How venture capital firms can promote growth and efficiencies in their portfolio companies

29 February 2024
The days of cheap money may or may not be gone for good, but for venture capitalists, one thing is certain: financial due diligence is here to stay.

More than ever, venture capital firms want to see their investments generate profits, or a clear road to profits, not just growth. To help their portfolio companies achieve financial sustainability, venture capital firms are taking an increasingly active role in management, working with founders to develop strategies and provide advice on everything from corporate governance to hiring a multi-country payroll provider.

One sure way to get and stay on the road to profitability is to maximise operational, tax and other efficiencies while minimising compliance risks. This is especially important for portfolio companies, which tend to grow rapidly not just in headcount but in their countries of operation. A company that has its house in order will be significantly more appealing to buyers than one that has expanded recklessly and failed to implement proper controls and processes.

This article examines six areas venture capital firms should understand to help their portfolio companies grow and operate efficiently and compliantly in a volatile, competitive global economy. It’s not intended to be comprehensive, but to summarise some of the most important elements of running a sound multinational organisation. It should also be noted that some of the sections below — such as the one on rationalisations — may be less relevant to a portfolio company than others depending on the company’s global footprint, lifecycle stage and other factors.

Expanding internationally the right way

There are many reasons to expand into a new country, from entering a promising market to tapping into a skilled workforce to supporting a valued client. Any company new to international expansion should establish a standing group of stakeholders from finance, HR, tax and legal to vet and approve any new international activities and regularly review existing ones. This will help ensure planned and existing operations align with current corporate strategy and are compliant and necessary. The company should also work with an international expansion and operations provider to understand its compliance obligations and options, and to keep abreast of new and proposed regulatory changes.

A third-party expert will also help establish realistic budgets and timelines. Even an organisation that has expanded into one country will typically find that expanding into another is a very different experience. To take just one example, the time and costs of establishing a bank account can vary significantly by country, which can affect when you can pay any new local workers, among other things.

It’s critical to understand an organisation’s options for paying workers in a new country. The optimal choice will be dictated by planned activities, how quickly the company needs to get up and running, local regulations, short- and long-term corporate strategies, and other factors.

Hiring and paying workers as independent contractors — either to test a market or as a long-term solution — is extremely risky. Such arrangements commonly break local employment rules and can lead to steep fines and penalties.

Using an employer of record, or EOR, to pay workers can be a good solution depending on the expansion situation. An EOR will have a legal entity and associated payroll in the target country. The expanding company uses the EOR to pay its new, locally based employees while it (that is, the expanding company) actually directs and controls the workers. The EOR also provides local benefits and withholds local income and social security taxes and remits them to local authorities. It should be stressed that EORs are not intended to be a permanent solution and do not eliminate permanent establishment risks. In some cases, a company may choose to use an EOR as a stopgap (for example following an acquisition) or medium-term solution until migrating to a more permanent option.

Which brings us to establishing a local legal entity in the target country. The short-term costs are relatively high when using this solution, and the process can take months, but establishing a legal entity — such as a subsidiary or branch — is almost always the most flexible, least risky option for paying local workers when expanding into a new country. Once established, the organisation can run a local payroll through the entity and participate in a wide range of activities. Of course, the organisation will also be responsible for paying local corporate taxes and fulfilling other compliance obligations. In short, it’s similar to operating a company in the home country.

Depending on the jurisdiction, there may be other options for paying workers, such as registering as a non-resident employer, or NRE. As mentioned, performing due diligence on each option, and working with an expert familiar with target-country rules, will reduce costs, compliance risks and the possibility of costly missteps.

Developing a sound corporate governance structure

As mentioned, VCs are working more closely than ever with founders, from offering operational and strategic advice through to sitting on boards. Providing advice on corporate governance best practices can be one of the most important steps a VC can take to help its portfolio companies succeed.

Sound corporate governance policies and practices are not simply a matter of common sense. They can be difficult to understand and implement for startups. Corporate governance may in fact be all but ignored by early-stage companies consumed with developing products and growing customer bases.

The stakes, though, are high, with proliferating ESG reporting requirements, public expectations related to diversity and inclusion, and widespread demands for corporate transparency. The reputational damage that can result from poor corporate governance practices can be more devastating than related fines and penalties, no matter how severe.

There are many hallmarks of good corporate governance, such as conducting regular board meetings and taking thorough meeting minutes, giving consistent trainings for and assessments of senior leadership, engaging in sound reporting practices, and employing a company secretary. As usual, working with an experienced third-party expert to implement and regularly review an organisation’s corporate governance framework will help lower compliance and reputational risks.

Maintaining compliance in all counties of operation

One of the most challenging and administratively burdensome aspects of expanding and operating across borders is understanding, following and keeping abreast of compliance obligations in each country of operation. A couple of previously mentioned practices can help ease this burden: that is, maintaining a standing international expansion and operations committee and working with a third-party international expansion expert. Ideally, a representative from the third party will be a standing member of the committee to provide regular updates and answer questions.

It should be emphasised that the word “compliance” covers a wide range of obligations, from corporate and indirect taxation to immigration to transfer pricing to labour law to accounting to data protection and on and on.

If maintaining compliance globally sounds daunting, it should. But doing so is essential to running a successful company, even a growing startup. All startups will be familiar with the early Facebook motto “Move fast and break things,” which is precisely the wrong way to act with regard to laws and regulations. Facebook has borne the consequences over the years, including in May 2023, when it was fined USD1.3 billion by Ireland’s Data Protection Commission for unlawful processing and transferring of data across borders.

There are countless other examples of fines and reputational damage incurred through non-compliance. There is perhaps no better way to protect a company’s bottom line and reputation — and to make it appealing to buyers — than to develop, implement and document sound compliance policies and practices.

Consolidating vendors

Just as compliance obligations in each jurisdiction are difficult to track and fulfil, vendors can present challenges. Vetting and managing local payroll providers, legal and regulatory experts, accountants, and other third parties in each jurisdiction becomes increasingly burdensome and costly with each expansion.

Hiring a reputable corporate services and fund administration firm can greatly reduce administrative burdens by providing a single point of contact for legal and regulatory advice, entity management (including reporting and corporate and indirect tax filings), payroll, governance and more. Some providers have platforms that give insight into a company’s entities all over the world.

Due diligence, including asking the right questions, is critical when selecting a provider. Do they have a large global footprint with expertise in all major jurisdictions? Can they provide advice and services in all areas of international expansion and operations (including tax, legal and HR)? Can they deliver multi-country payroll, act as an employer of record, and set up and maintain legal entities throughout their lifecycles? Do they have centralised, secure platforms that provide insight into and control over entities and funds located around the world? Do they deliver their services directly or primarily through third parties?

These are just some of the questions an organisation should be prepared to ask when vetting a provider. For a good example of due diligence preparation in just one area of corporate services, see the article “12 questions to ask when hiring a global payroll provider.”

Conducting legal entity rationalisations

As we’ve seen, late-stage startups may expand into new markets for various reasons, and they may grow organically and/or through acquisition. In any cross-border growth scenario (and particularly one involving acquisitions) keeping track of all legal entities in an organisation’s structure can be difficult. In fact, keeping track of legal entities often falls through the cracks when a rapidly growing organisation develops and implements controls.

To reduce compliance risks and promote cost and operational efficiencies, a multinational organisation should periodically review its legal structure to determine if all its entities provide value. This process is known as rationalisation, or global entity rationalisation, and its primary goal is to uncover nonessential entities and reduce costs. We estimate that an entity costs up to USD 50,000 annually just to maintain, so eliminating gratuitous entities can be a significant boost to a multinational’s bottom line. It can also reduce compliance risks (such as those related to missed filings) and tax leakage.

As usual, it’s best to conduct a rationalisation with the help of a third-party tax expert. The process can be complicated and may involve consolidating entities, striking off one or more entities completely, and/or allowing one or more to become dormant. There can also be tax consequences to striking off an entity that may go unrecognised without expert guidance.

Winding down unnecessary entities

If a company finds it must strike off one or more entities following a rationalisation or for any reason, it needs to understand what’s entailed so it can set realistic budgets and timelines. Timelines for winding down an entity vary by country, but an organisation should plan on the wind-down process taking at least six months, and in some jurisdictions it can take up to 12.

The wind-down process also varies by country, but typically it involves eliminating the entity’s tax liabilities and debt, undergoing a financial audit, and ceasing trading, among other steps. The cost of winding down an entity can also be significant, depending on the jurisdiction, entity type and other factors. As a result, associated cost savings may take time to materialise.