Venture Capital 2024 Comparisons

After the venture capital (VC) market hype in 2000 and 2001, start-ups faced what some called the “winter of start-ups” in 2022 and mid-to-late 2023. A survey commissioned by Valor and conducted by Sling Hub (a data intelligence platform for the sector) revealed a 39% decrease in investments in the Brazilian VC market in 2023.

However, it is fair to say that the VC landscape in Brazil entered a period of consolidation in 2023, and is once again proving to be both resilient and an important driver of innovation and economic growth in the Brazilian economy, amidst a continued global market downturn.

According to data released by the Association for Private Capital Investment in Latin America (LAVCA), investors deployed USD4 billion across 770 transactions in Latin America, with USD 1,764 billion being directed at 325 Brazilian start-ups.

VC rounds in early-stage start-ups continued to represent most VC-related transactions. A report issued by innovation platform Distrito states that 74.2% of VC investments in Latin America were made in seed-stage rounds.

Valuations were still subject to a large gap in terms of expectations between founders and investors, since peaking in 2021.

Due to the increase of interest rates (encouraged by the Brazilian government to contain inflation) and global macroeconomic uncertainties, VC investors have become increasingly selective regarding their participation in (and deployment of) new capital in high-risk ventures.

Wealth managers, endowment funds, pension funds and development financial institutions that used to allocate funds in the VC industry understood that they needed to refrain from investing in alternative high-risk classes until their allocation in liquid assets regained the expected relevance in their portfolios, and rebalanced their allocations.

VC funds understood that their own fundraising would be challenging, and wisely spared more dry powder for follow-on rounds regarding their best-performing portfolio companies.

As a consequence, investors started to prioritise start-ups that showed the ability to preserve cash and to break even, as opposed to those that continued pursuing the familiar path of burning cash, aiming for fast growth and scaling.

According to a LAVCA report, the fintech industry has continued to reign supreme in Latin America, with fintech start-ups attracting 46% of VC dollars in 2023. This represents more than the next nine verticals combined (ie, proptech, logistics tech, e-commerce, HRtech, legaltech, healthtech, CRM/sales management, transportation/mobility and cleantech).

Fintech start-ups led in terms of number of VC rounds as well as in volume of investments.

As regards a trending topic for 2024, artificial intelligence (AI), and other related cutting-edge technologies that will integrate AI into business in general, will change how start-ups do business and develop. Mergers and acquisitions (M&A) and acquihires in the SaaS universe will become even more frequent as a means for driving hyperbundling, such that companies can:

• acquire complementary technologies;
• expand their customer and talent bases; and
• consolidate their market positions.

On the investors’ side, according to a Global Corporate Venturing report, most corporate VC units in Brazil were set up in the past three years; the funds are still relatively small, but corporate VC is already playing an outsized role in the Brazilian start-up economy. Some 59% of all start-up funding rounds in the country have included money from corporate investors.

Many players are involved in a typical VC funding structure, including (among others):

• institutional private equity funds on early stage, growth stage and late stage modalities;
• single LP funds with corporations as limited partners (also called corporate venture capitals);
• development fund investors (DFIs);
• angel investors;
• accelerators and incubators; and
• development agencies.

Private equity funds (fundos de investimento em participação – FIPs) are the most widely used types of investors and the main providers of funding to start-ups in the VC industry.

FIPs are mainly governed by their related regulation (regulamento) registered at Brazil’s Securities and Exchange Commission (CVM) – such regulation forms the equivalent of a corporation’s by-laws, containing the rights and obligations of the fund, decision-making processes and restrictions.

There are two key and mandatory service providers for FIPs: the administrator and the manager. The administrator is responsible for the legal representation of the fund and for all back-office activities (such as treasury and controller activities, bookkeeping, and compliance with legal requirements and internal policies). The fund manager has the essential roles of defining the fund’s strategy, deciding on and monitoring investments, and determining divestments (supported or not by the investment committee).

The regulation also requires auditing by independent auditing firms, and the disclosure of relevant information.

Participation of Fund Principals in the Economics of the VC Fund

Fund initiators, managers or principals can participate in the economics of VC funds in several ways.

Fund principals are mainly remunerated by management fees and performance fees. In VC, these fees are usually established in the “2 with 20” format, an expression that summarises the practice of charging 2% per year (calculated on the fund’s capital) as administration and management fees, and 20% of the profitability earned by the fund’s investors as a performance fee or carry.

Management fee

This fee is typically calculated as a percentage of the capital commitments or the assets under management (AUM), paid to the fund principals for their role in managing the fund’s investments. The standard rate is around 2% per annum, though this can vary depending on the size of the fund and the reputation of the management team.

Performance fee

Also known as “carry”, this is the share of the profits that the fund principals receive from the investments made by the fund, serving as a performance incentive. The standard “20% carry” is common, meaning that the fund principals receive 20% of the fund’s profits after returning the original capital, and sometimes a preferred return to the investors.

Other key terms developed as market practice include the following.

Co-Investment Opportunities

Fund principals, and sometimes employees, of the management company may have the opportunity to invest their own money alongside the fund in specific deals. This aligns their interests with those of the limited partners (LPs) by their having personal stakes in the success of the investments.

Hurdle Rate or Preferred Return

This is a minimum rate of return (typically between 6% and 8%, corrected by inflation) that the fund must achieve before the fund principals can receive their carried interest. It is an investor protection mechanism ensuring that LPs receive an acceptable return on their investment before the fund principals can share in the profits.

Claw-Back Provision

This ensures that, if the fund does not overall achieve a certain level of performance, any carried interest paid to the fund principals must be returned. This protects investors from overpaying the fund principals during the life of the fund if early exits provide temporarily high returns that are not sustained.

General Partner (GP) Commitment

Fund principals are often required to invest their own capital into the fund, typically 1% to 3% of the total fund size. This “skin in the game” aligns their interests closely with those of the LPs.

Governance and Voting Rights

These often include provisions about the governance of the fund, specifying the rights of the LPs to have a say in major decisions.

Key-Person Clauses

These clauses are triggered if certain key individuals (usually senior fund principals) are no longer actively involved in managing the fund. This can lead to a halt in new investments or even winding-down of the fund if replacements are not suitable.

Transparency and Reporting Requirements

Regular, detailed reporting on the performance of the fund, the status of investments and the management fee calculations are required to maintain transparency. This includes annual audits and frequent performance reports.

The forgoing mechanisms and terms have been developed to ensure that fund principals are motivated and incentivised towards good performance, while providing investor protection and governance in the VC ecosystem. It is important to note that the specifics can vary based on the fund’s structure, strategy and the regulatory environment in which it operates.

Investment funds in Brazil are classified as condominiums according to the Brazilian Civil Code, and are regulated by Resolution No 175 of the CVM, enacted on 23 December 2022. FIPs, in particular, are regulated by Annex IV of said CVM Resolution 175/2022.

It is very common for VC investment funds to be categorised in accordance with the adopted investment strategy (ie, early-stage, growth, late-stage, series A, series B, impact investments and others).

Although many funds are agnostic in terms of industry, some industry-focused funds exist, including for fintech, agritech, cleantech and healthtech.

Due diligence is an essential element in the process of completing an investment or acquisition.

Start-ups at initial stages of start-up development are usually subject to fast and less-complex due diligence proceedings, since they tend to have few years of existence and thus fewer clients or contractual obligations. Due diligence of early-stage start-ups is focused on corporate aspects – ie:

• to analyse the holders of the company’s share capital (on a fully diluted basis), as well as intellectual property and regulatory aspects; and
• to ascertain whether the start-up has the necessary assets and licences for the development of its business, as well as the legal certificates confirming it is involved in administrative or judicial proceedings, and the corresponding risk assessment.

For start-ups at more advanced stages of company development, due diligence is deeper and more complex, covering financial and accounting aspects in addition to full legal due diligence, so that investors can identify contingencies (potential or materialised) and whether any mitigation measures can be adopted to address such issues.

Investment Process and Timing

The timeline for a new financing round in a growth company involving new anchor investors can vary significantly based on several factors, including:

• the complexity of negotiations;
• due diligence requirements;
• the current financial condition of the company; and
• the level of interest among potential investors.

The following is an outline of a typical fundraising process.

• Preparation phase: this includes getting the company’s financials and corporate structure in order, preparing pitch decks, and potentially hiring/working with advisers.
• Initial discussions: the company begins to approach potential new investors (anchor investors) and re-engages existing investors to gauge interest.
• Term sheet: this involves negotiation and outlining the key terms of the investment.
• Due diligence: this begins concurrently with or following the execution of the term sheet. New investors will scrutinise the company’s financial, business model, market potential, legal, compliance and other critical aspects.
• Legal documentation and final closing: after agreeing on a term sheet and satisfactory due diligence by the investor, legal documents are drafted, negotiated and executed.

Overall, for a priced equity round, a typical timeline to close is three to six months. For a convertible instrument, this could be as little as one to three months.

Relationships Between Various Parties

Existing versus new investors

Existing investors may have different interests compared to new investors, particularly regarding valuation, dilution and the strategic direction of the company. Existing investors typically want to protect their stake and to ensure continued influence, while new investors may push for terms that favour their new injection of capital.

New investors might also negotiate for preferential terms such as liquidation preferences or anti-dilution protections, which can lead to conflicts with existing shareholders.

Joint versus separate counsel

Often, each party or group of parties with aligned interests usually has separate legal counsel to ensure their interests are fully represented. However, in some cases, particularly in smaller rounds or when parties have pre-existing alignments, joint counsel may be used. A group of investors may also share the same legal counsel.

Majority requirements versus consent of all existing investors

The most common form of investor consent is majority approval, especially for key decisions such as additional equity issuance or other matters with dilution consequences. However, in some cases, protective provisions for a specific investor or group of investors are negotiated.

In early-stage financings in Brazil, convertible debt instruments are much more common than equity issuances.

Convertible Debt

The most widely used debt instruments in the Brazilian VC industry are convertible loans and convertible debentures. The loan agreement or debenture deed will establish the obligation of the start-up to pay the debt on the maturity date, with the option (or obligation) for the investor to contribute its credit into the startup’s share capital, subject to certain future events and as contractually established.

Such instruments are widely used for three main reasons:

• for the investor to avoid potential liability for the debts of the company – although shareholders are generally subject to limitation of liability and separation of assets of the company, cases where the shareholders are held liable for the company’s debts are common;
• as a creditor of the company, the investor will have a more senior-rank position than the shareholders for receiving liquidation assets of the company, in the event of bankruptcy; and
• early-stage start-ups are still poorly structured in terms of financial and operating metrics as regards using traditional valuation methods to enable calculation of equity interest.

Please note that the investor’s ultimate goal is to have the debt instrument converted into equity, typically preferred stock, under certain conditions (such as a subsequent financing round – often a Series A round), provided the start-up is progressing satisfactorily and moving forward on its journey. It is very unlikely that a successful start-up will repay the loan to the investor, as if it were a traditional lender.

The key features of a debt instrument include:

• conversion discount – provides a discount on the price per share when the loan/note converts in the next financing round;
• valuation cap – sets a maximum company valuation at which the loan/note will convert, protecting investors from too much dilution;
• interest rate – accrues until conversion;
• maturity date – specifies when the loan/note must be repaid or converted; and
• main rights of the investor after the conversion, such as protection against dilution, liquidity rights and protective provisions.

Simple Agreement for Future Equity (SAFE)

The SAFE is a contract model designed and popularised by the US accelerator Y Combinator (YC) for early-stage investments. It is widely used in the USA and for start-ups’ investment deals structured offshore (usually through Cayman Islands and Delaware entities).

SAFEs do not have the nature of debt, which means that the investment must necessarily be converted into equity interest (upon the occurrence of a liquidity event) or cancelled (in which case the investment is written off). A SAFE has a standard model, which reduces the need to negotiate the terms of the investment and, consequently, the transaction costs.

Choosing the right instrument involves considering current valuation, expected future financing needs and the strategic goals of the company.

Note that Complementary Law Bill No 252/2023 is currently being debated and voted on at the National Congress, which would create a new contractual form for VC investments in Brazil similar to the SAFE, called the Convertible Capital Investment Agreement (CICC).

Deal Documents

In a growth company’s financing round, several key documents are typically required to successfully negotiate and close the deal. The exact nature of these documents can vary depending on the jurisdiction, the structure of the financing (eg, equity versus debt) and the stage of the company. However, certain documents are almost always part of such transactions, as follows.

Term sheet

This is a non-binding document outlining the key terms and conditions of the investment. It serves as the basis for drafting detailed and definitive legal documents.

Investment agreement (subscription agreement or stock purchase agreement)

In an equity financing round, this binding and definitive agreement details the terms under which the securities are issued to the investor, including:

• the purchase price;
• representations and warranties of the company;
• conditions for closing; and
• covenants of the parties involved.

Shareholders’ agreement (or investors’ rights agreement)

This agreement outlines the rights and obligations of the shareholders post-investment, including:

• governance provisions;
• rights of first refusal;
• drag-along and tag-along rights;
• voting rights; and
• information rights.

Amended and restated articles of incorporation (or memorandum and articles of association)

When the company is structured offshore and the financing deal is made at the Cayman company level, the transaction documents would include amendment to the company’s articles of incorporation, to reflect the new capital structure and any rights or preferences attached to the newly issued shares.

Disclosure schedule

This document complements the investment agreement by disclosing exceptions to the representations and warranties made by the company and the founders in the stock purchase agreement. It is critical for risk allocation between the parties based on due diligence findings.

Frequently used templates

No standard templates are used in deals conducted mainly in Brazil. In other jurisdictions with a more developed start-up and VC ecosystem, certain organisations or legal entities have provided standardised templates for streamlining financing rounds, such as:

• Y Combinator’s SAFE;
• National Venture Capital Association (NVCA) models widely used in the USA;
• British Venture Capital Association (BVCA) models for VC and private equity transactions in the UK; and
• Australian Investment Council (AIC) models.

In VC financing, investors often negotiate for specific terms to protect their investment in “downside scenarios”, such as the winding-up of the company. Such terms include the following.

Liquidation Preference

This is perhaps the most critical term for protecting VC investors in a downside scenario. Liquidation preference ensures that VC investors are paid out before common shareholders (including founders and employees) in the event of a liquidation, sale or dissolution of the company.

Sometimes, this is structured as a multiple of the original investment (eg, 1x, 2x). Liquidation preference provisions can also include participation rights, in which case investors have the ability to not only recover their initial investment but also to participate in the distribution of the remaining assets alongside common shareholders.

Down-Round Anti-dilution Provisions

Anti-dilution provisions protect investors from equity dilution in the event that new shares are issued at a lower price than the price per share paid by the investor. There are typically two forms, as follows.

• Full ratchet anti-dilution: this form of anti-dilution adjusts the conversion rate of preferred stock to the price at which new shares are issued, regardless of the amount of new capital raised. This is quite protective for investors but can be very punitive for existing shareholders.
• Weighted average anti-dilution: more common than “full ratchet”, this method uses a formula to adjust the conversion price based on the number of new shares issued and on the price at which they are sold at each financing round and share price. It is generally seen as more equitable than the full ratchet method.

Pre-emption or Subscription Rights

Pre-emption rights, also known as rights of first refusal, allow existing investors to maintain their percentage whenever new shares are issued. This is crucial for investors wishing to avoid dilution in subsequent financing rounds. The terms specify how investors can participate in future rounds, typically requiring them to act within a certain timeframe when new shares are offered.

Protective Provisions and Governance

VC investors often negotiate for specific rights that allow them to exercise significant influence over the management and corporate affairs of the companies they invest in.

Effective governance rights for investors help ensure that the company is managed in a way that aligns with its long-term strategic goals, and that protects the interests of all shareholders, aiming at profitability or a successful exit. The challenge lies in establishing governance rules that are compatible with each stage of the start-up’s development. More robust governance is secured when the company is structured as a corporation (rather than as a limited liability quota company). For this reason, VCs normally require start-ups to be transformed into corporations prior to the conversion or equity investment.

Board of Directors

Significant influence is generally obtained by the investor (or group of investors) having the right to appoint one or more members to occupy a minority of the seats on the board of directors. It is important to note that VC investments usually involve minority stakeholding in the share capital, in such a way that the objective is not to take control of the company’s management. The majority of the seats on the board remain occupied by the founders. It is also common to see investors appointing people to act as “observers” of the board. Such investors generally do not have a relevant stake in appointing an effective member, but still wish to appoint a representative (without voting rights) to follow the board meetings.

Protective Provisions

These provisions typically require that the investor’s consent is needed for certain actions (veto rights), such as: 

• changes to the rights attached to the investor’s preferred shares;
• changes to the company’s charter or by-laws;
• issuance of new shares or new classes of shares; and
• the company’s undertaking significant indebtedness and entry into new business areas, or discontinuation of significant operations.

Information Rights

VC investors are often entitled to regular, detailed financial and operational reports from the company. These rights can include quarterly and annual financial statements, budgets and audit reports.

Right of First Offer/First Refusal/Pro Rata

Such rights enable investors to participate in future funding rounds, to maintain or increase (super pro rata) their equity position.

Representations and Warranties

The company and the founders provide representations and warranties in the investment agreement, making a series of statements in favour of the investor regarding the start-up and its business, in order to provide the investor with a “picture” of the start-up’s situation at the time of the investment. Typical representations and warranties provided in relation to the company include the following:

• organisation and good standing – attesting that the company is organised, validly existing and in good standing under the laws of its jurisdiction;
• authorisation – attesting that all corporate actions required for the authorisation, execution and delivery of the investment agreements have been taken;
• use of proceeds – the company agrees to use the proceeds of the investment as stipulated in the agreement;
• financial statements – attesting that the financial statements provided are true and complete and fairly represent the financial condition of the company;
• compliance with laws – attesting that the company is in compliance with all applicable laws and regulations;
• intellectual property – attesting that the company owns or has the right to use all intellectual property necessary for its business, free of liens or encumbrances;
• litigation – information confirming that there is no litigation pending or threatened that could materially affect the company and/or the investment; and
• labour and tax compliance – confirming that the start-up is in good standing from a labour and tax point of view.

The content of the statements varies in each case, depending on the characteristics of the start-up and on the result of the due diligence carried out by the investor.

Indemnification

In the case of breach of any representations, warranties, covenants or undertakings, the recourses available to the investor typically include the following:

• indemnification – the defaulting party may be required to indemnify the indemnified party for losses resulting from the breach;
• right to cure – some agreements may allow the breaching party a certain period to rectify the breach before further legal actions can be taken;
• termination of the agreement – for severe breaches, the non-breaching party may have the right to terminate the agreement; and
• specific performance or injunction – in cases where monetary compensation is inadequate, a court order may be sought to compel the breaching party to perform its obligations or to refrain from certain actions.

Several types of incentives or programmes are provided by the government, to incentivise the development of start-ups and entrepreneurship in Brazil, including:

• differentiated tax regimes (simples nacional, a tax regime devised to simplify computation and compliance for small entrepreneurs);
• tax incentives for certain research and development activities;
• tax incentives focused on specific industries or regions of Brazil; and
• initiatives of national or regional development agencies and entities, such as the creation of Criatec’s investment funds by the Brazilian National Development Fund (BNDES), effectively deploying capital in the VC environment.

It is also worth mentioning the 2021 New Legal Framework for Start-ups (Marco Legal das Start-ups), which presents various measures for stimulating the creation of innovative companies and establishes incentives for investments through the improvement of the business environment in Brazil.

These initiatives aim to:

• create a favourable environment for the emergence and growth of start-ups;
• improve the competitiveness and innovation rates of companies;
• increase the number of enterprises;
• promote income and employment generation; and
• expand the supply of innovative goods and services in Brazil.

Many state governments also support or fund start-up accelerators and incubators, which provide equity financing, mentoring and resources in exchange for a small equity stake.

No specific tax treatment applies for growth, start-up or VC fund portfolio companies in Brazil. They are treated just like any other company, and the tax rules applicable to such company will vary according to the type of tax regime chosen: real profit, deemed profit or “SIMPLES”.

Companies opting for real profit can deduct necessary and usual expenses of their operating activity from the tax basis of their corporate income tax and social contribution on net profit. In addition, companies that invest in technological innovation can fill out their tax deduction basis by investing in technology development and technological innovation projects. This was established by Law No 11,1196 of 2005, known as the “Good Law” (Lei do Bem).

No major initiatives specifically designed to increase the level of equity financing activity in the VC industry are conducted by the Brazilian government, though there are many programmes of lower relevance.

Employment Incentives

Securing the long-term commitment of founders and key employees is crucial for the stability and success of a start-up. This commitment is typically achieved through a combination of contractual agreements, equity incentives and cultural strategies designed to align the interests of the founders with those of the key employees, and with the growth and goals of the company – thus creating a sense of ownership for such individuals.

Equity incentives

Usually, a primary tool for ensuring the long-term commitment of founders and key employees is through long-term incentives and equity-based compensation, which focus on the appreciation of the value of the company’s shares over time.

Cultural and non-financial incentives

Developing a strong company culture and providing a positive work environment are also vital. Measures aligned with those objectives include:

• development of growth opportunities for professionals, and training and educational programmes that help individuals advance their careers within the company;
• regular acknowledgment of employees’ hard work and achievements; and
• work-life balance, through initiatives that offer flexible working conditions, wellness programmes and family-friendly policies.

Exit opportunities

Clearly defined exit strategies for founders and key employees can also play a role in their commitment. These might include lucrative buy-out options or favourable terms upon the sale of the company.

By combining these strategies, ventures can effectively motivate founders and key employees towards dedicating themselves to the company’s mission and objectives over the long term, minimising turnover and maintaining continuity in leadership and expertise.

Types of Long-Term Equity-Based Incentives

The most-seen types of equity-based incentives in the Brazilian VC market are as follows.

Stock options

Here the participant is granted, or purchases, options to acquire equity interest in the company at a future time, for a predetermined price (strike price). For the effective exercise of this right, the participant must comply with certain conditions, which may be related to time (vesting), achievement of goals or occurrence of a liquidity event, among others.

Partnership

Here the company offers the participant the opportunity to become a partner, acquiring a direct or indirect stake in the company, at market value. Payment of the purchase price is generally made in instalments.

Restricted stocks or units

Restricted shares, called RSAs or RSUs (“restricted share awards” and “restricted share units”) represent a type of long-term incentive according to which there is no investment or financial consideration on the part of the participant. The company grants the shares or units free of charge, in advance or after the fulfilment of a certain period (vesting). Unlike options, which must be exercised, RSUs are typically converted directly into stock upon vesting, which may then be subject to further mandatory selling periods or holding requirements. This is also a strong incentive for employees to remain with the company, as they gain full ownership of the shares after the vesting period.

Phantom shares

These instruments aim to fulfil the same economic purpose as options or restricted stocks, but with settlement in cash and not in shares.

The choice of long-term incentive that best suits the start-up must take into account a number of factors, such as:

• how employees are hired;
• the business model; and
• in particular, the company’s stage of development.

Standard Terms

Vesting schedule

Stock options or similar instruments usually vest over a period of time to encourage employees to remain with the company. A common vesting schedule is for four years, with a one-year cliff (meaning that no vesting occurs until the end of the first year), followed by monthly or quarterly pro rata vesting.

Exercise period

After vesting, employees typically have a set period during which they can exercise their options – eg, ten years from the grant date.

Exercisability

Options are generally exercisable once vested, but may have additional conditions based on company performance or milestones.

Claw-back provisions

Some incentive plans include claw-back provisions that allow the company to reclaim the value of equity compensation under certain conditions, such as for misconduct or breaches of contract by the employee.

Other clauses

Formal employment agreements executed with founders and key employees often include other clauses designed to ensure or protect their long-term involvement, including non-compete and non-solicitation clauses.

Taxation for Long-Term Incentives

Brazilian legislation still does not have specific regulations regarding an incentive pool for founders and employees. However, labour and tax jurisprudence has tried to introduce relevant definitions. So far, key decisions have related to companies in the traditional economy, with a high level of maturity and consolidated in the market, and whose main objective was to bring prestige to their employees or top executives.

Based on the forgoing, the key tax factors to consider are as follows.

Nature of incentive plans

The legal nature of the incentives will determine the tax burden levied on it. Depending on the characteristics of the incentive plan, it may be of a mercantile or compensation nature.

In the start-up ecosystem, incentive plans have the purpose of attracting and retaining people that have been important for the company’s development since the beginning of the company, with little market exposure and low revenue. Therefore, an incentive plan becomes a mechanism whereby the beneficiary assumes the risk of the startup’s business. As such, a start-up’s incentive plan would offer more subsidies and characterise them as contracts of an effectively mercantile legal nature.

Tax rates

If the incentive plan is of a mercantile legal nature, the income tax levied will be a progressive levy of between 15% and 22.5%. If it is of a salary nature, income tax will be levied based on the progressive personal income tax table, up to 27.5%, as well as a social security contribution of at least 20%.

Tax basis

One encountered difficulty is establishing the tax base – whether this is the value paid/assigned to the founder/employee at the time of the grant, or the value after vesting. The latter is particularly difficult where it is hard to establish the market value of a start-up’s share at the time of granting, or even for the vesting exercise.

Option Pool

The processes for implementation of an investment round and the setting-up of an employee incentive programme are intrinsically related. During the negotiations of an investment round, the parties evaluate the company’s needs, including how much equity is expected to be allocated for employee incentives (both for current and future employees). From the investors’ perspective, a robust employee incentive programme is valuable for driving the company’s growth.

The size of the employee stock option pool is typically negotiated as part of the investment terms. If the existing pool size is not sufficient to meet future hiring needs, investors may require an increase of the pool size, with dilution effects on the shareholders immediately prior the completion of the investment.

Sales to strategic buyers or other institutional investors comprise the vast majority of exit forms for VC-backed start-ups in Brazil, though the number of successful IPOs in past years has increased.

Exit-related provisions in shareholder agreements to regulate those processes include the following.

Drag-Along Rights

Certain shareholders (usually majority shareholders) can force other shareholders to participate in the sale of the company. In the VC industry, a typical drag-along clause states that, if shareholders holding a qualified majority of the share capital (eg, 70%) wish to sell their shares to a third party, they may require the other shareholders to include their shares in the sale, under the same conditions offered by the third party. To protect themselves from unfair “forced” sale, some investors require the inclusion of a contractual provision whereby they can only be “dragged” into a sale transaction if the price per share offered by the third-party purchaser is higher than a certain multiple of the price per share paid by the investor.

Tag-Along Rights (Co-sale)

These are used as a protection mechanism for minority shareholders, by giving them the right to join in a sale of shares by majority shareholders on the same terms. This ensures that they can benefit from the same terms as the exiting, selling shareholders. VC investors require tag-along rights in investment rounds, as an alternative to pre-emptive rights. Once the lock-up period is over, if the founders wish to dispose of their shares and have received a binding offer from a third party, they must notify the investors that, within a certain period, they may alternatively:

• exercise the pre-emptive right and acquire the founders’ shares; or
• exercise the tag-along and sell their shares together with the founders’ shares.

Other Transfer Restrictions

Other transfer restrictions include right-of-first-refusal (ROFR) and right-of-first-offer (ROFO) provisions, giving the non-selling shareholder a prior-refusal right or first-offer right, as applicable, in the event of a sale of shares by the selling shareholder.

Exit Triggers

Exit triggers are specific conditions defined in shareholder agreements that activate certain rights or obligations concerning an exit event. Sale of a company’s control (often defined as a transaction where more than a certain percentage of the company’s shares are sold, or where there is a sale of substantially all assets of the company) and IPOs are typical exit-triggering events.

Understanding and negotiating these provisions requires careful consideration of the dynamics between different groups of investors and the founders, as well as of the strategic goals of the company. When properly structured, these provisions ensure that all parties can realise the value of their investment under fair and equitable conditions during an exit.

In spite of the timid increase in the number of exits through IPOs in Brazil, the country’s capital market deals are pretty modest when compared with developed jurisdictions.

The whole process is time-consuming and costly. Preparation for an IPO takes around 12 to 18 months, and requires a certain mindset and operational change, in view of the numerous compliance and regulatory requirements.

There is no legal provision for secondary market needs in the context of an IPO. In fact, this is a major problem for the development and growth of the Brazilian capital market, which is still incipient in this respect and where there is not enough demand. There is no legal provision for promoting or stimulating liquidity of the secondary market. Nonetheless, there are sometimes certain acquisition priorities in employee IPOs as well as preferences for primary offering versus secondary offering.

Under the applicable laws of Brazil, an offering of securities is deemed to constitute a “public offering” whenever:

• the issuer publishes any form of advertising (or materials that may be deemed to constitute advertising) or announcement expressing the issuer’s intention to sell securities to the general public in Brazil;
• the issuer hires brokers or agents, or uses employees, to search for underwriters or purchasers for the securities; or
• if the trading of the securities is to be carried out in a public space, the issuer uses public communication devices.

An important aspect in determining whether a placement constitutes a “public offering” is the public sought by the offer – ie, whether the offer is directed towards the general public. The CVM defines “general public” as any class, category or group of people, even if individualised, besides those who have had a regular and previous relationship with the issuer. Therefore, the offer is deemed “public” whenever it is not possible to identify or individualise the investors to whom it is directed.

If any offer is made within Brazil, such distribution must be conducted by entities authorised to do so by the CVM.

Foreign direct investment (FDI) restrictions are more common in the real economy than in relation to technology companies. However, some existing FDI regulations may apply to growth/portfolio companies of foreign VC investors, as follows.

Sector-Specific Restrictions

Certain sectors may be sensitive or strategic, requiring special approval or outright prohibiting foreign investment. Defence, telecommunications, real estate (rural areas) and gaming are examples of sectors that are subject to FDI restrictions. Most of the time, the restrictions are limited to a cap on the percentage of ownership that foreign investors can hold in domestic companies; therefore, minority interests of VC investors may not be affected by such limitations.

Banking and Financial Regulations

Participation of foreign investors in the capital of financial institutions in Brazil is subject to authorisation, pursuant to an international treaty providing for reciprocity, or, in the event that such investment is recognised by the Brazilian government as being in Brazil’s best interest, through the enactment of a Presidential Decree.

There are no restrictions on FDI into fintechs that do not qualify as financial institutions (SCDs or SEPs). However, even for fintechs that qualify as financial institutions (credit fintechs), a Presidential Decree (with a general ruling) was issued to stimulate the development of the industry in Brazil, establishing that foreign capital participation of up to 100% in credit fintechs is, in general, in the best interest of the government, as it favours competition and technological innovation in the industry.

It is crucial for foreign investors to consult with legal experts in the target jurisdiction, to understand the specific legal requirements and to ensure compliance with all applicable regulations. This due diligence is essential not only for legal compliance but also for assessing viability and potential investments in foreign markets.