On July 22, 2020, the National Assembly approved, after a third debate, Draft Law No. 83 (the “Draft Law”), which regulates limited liability entrepreneurship companies (the “LLECs”) in Panama, and is now awaiting the signature (or veto) of the President of the Republic.

The Draft Law’s object is to “streamline and simplify constitution procedures” of these special legal entities, so as to reduce the costs and the bureaucracy that usually prevail in the path towards entrepreneurship, as well as to “promote job creation through a new form of business.” It is clear that this Draft Law is a great step towards the formalization of many businesses, furthermore, it is an additional incentive for Panamanians to start a business and contribute to the development of the local economy. However, it is necessary to evaluate whether this Draft Law, if signed by the President, will effectively contribute to the creation of an entrepreneurship “hub” in Panama, and if the entity is an attractive one for a startup.

As we have mentioned in the past, startups are characterized by rapid and exponential growth, and require large capital injections in a short span of time in order to finance their operations, achieve the necessary scalability to penetrate international markets and become true disruptors. It is for this reason that, as a premise, we pose that startups, by nature, should not be considered analogous to a micro, small and medium enterprise (MSME), given that they that grow rapidly and require a lot of capital, unlike MSMEs that grow gradually for extended periods of time and capital injection will depend on their scale over time. Within the applicable regulations, startups should not be defined based on the same criteria used to define MSMEs, because this would be an inadequate definition of what a startup is and of its potential. We underscore then, that according to Article 25 of the Draft Law, LLECs have revenue limits based on the definitions of micro and small companies, and that, if a company generates gross revenues above those limits, it would lose its status as an LLEC. This is inconvenient for a startup given its exponential growth. If a startup quickly gains scalability, its gross revenues can be very high from the beginning, however, high gross revenues do not necessarily mean that a startup is turning a profit. Measuring the status of a startup based on its gross revenues (which is effectively treating a startup as if it were a MSME) gives a false perception that the company is not, in effect, a fast-growing company. In the recommendations that emerged from a 2016 study published by the Organization for Economic Co-operation and Development (“OECD”) and entitled “Startup Latin America: Building Innovative Future” (hereinafter the “OECD Study”),   reference is made to, for example, countries like Chile and Mexico, leaders in the promotion of startups in Latin America, who opted to define a startup based on their performance (growth potential), innovative potential, global target market and capacity to meet the specific needs of a country or region.

In its Article 5, the Draft Law stipulates that LLECs may only be composed of members who are natural persons, effectively limiting the type of person that can invest in these companies. Although it is true that at the beginning of a startup’s life, the founders will likely be natural persons, it is possible that a startup would want to invite a capitalist partner to join the company (often, in addition to providing capital, these partners have vast experience and can serve as mentors or advisors). It is possible that these potential capitalist partners will wish to invest, for various reasons, through their own legal entities; so, this limitation on who can be members must be taken into account when considering the type of legal entity under which the startup will be organized. In addition, since private companies often have the ability to contribute seed capital to a startup, encouraging the private sector to devote part of its resources to invest in startups and encourage local entrepreneurial culture is key to creating a robust startup industry. On this, the aforementioned OECD Study commented that:

“[…] Commercial banks, development banks and investment funds could boost the region’s entrepreneurial ecosystems. The region still needs to channel more private capital towards productive investment, but for this to happen, countries will need to reform legislation to foster private investment, while investors will need to change their mindsets.”

Additionally, Article 7 dictates that “one to five persons […] residents of the Republic of Panama” may constitute an LLEC. From this, it is not clear whether only the persons who constitute the LLEC are required to be residents of Panama, or whether the LLECs are reserved for Panamanian residents, meaning that there can be no foreign members in LLECs. If the latter is true, then the effort to attract foreign investors and entrepreneurs to Panama would be frustrated and would further reduce the pool of capitalist partners that may invest in LLECs. According to a 2019 Forbes’ publication, 50 of the 91 billion dollar startups in the United States of America, which have a combined value of US $ 248 billion, were founded by immigrants. Hence, if Panama seeks to become an entrepreneurship hub, closing its doors to foreign ventures that turn to other countries in the region due to the limitations imposed by the laws in their jurisdictions does not contribute towards achieving this goal.

An important aspect of a startup is that relationships between shareholders and investors are extremely complicated and ever-changing. Allowing an LLEC to be created without seeking advice of an attorney can be good from the point of view of streamlining the process, but for a startup it can result in future complications, in the event that there is friction between shareholders or investors. This is why a startup’s articles of incorporation must have clear rules on, for example, shareholder rights and sale restrictions. In the absence of these, the shareholders of a startup must execute a shareholders’ agreement, so that corporate governance rules, as well as any other aspects of the company that they wish to regulate (such as capital commitments and dilution of shareholding) are duly agreed upon. Under the Draft Law, LLECs may be constituted through the filing of a “standard statute,” a model of which will even be provided by the PanamaEmprende portal. An entrepreneur is rarely thinking about the legal consequences of incorporating a company or the rules under which that company will be governed. That’s why it is important to seek legal counsel to which the entrepreneur can explain his or her needs and concerns, so that the attorney may produce documents that meet those expectations and better manage the problems that may arise in the future.

Amongst the most common methods in which a startup raises capital to finance its operations is through the sale of its shares; so, the shareholding structure of a startup will undergo various changes throughout its life. Additionally, often the shares sold in different financing series have different rights and obligations from those owned by founding shareholders (such as preferential liquidation rights and conversion rights), which provides an additional incentive for an investor to contribute capital to the startup. Under the Draft Law, LLECs, which have a structure similar to that of limited liability companies (“LLCs”), must keep “all the information regarding changes to their structure or their administrators and/or members” up to date. Thus, information regarding the members is not private and transfers or sales of participating quotas must be recorded in the Public Registry; a process which may be cumbersome and would add an additional layer of complexity to financing rounds, a fundamental phase of any startup. Additionally, nothing in the Draft Law seems to indicate that LLECs can issue participating quotas of different classes, which means that in a financing round, only participating quotas with the same rights, obligations and restrictions as the rest of the partners could be offered to new investors (same situation as with SRLs). Encouraging private investment in startups is an essential component of the development of these businesses, and shares of different classes with, for example, preferred liquidation rights, are part of the allure of investing in a startup. The Draft Law significantly limits the chance to attract capital to the LLECs.

It is thus clear that the corporation, which is widely known to both Panamanian and foreign investors, is the preferred legal entity for a startup since it allows transfers to be made through private documents, the shareholding structure does not have to be recorded in the Public Registry and the issuance of shares of different classes is allowed.

Finally, the treatment that would be granted to LLECs in government bidding proceedings by way of Article 36 could be prone to abuse. Under said article, individuals or legal entities that participate in public bids for better value and include one or more LLECs in their proposals will enjoy “an additional score of 5%”. This preferential treatment may cause consortia to include LLECs in their bids just to get the benefit of the additional score, and not because SERL truly contributes something to the consortium. Likewise, it is not clear how this benefit is administered — that is, whether it applies to both price scoring and technical scoring, or only the latter. This confusion may result in legal challenges to bid proceedings, which would have a counterproductive effect.

It is worth mentioning that, in principle, a law that encourages entrepreneurship and the creation of companies in an easy, dynamic way and under a streamlined process is a good step in favor of the startup industry. In fact, the OECD Study mentions several of the components contained in the Draft Law as important components for the promotion of startups, such as the simplification of the incorporation procedure, the promotion of entrepreneurial culture and implementation of strategies aimed at improving entrepreneurial-related education. However, for Panama to become a true hub of innovation and startups, there are several other aspects to be considered, such as the promotion and facilitation of investment, removal of entry barriers to certain industries such as financial and retail, the introduction of new financing methods such as crowdfunding and the provision of instruments that expedite such forms of financing.  We are at your service for any queries you may on have on these matters.

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An entrepreneur has a lot to consider when starting a new business. Who will be part of the team? Who will manage the company? How will decision-making be handled? Without a doubt, from the legal standpoint, among the first questions that an entrepreneur must ask him or herself is: What type of entity should I incorporate? Although this question may seem strictly legal, the type of entity that is chosen has important consequences for the administration of the startup and for the relations between the partners and/or shareholders, among other things.

Imagine two people (hereinafter, the “Entrepreneurs”) have been developing a business idea they believe to be marketable. The Entrepreneurs are willing to invest capital and effort to develop the idea, but they are unsure about how to structure the entity under which the business will be handled. To this end, the Entrepreneurs request the advice of a lawyer to advise them on such structure.

The lawyer explains to the Entrepreneurs the importance of organizing the company as a separate legal person, given that this way the company will have its own legal personality, separate and distinct for all its acts and contracts, from that of the Entrepreneurs. If, for example, the entrepreneurs start their business without a duly organized corporation, there are circumstances under which it may be considered that  they have constituted a “de facto” partnership, which would mean that the Entrepreneurs are jointly and severally for the contracts that the partnership enters into, as well as any other obligations assumed by the partnership. That is, the Entrepreneurs could end up being personally liable for the debts incurred by the partnership, without any type of limit. The Entrepreneurs explain to the lawyer that, given the potential for rapid growth that they expect their startup will have, they wish to establish a company in which they can designate the everyday decision-making power to a limited number of people, however, the Entrepreneurs, as shareholders, want to maintain control over certain major decisions. In addition, they do not rule out that there might be some interest on the part of investors, who will want to finance the Startup’s operations through the purchase of shares in the company, as long as there is a difference between the shareholding of these new investors, and the Entrepreneurs, who would be the original founders and shareholders.

The ideal type of entity for this startup would be a Corporation (Sociedad Anónima) (hereinafter, “Startup, S.A.”). The incorporation process is simple; for the corporation to acquire its own legal personality, two or more persons, regardless of their nationality or domicile, must execute the Articles of Incorporation before a local Notary Public and record it in the Public Registry.

Hence, below are some of the characteristics that Startup, S.A. will encompass:

After incorporation of Startup, S.A., the Entrepreneurs will need to take certain steps in order to operate and protect their business, and make sure that it is attractive for future third party investments:

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In the corporate world, there is a novel type of enterprise labeled “startup,” which is known for its rapid growth, partly, because of the fact that it is highly related to the general use of information and communications technologies (ICTs) and the latest business trends. Given the rapid growth and scale that characterizes a successful startup, one of the initial considerations when launching a business of this type, and one that will significantly impact the way the company is managed, and the relationships with and between shareholders and investors, is the law under which the company is organized.

With this in mind, and as an introduction to a series of articles we will be publishing focusing on startups, we briefly summarize the reasons why organizing a startup under Panamanian law could pose benefits for its creation, capitalization, hiring of personnel, operations, financing, and eventual sale or public offering.

Before elaborating on the benefits of submitting a business to Panamanian law, it should be noted that according to the World Bank’s Doing Business 2020[1] report, Panama obtained a score of 92 out of 100 regarding the ease of starting a business, and one of 80 out of 100 on the ease of obtaining credit. The average score for Latin America and the Caribbean was 79 and 52, respectively, which positions Panama as a leading country in the region. This, coupled with the fact that its legal currency is the United States of America dollar, and the interconnectivity that it offers to the region thanks to its geographical location, positions Panama amongst the best Latin American countries to start a business in.

Once an entrepreneur has a concrete idea that he or she wants to develop and commercialize, the first step he or she must take when entering the world of startups is to incorporate its business. The main advantage of starting a business by way of a corporation is the fact that the company will have its own legal personality, separate and distinct, for all its acts and contracts, from that of its founder and shareholders.[2] It would be ill-advised for a founder to carry out her commercial activities in a personal capacity due to the implicit risks of each business, so, having a corporate structure that limits the liability of the shareholders is paramount. Undoubtedly, the most common legal vehicle in Panama is the corporation, which is regulated by Law No. 32 of 26 February 1927 (the “Corporations Law”), and details the requirements for the constitution, shareholding structure and administrative bodies, among others, of the corporation. The Corporations Law dictates that to incorporate a company, two or more persons of any nationality and domicile must execute the Articles of Incorporation before a local Notary Public; once the Articles of Incorporation have been recorded as a Public Deed and registered in the Public Registry, the corporation effectively acquires legal personality.[3] This incorporation process is relatively simple and can take between 4 – 6 business days. However, it is important to engage legal counsel, who, in compliance with the Corporations Law and the regulations over resident agents, will act as resident agent and carry out the due diligence prerequisites needed for the resident agent to act as such, and will ensure that the Articles of Incorporation contain everything that the Corporations Law requires and that the process be carried out correctly so that the law will produce all the effects and meet all the practical needs of the respective business.

It is also important to mention that there are other types of commercial entities in Panama, such as limited liability companies (“LLCs”), for example. However, for purposes of a startup, corporations are the preferred legal entity because of their flexibility in the offering of shares to the public, among other reasons. One of the most common ways in which a startup raises capital to finance its operations is through the sale of shares to investors (generally “angel investors” or “venture capital investors” will request shares in exchange for their investment). If the startup is organized as an LLC, the company’s articles of incorporation, which is a document that is recorded in the Public Registry, must be modified every time participating quotas are sold to an investor, therefore, each of these sales will need to be recorded in the Public Registry.[4] Furthermore, the members that have paid for an LLC’s participation quotas in full will have the right to vote in the deliberations of said LLC, [5] which means that LLCs may not issue participation quotas that consist, exclusively, of economic rights. Conversely, a corporation may issue or transfer its shares through private documents, and such shares may be of different classes and grant different economic and voting rights (for example, special voting rights for the class of shares issued to the startup’s founders). The latter is relevant when it comes to public offerings of shares, or even private placements targeting sophisticated investors.

Regarding taxation, Panama’s fiscal regime is governed in accordance to the Territoriality Principle which establishes that a natural or legal person is subject to the payment of income taxes only on income that is generated within Panama, that is, through operations or activities carried out within the territory.[6] Our Tax Code establishes that activities such as directing operations that are being carried outside the territory, from an office in Panama, and distributing dividends that come from income not produced within the territory, for example, do not give rise to taxable income in Panama. This means that a startup organized under Panamanian law would only pay taxes on the income that is generated by its Panamanian operations, which can represent significant savings for a company in its seed stage.

Additionally, Panama provides for series of tax incentives that could be applicable to a startup depending on its business. There are laws that exempt from paying certain taxes and grant tax credits, among other incentives, to industrial manufacturing, agro-industrial and marine resource re-purposing companies[7]; companies located within the Fundación Ciudad del Saber complex that are dedicated to research and innovation in scientific, technological, humanistic and cultural fields; [8] companies established within the Panamá-Pacifico Area;[9] companies established within Free Zones;[10] tourism companies and investors in such tourism companies;[11] multinational companies’ headquarters;[12] and micro, small and medium-sized enterprises,[13] among others. Our second article will address these in detail, so stay posted for future articles of this series.

For those startups that need to import talent from abroad, there are also immigration incentives in place, such as temporary resident permits for trusted personnel, executives, experts and / or technicians, among others. This could be advantageous for startups interested in having advisors or mentors in key positions of their startups to guide the founder in financing rounds, for example.

Having said all this, it is important that each business idea be evaluated considering the provisions of the law so that decisions are made based on the particulars of each case and the advantages that may be offered by Panamanian legislation are harnessed at their highest level. We are at your service for any questions you may have on these issues.

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[1] https://www.doingbusiness.org/content/dam/doingBusiness/country/p/panama/PAN.pdf
[2] Article 251, Commercial Code of the Republic of Panama.
[3] Article 1, Corporations Law
[4] See Law 4 of 9 January 2009.
[5] Article 3, Law 4 of 9 January 2009.
[6] Article 694, Tax Code of the Republic of Panama.
[7] Law No. 76 of 23 November 2009, as modified to this date.
[8] Law Decree No. 6 of 10 February 1998.
[9] Law 41 of 20 June 2004, as modified to this date.
[10] Law 32 of 5 April 2011.
[11] Law 80 of 8 November 2012.
[12] Law 47 of 24 August 2007, as modified to this date.
[13] Law 8 of 29 May 2000, as modified to this date.