While raising money, companies may consider bringing on foreign investors as stockholders, members, or partners. Such outside investment can provide a number of benefits, however, companies should consider several factors before moving forward. For a US-based company, taking on a foreign shareholder can result in unwanted complications if the ramifications of foreign investment are not properly understood.
This article highlights five factors entrepreneurs should keep in mind while considering a foreign investor. Not all of these factors will apply in every case, but they should be on a company’s radar during fundraising.
The US government maintains a routinely updated list of countries and people with whom the US prohibits US persons doing business. The Office of Foreign Assets Control (OFAC) maintains the Specially Designated Nationals and Blocked Persons list, as well as other lists, and provides searchable databases to determine whether sanctions exist against particular countries, entities, or individuals. Understanding who a potential foreign investor is and ensuring that they are not on any of these restricted lists is key, as companies can face severe consequences for violating the OFAC prohibitions.
As with all issuances of securities by US companies, any transaction with a foreign investor must comply with US federal securities laws. Generally, when raising money, early-stage companies ensure compliance by requiring investors be “accredited,” allowing the company to issue securities according to the Rule 506 exemption under Regulation D or Reg D. While the Rule 506 exemption is the most common exemption companies use when raising money from domestic investors, it may not be the best option for foreign investors. If investors are not US citizens, nationals, or permanent residents, the Regulation S or Reg S exemption may allow companies to issue securities to foreign investors even if the investors are not accredited. Companies must meet certain requirements in order to take advantage of the exemption provided by Regulation S, including that the offer and sale of the securities must occur abroad. In addition to compliance with US securities laws, any issuance to a foreign investor will need to comply with the securities regulations or laws of the country where the offer and sale occurs. Companies should consult with qualified legal counsel about the applicability of Regulation S as well as any applicable local laws or regulations before moving ahead with a securities offering involving foreign investors.
The US Department of Commerce requires US companies to file annual reports of foreign direct investments with the Bureau of Economic Analysis (BEA) if companies exceed certain thresholds. Companies trigger the basic thresholds if, for example, (1) a non-US entity acquires direct or indirect ownership or control of at least 10% of the company’s outstanding “voting securities” and (2) the cost of acquiring such interest exceeds US$3 million. If a company meets these thresholds, the company must file a BE-13 form with the BEA. If the cost of the acquired interest does not exceed the US$3 million threshold, then the company may file a BE-13 Claim for Exemption. While the BEA has informally indicated that it does not intend to penalize entities that fail to file the required forms, persistent failures to do so may result in civil or even criminal penalties. Please see the BEA website for more information.
Taking on foreign investors can have important tax consequences for both a company and its investors. For example, if an entrepreneur has organized a company as an S Corporation, and has elected to employ pass-through taxation, then taking on foreign investors may not be in the company’s best interest, as it would no longer allow the company to qualify as an S corporation and the company would be taxed at the corporate level. Investors may be wary of pass-through taxation and may prefer to have tax assessed at the company level. This avoids the chance that the IRS might consider the investor to be doing business in the US — thus requiring the investor to file IRS documents. Companies will want to have a full understanding of the tax consequences of any foreign investment and weigh those implications against the investment benefits.
Aside from the above legal and regulatory considerations, companies should consider the practical limitations that a foreign investment relationship might entail. For example, consider if any communication barriers may exist, whether due to language or culture. Keep in mind where an investor is located, any time zone differential, and how such differentials could impact communicating with investors for advice, input, and business necessities (i.e., stockholder consents, wire transfers). The last thing a company wants is to take on an investor who becomes unreachable and ultimately complicates future decisions or actions.
Companies should consider all of the implications and consult outside counsel about uncertainties before taking on foreign investors.