Felipe Barreto Veiga
BVA - Barreto Veiga Advogados, São Paulo
felipe@bvalaw.com.br

George Luna Bonfim
BVA - Barreto Veiga Advogados, São Paulo
george@bvalaw.com.br

Introduction

The Brazilian venture capital (VC) market seems to be on the rise again. After the outstanding results in 2021, the number of VC transactions, as well as the amounts invested in these transactions, declined in 2022^[1], despite the excellent performance of some specific sectors such as finance, insurance, health, advertising and marketing.

Even with the initial uncertainty relating to the local political scene in 2023, which is currently being adjusted, VC in Brazil has finally reached a consolidated investment practice, especially due to the following characteristics, among others, that offer great opportunities for VC investments: a consolidated economic structure; a huge and still undeveloped internal consumer market, to be explored in regions beyond the São Paulo–Rio de Janeiro axis; the innovative culture of local entrepreneurs that are used to facing adversities in a very creative way; the high number of alternatives for startup investments; and the increase in the number of investors, with a special emphasis on corporate venture capital funds (CVCs), that seeks to carry out investments in Brazil.

In addition to the characteristics described above, some initiatives by the public authorities have reinforced the importance of the Brazilian VC market. The recent changes brought about by Complementary Law No 82/2021 (the ‘Startup Legal Framework’) have reduced the bureaucracy in the previous legal structure in several instances, including regarding the conditions that were hindering the proper development of startups, especially considering the special tax regimes that may be available to them.

The Startup Legal Framework

One of the main issues addressed by the Startup Legal Framework was the limitation to investor liability of investments that do not directly affect the equity ownership of the company, except in cases involving fraud or the wilful misconduct of the investor. The Startup Legal Framework offers more certainty on the obligations that could arise from the startup (labour, tax and consumer relations matters, for instance). Due to the outcome of such a legal provision, several instruments used in the VC environment were affected and had to be adjusted in order to reflect the terms and conditions of the Startup Legal Framework, such as convertible loan agreements, debentures, call options and the simple agreement for future equity (SAFE).

The updates to the Startup Legal Framework brought more flexibility for companies incorporated as a Brazilian joint-stock company (sociedades anônimas), regulated by Law No 6.404/1976 (the ‘Brazilian Corporation Law’), provided that they meet certain financial requirements, such as a limit on their annual income, which represent a relevant reduction in the bureaucratic aspects of the rules, especially concerning: the incorporation process; the reduction of officers and board members; the possibility of having digital corporate books instead of the regular books; and release from the obligation to publish several corporate documents.

The new CVM regulations

Another important step towards the growth of VC activity in Brazil was reflected in the new regulations enacted by the Brazilian Securities and Exchange Commission (Comissão de Valores Mobiliários or CVM), with a special mention for CVM Resolution No 88/2022, which has updated the public offerings for certain companies through equity crowdfunding using an electronic platform approved by the CVM. Among the well-received changes introduced by the new regulations are: the increase in the limit for fundraising to BRL 15m; the new threshold for companies that are eligible to perform their investment through equity crowdfunding, which is now capped at BRL 40m of gross revenue per year; the improved marketing and advertising procedures for public offerings, including the possibility to use companies and influencers in their strategies; and the establishment of a secondary market for invested securities, allowing investors to perform transactions using an electronic platform.

However, all the above efforts will need to be considered in connection with the evolution of the VC practice itself, which has constantly changed over the years, especially regarding asset allocation, strategy and negotiation during fundraising and company perpetuation in the long term.

The evolution of VC

Regarding the asset allocation perspective, players in the VC sector are realising that companies are staying private for longer, relying on VC or private equity entities to fund their activities, in a transaction that seeks to offer to all shareholders of such companies more certainty in their investment and in the development of the business for a future transaction in the private market, in spite of the bigger wages from a successful initial public offering (IPO) in Brazil or abroad.^[2]

The strategies related to the negotiation and selection of the right startup involve a clear understanding of the risks and opportunities that a VC transaction offers, which may be completely different from an investment through M&A transactions. This may seem obvious at a first glance, but since the sharp increase in VC investors in the Brazilian market, it is possible to identify that some players did not do their homework very well, mainly CVCs.

Since a great number of corporations have perceived the benefits from investing in startups at the beginning of their journey, considering the synergies of the products or services developed by the startup inside their own business and the possibility of paying a purchase price for a company that could have, in a few years, a valuation of ten to 20 times the initial amount invested, those corporations have decided to incorporate their own CVCs in order to allow them to enter into the ‘VC membership’s club’.

However, on several occasions, the methodology of these CVCs used to conduct the negotiation is not aligned with the VC timeframe, usually concluded within 60 to 90 days, mainly when such CVCs are considering investing in a new startup, which is in the initial fundraising rounds.

Instead, the managers of the CVC handle the VC deal like a classic M&A transaction, with extensive due diligence, requests for heavy conditions to protect them from possible liabilities and losses, or a detailed discussion of the transaction documents, lasting between six and nine months in order to close the deal. This happens mainly due to the experience of the executive team conducting the VC transaction (which is more used to working on M&A transactions) or simply due to a lack of knowledge of VC transactions. The recommendation here is to hire staff with the relevant experience of VC deals and to accommodate the expectations of both the shareholders and top-tier executives (board of directors, officers, etc) responsible for the CVC or its controlling entity, highlighting the pros and cons of this type of transaction.

The last matter that deserves some attention is the alignment of the expectations on what kind of business the founders and executives of the startup wish to create. During the last ten years, the main drive for entrepreneurs investing in VC transactions was turning their startups into successful $1bn unicorns, regardless of the costs involved. The pursuit of this dream, most of the time, involved extensive cash burn from the company's investors and aggressive, turbulent and unsustainable growth.

This strategy proved to be a disaster for several companies (even considering the appearance of some unicorns), with massive layoffs, the closing of local operations (subsidiaries) or a lack of money for the startup’s own working capital, demonstrating how bad this strategy was, at the end of the day.

As a response to the fabled unicorn, in more recent years, the market has discovered camel startups^[3]: companies that are capable of surviving the most adverse conditions, have a very controlled cash consumption rate, can change their management course to keep their sustainability commitments, and due to these and other strategies, are capable of perpetuating their activities for a much longer period of time. Camel startups currently represent a reality not only in companies abroad but also in Brazil.^[4]

Conclusion

Founders are now capable of selecting what kind of company they want to incorporate, and as a result of that, are seeking to attract a VC investor more aligned with their philosophy and business thesis. While the unicorn startup may present a faster way of reaching impressive results and may reflect an outstanding valuation for their business, it may not survive the market turbulence that may reduce its valuation to dust. The camel startup, on the other hand, may represent a business more focused on sustainable and modular growth, without the sacrifice of equity, cash or both, even if it takes a longer time to reach the oasis in the desert.

From all information discussed herein, it is possible to consider that the Brazilian VC ecosystem in 2023 may offer very interesting business opportunities for all players that are seeking to develop their own businesses and/or invest in startups that focus on innovation and wish to develop their activities in several places in Brazil. The thriving aspect of the Brazilian internal market has the capability to allow great business growth, notwithstanding the problems and obstacles that are usually present in the internal market. A clear understanding of the investment purpose to be performed (and the time for its return), the strategy to be followed during the negotiation process and the kind of company that is being incorporated are some of the most relevant factors that should be envisioned to set all the expectations on the same path.

Additional sources:

www.bloomberglinea.com/english/venture-capital-investment-in-latin-america-continues-to-decline/ (accessed 3 April 2023) 

https://hbr.org/2022/07/is-corporate-venture-capital-right-for-your-startup (accessed 3 April 2023)