Corporate structuring may not always be a focus area for established, thriving businesses. However, startups that have recently commenced operations or are about to do so would require paying attention to detail in their structure. For instance, the choice of the overall corporate and tax structure, including holding subsidiary companies and the contractual interrelationships between entities, requires serious decision-making. This article explores some aspects regarding the structuring of startups keeping in mind specific startup needs and goals.
A start-up is a recently established business, typically small in scale, initiated by either an individual or a group of individuals. What sets it apart from other enterprises is its offering of a unique product or service not available elsewhere in the same manner. Therefore, the initial step is always to conceive an idea, followed by determining a suitable business structure that aligns with your specific needs. The chosen structure will have far-reaching implications for your business, influencing everything from employee recruitment to scalability as your venture expands. This article attempts to answer a few common questions that arise with founders in the context of structuring their startups:
Do I need a holding company?
Do I need other subsidiary companies?
Setting up relationships between the entities
A. Do I need a holding company?
A company is said to be the holding company of another company when the former is a shareholder (wholly or partially) in the latter company. In other words, the holding company is the shareholder of its subsidiary company. There are several key benefits and reasons why a startup may choose to incorporate a holding-subsidiary setup in its corporate structure:
Organizing multiple businesses and ventures becomes easier because the holding company can have multiple subsidiaries, each engaged in a different business from that of the others.
Organizing the same business in multiple jurisdictions and countries is easy. While the holding company remains the same, a separate subsidiary may be incorporated in each country according to its laws and regulations. This simplifies territorial expansion.
Shielding one subsidiary from another is relatively simpler. If one subsidiary faces some business or legal risk, the other subsidiaries are isolated from the risk because they are contained in separate legal entities with limited liabilities. This separation of liabilities safeguards the overall business.
Tax efficiency can be achieved by organizing different functions in different subsidiaries based on the relative tax rates and incentives available in different jurisdictions.
Intellectual property and other intangible assets that the startup owns could be residing with the holding company, and legal risks could be minimized. The holding company could license the intellectual properties to each subsidiary on a need basis.
Flexibility of investment is available to investors. Value-creation takes place at the holding company level and investors have the choice to invest either in the entire group (by investing in the holding company) or to invest only in one particular business (by investing in a particular subsidiary).
Access to global finance is made easy by having a foreign holding company. Based on its financial strength, this company can access cheap funds from sources abroad, which can be utilized to fuel the growth of its operations in multiple operational jurisdictions.
The flexibility of exit is available to investors as well as founders. They could exit from one business or the entire group. This is typically useful in the case of reorganizations such as mergers and acquisitions.
Startups, especially technology startups, which operate in highly volatile environments in terms of innovation, technology, and finance, would be highly recommended to incorporate a holding-subsidiary setup in their overall structure, considering the above advantages.
The obvious question would then arise—where should the holding company be located—India or abroad? Setting up foreign holding companies is relatively easy. Thus, this idea should not be discarded merely because we’re talking about a foreign or unknown country where the founders may not have any presence at all. Professional services are available to individuals and other service providers to take care of the initial friction in this regard.
In case the startup’s business is entirely, and forever, going to be located in India, the startup may choose to have an Indian holding company. Further, suppose the startup does not need immediate seed or angel or venture capital and does not also contemplate any exit to be provided to any investor or founder. In that case, it may restrict itself entirely within India. On the other hand, a startup that has ambitious global growth plans and requires access to global investor funds would want to have its holding company situated in a jurisdiction that has these factors readily available. Similarly, a startup that immensely relies on intellectual property generation and monetization would choose to base its holding company in a jurisdiction that offers a wonderful intellectual property regime.
The decision regarding the exact location of the holding company should be made with expert advice because a number of factors would go as inputs into the decision-making. The decision-making would involve projecting the founders’ plans and vision into the business, legal, and tax realities of various jurisdictions, and a qualitative comparison of the relative advantages and disadvantages.
B. Do I need other subsidiary companies?
Suppose the startup already has a holding and subsidiary setup in its corporate structure. In that case, the founders may often be faced with a question when starting a new line of business – whether to incorporate a new subsidiary or to commence such business in the present subsidiary itself. The answer could be determined through three critical factors:
Dependency on the present business – if the new line of business is naturally integrated and entirely depends on the present business, a new subsidiary would needlessly distance it from action and discount the possible synergies. Setting up a new subsidiary, where the end-product or service offering to the customer is integrated with the present business, would complicate the business model and optically look suspicious. On the other hand, if there is a remote degree of reliance on and connection with the present business, it would be desirable to open the new business line in a new subsidiary.
Fund availability and requirement—if the new line of business requires funds that are only available with the present business or subsidiary and if the investors are not keen to fund the new business separately, a new subsidiary may not be advisable. However, if the holding company is deep-pocketed or the investors are ready to put in additional funds either into the holding company or the new line of business separately, a new subsidiary would be a suitable option to go with.
Risk involvement—If the new line of business is prone to risks (including legal, financial, competitive, and operational risks), it would be recommended to commence such business in a new subsidiary so that the existing business(es) can be isolated and shielded from the risks.
The above three factors applied together, would largely give a correct answer to the posed question. A new line of business, which is distinct from the existing business, can generate its own funds and carries a certain degree of risks, should be initiated in a new subsidiary.
(C) Setting up the Startup Charter and defining relationships between the entities
An aspect that is mostly overlooked is the establishment of written, precise relationships between the constituent entities in a corporate structure. While a startup may create holding and subsidiary companies, the relationships between these entities are largely informal and dynamic and do not care about or respect the legal separation of their existence and identities of these entities – this is unwarranted and should be rectified at the earliest.
The foremost thing is to create a Startup Charter, that would serve as the philosophical guiding tool for all those dealing with the startup’s business, including founders, employees, investors, as well as regulators. The Startup Charter should clearly identify and lay down the:
Overall vision and business functions of the startup
Distribution of the functions between each entity
Management of each entity and allocation of resources
Transactions between the entities
Dos and don’ts regarding the structure
Thereafter, they should be put in place written agreements or documents laying out the functions and transactions between each entity. It is important that no transactions should take place between entities that are not backed by or based on some written document or agreement. The relationships should be developed having regard to the overall vision and business of the startup, as well as legal requirements such as corporate law, tax laws (e.g., income tax and GST), permanent establishment provisions, transfer pricing, securities laws, etc. Written agreements would serve as the foundation for accountability and transparency while also providing legal protection in case of unforeseen circumstances.
Conclusion
In conclusion, the journey of structuring a startup demands careful consideration, not only at its inception but throughout its growth. This article has shed light on the significance of corporate structuring, emphasizing that even for thriving businesses and startups alike, the choice of structure can significantly impact their trajectory. For startups, especially those in the dynamic landscape of technology and innovation, the adoption of a holding-subsidiary setup can offer invaluable advantages, ranging from risk mitigation and tax efficiency to access to global finance. The choice of the holding company's location, whether domestic or abroad, is a decision that warrants expert advice, given its far-reaching implications.
Furthermore, the article underscores the importance of meticulous planning and documentation in shaping the relationships between entities within the corporate structure. The establishment of a Startup Charter, serving as a guiding beacon for all stakeholders, sets the stage for transparency, accountability, and alignment with the startup's vision and goals. Equally crucial are written agreements and documents that govern transactions between these entities, ensuring that every interaction is grounded in a clear, legally binding framework. By taking these steps, startups can fortify their foundations, navigate legal complexities, and pave the way for sustainable growth and success.
For a concise summary of Structuring Fundamentals, please see the attached slide deck
Authored by Sanyam Aggarwal, Advocate at Metalegal Advocates. The views expressed are personal and do not constitute legal opinion.