“DGA”) of your holding and invoice a management fee to every company you work with. Easier than being employed by multiple companies.

The inflow of management fees allows you to tinker with all kind of tax benefits: mortgage, pension, lease car, or deduct costs. Knock yourself out. In most cases you can even avoid paying social security for employee’s insurance, making your startup more cost effective.

If you run an innovative startup, chances are your startup can apply for some kind of government, regional, or EU subsidy. But as you now are a 3rd party contractor to the main company, most subsidies don’t or only partly subsidize 3rd party work, so beware.

An exception is the WBSO/RDA subsidy. In this case you can apply subsidy for yourself as employee of the holding, linked to the innovation done in the main company. Your holding now benefits from the subsidy, not the main company. Not every shareholder will like that though. On the positive side, you can optimize the amount of subsidy by setting smartly choosing your own salary (the level of subsidy is based on all past salaries paid out in the entity).

Caveats?

As you are the single employee and owner, the tax authority demands you pay yourself a minimum wage (“minimum DGA loon”). The guideline is currently €44k/year, but if the tax authority feels the wages in your line of work are much higher, you might be held hostage to a much higher pay grade. On the other hand, Dutch government has recently stated that for startup situations, you can bring this down to Dutch minimum wage at approx. €20k/year.

The ties your holding has with the main company should have no signals of a hidden employment relationship (“verkapte arbeidsrelatie”). Even with a management fee construct, you may be seen as employee of the main company (“materieel in dienstbetrekking”). The government currently turns a blind eye to this (“wet DBA”), so you are seemingly safe until 2018. In addition, when your setup exempts you from mandatory payments of employee’s insurance, the government will be even more flexible. Also from 2018 onward.

As a general rule, if there is a chance that others (co-founders, investors) can kick you out of the company, your startup has to pay employee’s insurance.

The only way to prove you can’t be kicked out, is to make the case you are are critical to the company as a founder:

  • there are no investors, and
  • shares are equally split among all founders.

So tough luck. In case you cannot pose the above, the main company will have to pay the employee’s insurances (“premie werknemersverzekeringen”) for your management fees or salary. That amounts to roughly ₤7k to €8k per year per employee in the IT business.

2. Founders holding

It often makes sense to combine the founders into a single holding instead of each founder directly owning shares in the company. Investors may even require this, so they only have to deal with the founders as one single entity. And while they are at it, more easily create a right of pledge on all shares of the founders.

A single founders entity may also help you too, as you can negotiate that warranties and other scary constructs in the investment agreement are fended off to the holding instead of to you personally. Also, uniting the founders as a single voice at a shareholders meeting or investment negotiation may give some leverage.

High-tech, IP-heavy companies need lots of investment. If you plan to do many investment rounds, your individual share held by your holding may water down to below the magical interest (“aanmerkelijk belang”) limit of 5%. In that case you pay corporation tax over any dividend paid out and capital gain realized. If you combine forces with your co-founders in a founders holding, chances are the combined ownership floats well above 5%.

Caveats, anyone?

Not all startup marriages succeed, so plan for a graceful exit when a founder leaves. A good leaver/bad leaver clause in the founders holding makes sense to recoup shares for a replacement.

3. Share trust officesharetrust

The share trust office, let’s call it a STAK after the Dutch “Stichting administratiekantoor” is used to bring together many small shareholders and in principle exclude them from voting rights. These are typically used to hand out stock options to employees or convertible notes to friends and family in the early days.

Nowadays there are alternative options to let others benefit from your business successes that are worth considering:

  • Non-voting shares: made possible in the new Dutch flex-BV wet. Simply define a new class of shares without voting rights. You do need a notarial deed to issue and transfer them. These shares do have meeting rights, as well as voting rights on decisions that directly affect their profit-share. And you’ll have to convert them to something else (certificates and the like) when you do an IPO. A potential headache before you can pop the champagne.
  • Share appreciation rights (SARs). Not to be confused with the chicken virus. Your company pays the difference in share value between the moment the SAR is granted and the exit price. This is just a contract, so anything is possible. Therein also lies the risk; make sure to set this up right. For instance, you don’t want the company to be forced to pay SARs from its own cash when the exit sale was a pure share transfer with no cash involved.

While SARs have nothing to do with the share capital, they do eat up part of the profit in an exit scenario. Hence, you need full shareholder approval for the SAR agreement. But as they are not directly related to shares, you can hand these out to, say, your mother in law. Without the risk she’ll ever turn up and vote against you at your shareholders meeting.

SARs are nowadays taxed as income (“box 1”). So no tax-saving stunts to be had here, alas. For stock options, you can devise a vesting scheme where you exercise the options long before the company valuation goes through the roof—effectively transferring taxation from box 1 to shares in the more favorable box 3.

Caveats!

With a STAK, the participants hold no individual shares and hence you don’t need them for signatures on follow-up investment rounds etc. But take care to really avoid having to get signatures. For instance, it may be wise to regulate a system where the participants wave their pre-emptive rights (“afzien van voorkeursrecht”) in advance. When you are in a hurry to close an investment, you simply do not want to chase a signature from a participant that just went off kayaking the Beriman river in Papua New Guinea.

4. IP holdingipholding

Whenever you create intellectual property, e.g., software and patents, it often makes sense to separate that from where you contract customers and employees. This is simple insolvency protection: if the public facing entity can’t pay the wages, gets a tax claim, or let’s say a patent claim, you don’t want the administrator (“curator”) to take away the valuable goods: the IP. So keep it safely stowed away in a holding, or at least a separate entity. Secondly, if you decide to sell part of the company, the holding gives you a means to make a license deal. And keep the IP rights for the remaining business. Also don’t forget to regularly transfer the new IP to the IP holding; you can’t transfer everything in advance.

Caveats?

Investors are of course smart enough to buy into the holding, instead of investing in a subsidiary that can vanish into thin air. So don’t even try to trick them. Yet do watch out for legal paragraphs in bank loans and partner contracts that try to fish for the IP through the subsidiary all the way back to your holding.

5. Operating companyoperatingcompany

Below the IP holding are the operating companies (“werkmaatschappij” or “dochteronderneming”). This is where your employees work and you make deals with partners and customers. Each operating company can be a full subsidiary of the holding or totally separate. In practice, it makes sense to make these a full subsidiary of the holding:

  1. The holding will make a profit in the long term from licensing the IP to the subsidiary. The subsidiary will initially make a loss in developing the technology, although the holding should compensate the subsidiary to a certain extent. If the holding has more than 95% share in the subsidiary, you can combine these into one fiscal unity (“fiscale eenheid voor de VPB”). And can compensate the profit in the holding with the losses in the subsidiary.
  2. When the holding has a qualifying interest (“deelnemingsvrijstelling”) of more than a 5% share in the subsidiary, dividend and capital tax can flow untaxed from the subsidiary to the holding.

You can (and many will) have multiple operating companies to separate businesses from each other and spread the risk. For example a service company to provide services and training and separate companies for product X and Y. Each of these can then be sold independently while the IP remains with the holding.

Note that the IP holding should not be the director of the operating company! Leave that to the founders’ individual holdings or the founders themselves. That way, the IP holding (in principle) remains safe from any claim on the managers (“bestuurdersaansprakelijkheid”). That was the whole idea to safeguard the IP in a different entity, remember?

Caveats?

Typically the risks do not outweigh the benefits of setting up a fiscal unity for VAT (“fiscale eenheid BTW”). Watch out here. You just don’t want to run the risk of a VAT claim hitting your precious IP.

It does make sense to create a fiscal unity for the corporation tax (“fiscale eenheid VPB”). The fiscal unity does go against the idea of spreading risk. But you only make a loss in developing the technology at first. So the risk of a claim on corporation tax in the early days is much lower. Another downside is that the profits of all entities are added up for the corporation tax, and thereby will hit the higher 25% tax rate (“schijf”) earlier than if filed for each entity individually.

There is a slight risk that the tax authority will enforce a fiscal unity for VAT at their initiative. In that case, your tax advisor may still have some tricks in his book of magic to rescue you.

On the subsidy level, don’t forget to account for the Innovation Box when setting up your startup structure. The innovation box effectively taxes innovative income at a mere 5% corporation tax. Although the Innovation Box only becomes truly interesting when you get to tax paying mode, be prepared. A good foundation will make it easier to apply for the Innovation Box once the money flows in. In this respect, think of earmarking expenses and turnover from day one.

IP license and loan

So how do you get the investment dough from the holding to the subsidiary, and the customer payments back to the holding? Simple. The holding licenses the IP to the company. Say the company pays 10% of its profit for the use of the IP. The holding then loans the company its investment money to develop the IP.

You do want to use a loan instead of paying a share premium (“agiostorting”). Why? If things go south, the holding has a claim (“opeisbare schuld”) on the subsidiary for the loan. In case of a share premium, that money is gone. Also, it is easier to pay off the loan than to pay out dividend as the latter requires a complex calculation to check if you are legally allowed to do so (“uitkeringstoets bij dividenduitkering”). Furthermore, if the bank and investors let you, for example, you can create a (second) right of pledge (“pandrecht”) for the loan.

Plenty of caveats

Make sure the loan (or any loan for that matter) complies with the tax rules (“zakelijke lening”): paying interest that conforms to the market, a redemption scheme, and proper collateral (“zekerheden”).

At least to cover your bases when things go awry. Also, the tax authority may conclude a non-conforming loan was in fact an investment (“bodemloze put lening” or “schijnlening”) and apply a different tax treatment. If you have a fiscal unity between the IP holding and operating company, this all becomes less relevant.

The idea of the operating company developing the IP, whereas the IP should be held by the holding, requires a solid and defensible mechanism on the basis of which the operating company is reimbursed once the IP is transferred to the holding. This should take place in a business-like fashion, with factors such as the Innovation Box and WBSO to be accounted for.

So what’s the Minimum Viable Structure?

It would seem the minimum viable structure (let me claim the “MVS” abbreviation here!) to start off is an individual holding per founder and the founders holding. You can then fork off the IP holding as a subsidiary, and from there the operation companies, right?

In principle, you can always split off (“laten uitzakken”) a new subsidiary and transfer the assets there. The assets can be paid in shares or cash. Yet defining and documenting the value of the assets requires some serious black magic voodoo, which is obviously an expensive endeavor. Alternatively, you may want to choose a carve-out of assets in a tax neutral manner (legal demerger, business merger), making the necessity for a valuation less apparent and save tax on the go. Note that such a tax-neutral transaction may become a problem if you would like to sell shares of the new entity going forward. With careful planning when doing the carve-out, your tax advisor can prevent later taxation.

Essentially, you want to avoid all of that, and start off with the right structure. See “the bottom line” below.

The red taperedtape_licenced

What (written) agreements do you need to work out to get things going?

  • Articles of association (“statuten”). Totally standard so go for bottom dollar—as long as the investors don’t demand otherwise.
  • Shareholders agreement. With more than one shareholder, this is way more important than the articles of association. Take good care of the good/bad leaver clause. Think about what the board of directors versus shareholders can decide. Consult a good lawyer on this one.
  • Management regulations (“directieregelement”). The who does what in the management team. Not strictly necessary but good to manage and set expectations with your co-founders. Helpful to keep the articles of association clean. And you do want to keep those clean as they are published in the trade register of the chamber of commerce. So don’t put things in there like a minimum exit valuation at which the investors can decide to sell! Plus for every change of the articles of association you need to visit (and, well, pay) the notary public.
  • Checking account (“rekening courant verhouding”) agreement between the IP holding and the operational company. And regularly settle this account; this is often forgotten.
  • IP transfer agreement to regularly transfer IP built up in the operational company to the IP holding.
  • IP license agreement between the IP holding and operational company.
  • Loan agreement between the IP holding and operational company. If possible ask for security rights (such as a right of pledge) and don’t forget to actually create these.
  • Management agreement for each founder holding. Key clauses are the non-compete, non-solicitation, confidentiality, and transfer of IP rights.
  • Shareholder decisions (“aandeelhoudersbesluit”), management decisions and, if applicable, decisions by the supervisory board. You save yourself potential trouble by making a (digital) register of all these decisions. Make sure to capture these carefully from day one.

The bottom line

The MVS (minimum viable structure) is an individual holding for each founder, an IP holding, and at least one operating company. Lots of legal entities, but hey, at least the notary will love you.

What are your considerations in structuring your startup?

 


Credits to Sam Abbing from Taxperience for his invaluable tax insights and review; Joris Schreurs and Bas Groot from Halsten Legal, especially on the pains and gains of certificates vs. non-voting shares vs. SARs; Lodewijk Hox from Boels Zanders for his review and dotting the legal i’s, and the CEOs that kindly explained their considerations in setting up their software startup. Cheers!

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About Martijn Rutten

Technology entrepreneur with a long history in challenging software projects. Co-founder of life-long entrepreneurship with CET-x. Co-founded Vector Fabrics on parallelization of embedded software. PhD in hardware/software co-design at Philips/NXP. Startup coach at the Eindhoven HighTechXL accelerator. More about me.