Deep Dive: Moldova's SRL (Limited Liability Company) Reform
July 10, 2023
Today we’re going to take a Deep Dive into the Ministry of Economy’s proposed reform of Moldova’s Limited Liability Company structure called an SRL. Back in 2021 we wrote a series of articles looking at Moldova’s business structures and why they have serious challenges. These article were previously closed for subscribers only but are now open to all. They are not required reading for this Deep Dive but provide extra context for those interested:
Explainer: The Moldovan Stock Market: How Does (or Doesn’t) it Work? An article explaining Moldova’s public markets and public company structures.
Explainer: Limited Liability Companies and Offshore: How do SRL's work? and are offshore companies good or bad?
Also as a disclaimer, the Moldova Small Enterprise Alliance, where I serve as board president, has been a vocal proponent of many of the reforms discussed in this article.
SRL Reform Moves to the Government
This week the Ministry of Economy’s proposed reforms to the structures of Moldovan Limited Liability Companies is being considered in the government. If it is passed by the various ministries it will move to the parliament for their consideration. Parliament leaves for recess in late July so most likely it will be considered by them in autumn. Work on this reform has been ongoing for many months led by a working group within the Ministry of Economy and supported but companies and business associations such as AIM, AMCHAM, EBA, FIA and many others.
To understand this reform, and the potential impact that it can have we need to dig into the LLC / SRL construct.
What is a Limited Liability Company?
Wyoming was the first US State to create a structure for LLCs in the late 1970s. The basic idea is the creation of a business form that sits between a Partnership and a Corporation. LLCs are flexible business structures that protect their investors (called “members”) from personal liability and require much less paperwork than a corporation. LLCs quickly caught on in the US and are now the primary structure for businesses there. Following this boom and the success of the structure which allows investors to easily manage companies and take some financial risks, many countries around the world copied or adapted LLC laws to their jurisdictions (including Moldova). For our purposes, here are some key aspects of LLC in the US:
Limited Liability - Members of LLCs are not liable for company debts should the company become insolvent.
Operating Rules - Companies are free to form their own rules by creating “Operating Agreements.” If a company does not create one many states have “default” rules on company management which are in force unless superseded by a company operating agreement.
Shareholder Management - Companies can flexibly organize shareholders by creating stock (called “units”). Based on the company’s operating agreement units can be voting, non-voting, or have various dividend arrangements. Operating agreements can clearly stipulate how new investors enter the company, or how people leave it.
Flexible Dividend Assignments - Through the operating agreement companies can decide how they pay dividends. For example, an investor could be granted preferential dividend payments in exchange for some kind of investment or other arrangement. This means that as long as companies follow their own rules they don’t need to pay profits out strictly based on ownership percent.
Pass Through Taxes - LLC’s have multiple options on how to be taxed but tend to default to a “pass through” structure. This means that the company itself does not pay taxes on profits but passes a profit or loss to individual members who each pay taxes according to their own tax situation.
While this is only a short list of many aspects of how LLC’s work we will focus here because none of these factors applies in Moldova. Let’s go line by line:
Limited Liability - Members of Moldovan SRLs are personally liable for the company’s debts with little to no protection.
Operating Rules - Moldova has a “default” set of operating rules that companies can *technically* change but, in the case of small companies, rarely do. This is because each change must be pre-approved in a very bureaucratic process. This contrasts with US LLC operating agreements which are internal documents and not negotiated with the state.
Shareholder Management - SRL shareholders are largely fixed at the moment of the company’s founding. We go into this in much more detail in our past Explainer article. Put simply, SRLs are well suited to small family companies with 2-3 shareholders. The structure cannot easily be used for multiple fundraising rounds or bringing new equity into an existing business.
Flexible Dividend Assignments - SRLs must distribute profits according to the ownership percentage of each member.
Pass Through Taxes - SRLs are taxed as companies and do not pass through taxes to members. This results in higher paperwork burdens for the companies.
Put simply, Moldova SRLs are inflexible, have cumbersome paperwork and tax requirements and do not protect investors liability.
Why is this a Problem?
Most business owners from outside Moldova will look at the list of above facts and see a lot of red flags. Firstly, the threat of personal liability is a major inhibitor of the risk taking that is inherent in starting any business. Further than that, there are almost no companies of any real size that can exist without having a shareholder management mechanism. New investment is needed to grow and companies need mechanisms to manage these processes and protect themselves. The lack of these protections, as well as other factors that we’ll discuss below, have led to a situation where lots of companies in Moldova are “offshored” aka registered in foreign jurisdictions as holding companies that can benefit from LLC benefits. This holding company will then own a Moldovan SRL.
Let’s take a simple example. For some tech startup like Google in the 90s, or a new app, you might have a few friends start a company in their home or garage. As their product gets traction and they need to scale they can easily bring in new investors to their LLC in multiple fundraising rounds by diluting their ownership. Eventually, if the company is successful they might even go public. US laws around LLCs provide a fairly smooth path for companies that start small and scale.
In Moldova this isn’t possible. New investors can’t be brought into an LLC simply (or at all), there is no share dilution mechanism and there is no functioning public company market. Many of the legal tools needed for a successful tech startup simply aren’t here.
At this point it’s worth noting that Moldova passed a major IT reform law a few years ago that gives highly preferential tax treatment for IT companies. These companies pay a flat 7% tax on revenue and are not required to pay the standard ~38% salary taxes. This was seen as a good compromise to bring IT companies out of the shadow economy and the result has been highly impactful. Moldova’s IT sector has grown massively with both local companies and international companies such as Endava, Mixbook and Crunchyroll operating offices in Moldova.
At the same time, most Moldovan tech companies, including companies with 100% local ownership, are offshored for 3 main reasons:
SRL’s inflexible ownership structure means they cannot bring in new equity fundraising after they are founded.
IT companies tend to work online… and Moldova has no real online payments infrastructure outside of wire transfers. So in Moldova when you pay a taxi with your debit card… it is charged in Amsterdam. When you rent a scooter from Bolt, you’re charged in Estonia. And when you buy McDonald’s delivery with Glovo you are charged in Spain.
Too much paper. Receipts must be on paper, company documents need to be on paper. If a company operating in Chisinau is selling tech services to Australia it’s pretty crazy to have to send them a paper receipt.
Ok, so because companies are offshored and conduct their invoicing and shareholder management there it means that even 100% local companies are not paying taxes or even keeping most of their money here. Companies send enough money back to Moldova for salaries and office expenses - meaning that the 7% tax on “revenue” is really a 7% tax on salaries and rent. If Moldova ever had it’s own Google there is zero chance that the country would economically benefit from such a local champion outside of salary taxes.
Now, some people might say that in a global economy Moldova’s “Google” would never stay in Moldova anyhow. That might be right, even given the fact that 7% on revenue is a pretty good deal, but it’s not the point. The same issues faced by IT companies are faced by all companies including farms, restaurants and manufacturers. Without functioning shareholder management rules it is very hard to do any kind of business outside of a mom and pop mini-market.
So this is a real problem, not just for companies who find it really hard to operate but for the state that is losing tax income simply because they have an antiquated set of laws.
The Ministry of Economy’s Reform Proposal
The reform proposed by the Ministry of Economy has been formulated to address some, but not all, of the problems listed above. The proposal also has additional innovative ideas that go beyond what is simply broken and seek to modernize Moldova’s business structure. Here are some key elements of the proposed reform:
Flexible Operating Agreements - Companies will have much greater flexibility and a simplified process to organize their own operating rules (called a “Statute” in Moldova). This will still be registered and checked by the state but the ability to create more complicated company structures will be added.
Flexible shareholder management - Flowing from the simplification and flexibility of the “Statute,” companies will be able to add multiple classes of shares, designate shareholder rights more flexibly and have the ability to more easily bring in new investors by means of share dilution and reassignment.
Flexible dividend arrangements - Companies will be able to allocate dividends by company decision or from the “Statute” outside of the restriction of direct ownership percentages.
Phantom Stock / Dividends - Companies will be able to access a new tool for employee profit sharing called “Phantom Stock.” In this arrangement key employees can be allocated a share of company profits and paid in dividends even if they do not own shares in the company or participate in its decision making.
Taken together these reforms will make it much more possible for Moldovan SRLs to grow and restructure through equity investment arrangements with shareholders. The Phantom Stock arrangement also provides companies better tools to compensate and motivate key workers that were not possible before. Since Moldova does not have functioning public companies or “stock options” for employees this structure will bring some of those features into SRLs.
At the same time, there’s more to be done. Most critically this reform does not add or clarify any limited liability for investors in a company. Personal liability is deeply ingrained in banking and lending processes in Moldova and even though “Limited Liability” has been shown to be a key driver of growth in developed economies the Ministry has chosen not to pursue this reform now. So, effectively the “Limited Liability” in Moldova’s “Limited Liability Company” is still an empty set of words.
Conclusions
While this might seem kinda wonky we wanted to draw attention to these reforms because of the broader lesson that it has about the Moldovan economy. There are major structural issues that prevent Moldova from achieving serious growth and participating in the global economy. The government is working on many of them right now, for example we mentioned online / digital payments above. Some Moldovan banks and non-bank financial institutions are now rolling out products that allow you to transact business online in Moldova. This is due to changes in regulation, including from the National Bank, which are allowing some movement in this space. Still, it’s only the beginning and Moldova has a long way to go on digital payments.
For many years successive governments have been unwilling or unable to implement sweeping economic reforms to what remains a legacy Soviet regulatory system. Now, with a reformist government in place and hopes of joining the EU more real than ever, there is a major race to catch up. There are lots of reasons, some good, some bad, that this process is going slowly. But examples of reforms like this show that it is possible to make fundamental changes to parts of the economy in the hopes of unlocking future growth.
We’ll follow this reform’s progress and write more as it works its way to parliament.