Demystify the Australia to U.S. “flip-up” for Australian start-ups

If your Australian company is pursuing United States investors or seeking to grow its presence in the United States, you may want (or need) to consider a “flip-up” to a U.S. entity. While a flip-up can bring significant advantages, the process can be complicated and unfamiliar to entrepreneurs used to Australian startup structures. 

We demystify the flip-up process for Australian founders, and outline tax and other considerations that can prove costly if not considered.

What is a flip-up?

A flip-up is a reorganization in which an existing company (OldCo) becomes a subsidiary of a newly formed parent company (NewCo) in the desired new jurisdiction. Existing shareholders of OldCo exchange their shares for newly issued shares of NewCo, and if all shareholders make that trade, then OldCo becomes a wholly owned subsidiary of NewCo. Other securities of OldCo, such as share options, convertible notes and SAFEs (simple agreements for future equity), are also exchanged for similar securities of NewCo.  

Why should I consider a flip-up?

The principal advantage of a flip-up is that it makes your company much more attractive to U.S. investors.  While an increasing number of U.S. venture capital firms are willing to invest in Australian companies, most U.S. investors feel more comfortable with the corporate mechanics and standardised forms of U.S. investment documents. U.S. investors may also receive special tax advantages from investing in a U.S. corporation that Australian investments don’t qualify for, such as the Qualified Small Business Stock (QSBS) exemption. That allows eligible holders of eligible U.S. companies to receive up to a 100% capital gains tax exclusion under certain circumstances. Some incubator and accelerator programs (such as Y Combinator and LAUNCH) require Australian companies to flip to the U.S. (or a short list of other jurisdictions) as part of the program.  

Secondly, a U.S./Delaware corporation can be an advantage if you expect that the “center of gravity” of your future business (customers and employees) will be in the United States – U.S. customers may feel more comfortable dealing with a U.S.-headquartered entity, and U.S. employees may prefer the familiarity and tax advantages of U.S.-style stock options. Based on existing Australian tax law, ideally some of the Australian-based directors of OldCo will actually move to the United States in connection with a flip-up (for more information on this see below under “Other issues/considerations”). 

When is the best time to flip?

A flip-up is more common during early-stage investment and less so during growth-stage financing. This is generally because a flip-up becomes more complicated as the capital structure of the company become more complex and the company grows.

However, in our experience, most companies who intend to flip-up will wait until immediately before the closing of their financing – this is especially true if the reason for the flip-up is because of U.S. investor requirements. Flip-ups can be complex, difficult to unwind and involve significant expense. Most entrepreneurs won’t want to be saddled with an unfamiliar U.S./Delaware structure unless their U.S.-centric financing will close.

Why Delaware?

For flip-ups to a U.S. company, the U.S. company is almost always incorporated in the state of Delaware, as an extremely high percentage of U.S. venture-backed companies are incorporated there. Why is that? Delaware has created a very flexible corporate structure that entrepreneurs and investors appreciate, and lawyers appreciate that it has a vast and sophisticated body of corporate law able to address virtually any issue that might come up. However, the number one reason that venture-backed companies choose Delaware is because the entire U.S. startup and venture capital ecosystem is familiar and comfortable with Delaware.  So if you do a flip-up, you’ll almost certainly end up with a Delaware corporation as your parent entity.

Another attractive feature about Delaware for Australian entrepreneurs is that Delaware has virtually no reporting requirements. For example, in Australia, small proprietary companies are required to keep financial records that explain their transactions and financial position and that would enable true and fair financial statements to be prepared and audited, but they do not have to prepare or lodge annual financial reports or directors’ reports unless directed to by shareholders with at least 5% of the votes or by the Australian Securities and Investments Commission (ASIC). However, the company will take on additional reporting and lodgment requirements as it grows to be a “large proprietary company,” being one that meets at least two of the following criteria:

1. $50 million or more of revenue for the relevant financial year
2. $25 million or more in gross assets at the end of the financial year
3. employing 100 or more employees at the end of the financial year (in each case including the company and its controlled entities).

Once classified as a large proprietary company, an Australian private company must also submit financial and director’s reports to ASIC annually and have its financial report audited, further increasing costs.

Delaware has no filing or regulatory requirement for private companies other than a simple form to be signed in connection with payment of annual franchise taxes (which are quite modest for most early stage companies). However, Australian private companies with a foreign parent come under the same rules as “large proprietary companies,” regardless of size. After the flip-up, OldCo will therefore need to rely on ASIC relief to be treated as a “small proprietary company” and exempt from lodging audited financial and directors reports in respect of itself and its controlled entities. This requires various actions, including annual board resolutions and ASIC filings in the prescribed forms and meeting certain other technical requirements.

Australian Requirements

There are important tax considerations to keep in mind when structuring a flip-up. Companies should seek tax advice early in the process of deciding whether to flip up to ensure that the flip-up is appropriately structured and that tax issues are properly managed.

There are two key areas on which to focus.

Tax residency

CGT “rollover”

How long will a flip-up take and how much will it cost? 

The timing and cost of a flip-up can vary depending on the complexity of the Australian company.  At one extreme, if you have just a handful of cooperative shareholders, everyone holding ordinary shares, and no investors, the flip-up can be accomplished in a couple of weeks at an incremental cost of US $10,000 - US $15,000.  Factors that tend to add complexity and cost include:

• A large number of shareholders
• A significant number of small shareholders and/or optionholders in Australia who are not “sophisticated investors” and exempt from prospectus requirements
• Existing investor structures (notes, SAFEs or preference shares)
• Existing employee share option schemes that need to be converted to Delaware option plans
• Uncooperative shareholders or shareholders or investors who want to negotiate the terms of the flip-up
• Corporate records and capital structure that are not up to date and/or need correction.

Depending on how many of these complexities you have, the timing can increase to a couple of months, and costs could mount to US $50,000 or more. It is critical that 100% of the shareholders of a company participate in the flip-up, as even one reluctant shareholder will mean that the parent U.S./Delaware corporation will not own 100% of the Australian business, which will be a non-starter for investors. Accordingly, you should only start down the flip-up path if you are confident that all of your shareholders will support it.

Who do you need as your team and who does what? 

“Must-haves” for the team would include an Australian law firm, Australian tax advisors and a U.S. law firm, and it is highly recommended that both law firms have significant prior experience with flip-ups.   Your Australian law firm will help ensure that the flip-up complies with Australian law, and critically will also help structure the transaction so that it is tax neutral for the company and its interest holders. If the two firms have worked together on flip-ups previously, that is the best possible combination – they will have collaborated on many of the details of the flip-up process before, which will speed things up and reduce costs. The U.S. law firm will set up the U.S./Delaware structure so that it will be customary and market-standard for your future path as a U.S. entity. Often the company seeking the flip-up will be simultaneously completing a financing with U.S. investors, and the U.S. law firm would take the lead on that transaction. 

In addition, transfer pricing expertise will often be required to ensure the appropriate documentation is in place and the appropriate price is charged for any license of IP and royalty withholding tax is paid.

Other issues/considerations