Why tax compliance matters to venture capital firms

Despite its considerable importance, many venture capital (VC) firms overlook a startup’s level of compliance until late in the funding process. However, once noncompliance is noticed, it can significantly impact the chances of receiving an investment. So, it’s in a startup’s best interests to stay compliant.

Below, we’ve listed the three of the most crucial reasons why tax compliance matters to VC firms:

3 reasons why tax compliance matters to venture capital firms

1. The need to understand potential liability and past exposure

All businesses need to fully understand which authorities they owe taxes to and plan ahead to prepare for where they might owe taxes in future. For venture capital firms, the companies they invest in must have a solid understanding of liability, or those companies may incur significant financial and legal penalties.

To illustrate the challenge of understanding tax liability, we’ll use the example of an EU company expanding into the U.S. using VC funding. As well as continuing to send VAT returns to the relevant EU authorities, the company must now deal with U.S. sales tax laws. The U.S. is home to more than 13,000 sales and use tax jurisdictions, so understanding what rates to apply and who to remit taxes to can be an enormous challenge.

If the EU company struggles to deal with U.S. tax compliance and their finances become significantly impacted because of non-compliance penalties, the relationship between the startup and their investors can become strained.

2. An opportunity for more money to spend on growth

Another reason compliance matters to venture capital firms is that they have a financial interest in the companies they invest in. If that company has to funnel a large amount of the funding they receive into digital tax solutions, it cannot invest as much in more directly profitable business functions.

When a VC firm considers investing in a startup, it’ll create a term sheet that lists the terms and conditions of the funding agreement. If a startup doesn’t have a comprehensive compliance setup, one of the term sheet conditions may be to use some of the VC funding to ensure tax compliance. That money would be allocated to escrow and could only be used for compliance-related purchases. 

If your startup is already compliant, the term sheet doesn’t need to include that condition, and you’ll have more freedom on how you spend your venture capital money. Since you can invest in departments that are more directly profitable for your business, like sales or marketing, you’ll be increasing your profits and those of the firm that invested in you.

3. The potential for reputational damage

There are a number of ‘rounds’ of venture capital funding, each aimed at companies in different stages of their development. For instance, startup capital is VC funding for a business still in its earliest phases of development. At this point, the VC funding received might be used to fine-tune their products or build the management team.

One of the latest stages is the pre-public stage. A pre-public company will be highly successful and on the verge of selling its shares on the stock exchange. Funding here is used to ensure a successful IPO (initial public offering) or to help drive out competitors.

A comprehensive tax compliance strategy is essential here, as investors may not have much faith in the IPO of a non-compliant company. A company at the pre-public stage is likely to be quite large and dealing with a significant amount of money. Suppose a pre-public company is found to be non-tax compliant in a significant way. In that case, it can be a huge blow to the reputation of any brands or investors associated with the company.

As well as losing customers' trust  (and therefore sales), a business of this size that’s found to be non-compliant will struggle to maintain its partnerships and business relationships, further damaging its finances. The knock-on effect of reputational damage turning into financial impacts is a considerable risk for VC firms, so they are careful to only invest in companies that understand the importance of tax compliance.

Understand the importance of tax compliance with Avalara

We can help with tax compliance challenges your company might be facing. Below are a few common compliance issues to which we can offer a solution — as well as how they might impact your chances of getting VC funding.

  • Charge tax correctly: Although it’s indirectly related, charging the incorrect tax can affect your venture capital prospects. One of the key factors VC firms look for in a startup is an existing customer base that’s satisfied by the service the startup provides. If you’re charging taxes incorrectly, you can damage the customer experience from sudden price shifts. Additionally, charging incorrect tax can lead to significant legal and financial penalties, which can discourage investors.

    Accurate tax calculations are nearly impossible to do manually. However, using a tax calculation platform like our AvaTax platform can help provide the correct price to your customers whenever they make a purchase. Click here to find out how our software can support your business.

  • Stay aware of tax thresholds: Researching tax thresholds before shipping abroad is essential.For instance, in the EU, there’s a single threshold of 10,000 euros for goods and digital services sold via ecommerce. Beyond this threshold, sellers will be liable for VAT in the countries where their buyers are based.

    If you’re not focused on tax compliance, it might be that you breach these thresholds without even realising until you receive a penalty from the tax authority. These penalties reflect poorly on your company and might discourage venture capital firms from investing in your company.

    Avalara can help with doing a full risk assessment to identify your potential tax liabilities. If you’re interested, click here for our US assessment or here for our EU VAT assessment.

  • Discover more helpful tips for getting VC funding: Interested in more expert tax compliance advice? Click here to download our guide on how to improve your chances of winning venture capital funding by being tax compliant.

    If you have any other concerns about tax compliance, don’t hesitate to ask our experts. Click here to get in touch with Avalara today.
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