Venture capital investment in Brazil: market and regulatory overview
A Q&A guide to venture capital law in Brazil.
The Q&A gives a high level overview of the venture capital market; tax incentives; fund structures; fund formation and regulation; investor protection; founder and employee incentivisation and exits.
To compare answers across multiple jurisdictions visit the Venture Capital Country Q&A Tool.
This Q&A is part of the global guide to venture capital. For a full list of jurisdictional Q&As visit www.practicallaw.com/venturecapital-mjg.
Venture capital and private equity
Venture capital usually refers to investments in early stage or start-up companies. A venture capital fund, identifying early stage companies or start-ups that have a potential for growth, invests in this type of company. It also generally helps the invested company put in place its business plan and pass to the next level of its business' maturity. Once the company has reached a designated size and maturity, the venture capital fund usually adopts one of the following strategies:
Helping the company in a second round of investment (usually new money injection from another venture fund or a private equity fund).
Making a divestiture of its investment.
In Brazil, venture capital businesses, as risky transactions, have very low exposure to debt.
While private equity transactions in Brazil can also include venture capital, private equity typically relates to investment in more mature companies that require capital contributions to:
Expand their business.
Consolidate their market through mergers and acquisitions (M&A).
Start a new project.
Sources of funding
Brazil has very high interest rates due to its historically high level of inflation, which makes debt financing a very expensive option. Consequently, a great percentage of funding is obtained either through equity (institutional investors, pension funds, family offices and clients of private banks) or from governmental financing agencies or state-owned banks.
Early stage companies can obtain funding from various sources, such as:
Personal capital of the founders. Frequently, at a pre-operational or start-up stage, a company's founders inject their own money to fund the company. This capital is generally used to develop products and invest in the structuring of the company. Brazilian law does not require a minimum amount of capital to set up a company, which allows founders to freely establish the amounts necessary for the early stage business. Generally, this initial funding involves a small capital injection.
Governmental financing agencies or state-owned banks. Another funding option for early stage companies, especially companies involved in innovation or technology, are governmental financing agencies or state-owned banks. These agencies were created by the government to grant credit at lower interest rates for early stage or start-up companies, as an incentive to develop entrepreneurial markets in Brazil. In some cases, the finance provided by these government agencies does not need to be repaid if certain goals are achieved. Some examples of these agencies and banks include:
Research and Project Financing (Financiadora de Estudos e Projetos) (FINEP);
National Development Bank (Banco Nacional do Desenvolvimento Econômico e Social) (BNDES);
Federal Savings Bank (Caixa Econômica Federal); and
Banco do Brasil (a commercial state-owned bank).
These financing agencies and state-owned banks use government resources and offer an interest rate lower than that offered by private banks.
Angel investors, seed funds and venture capital funds. Angel investors are private individuals or groups of individuals that invest capital in companies at a very early stage, which can be considered seed capital for the companies. Seed funds and venture capital funds invest primarily in early stage companies but also in companies that have reached a further level of development, as long as the investment is used primarily for the company's expansion (for example, working capital, plant expansion, distribution chain, formation of a sales team and marketing strategies).
Strategic investors. A strategic investor is an entity or a person that has a common interest with the company in developing a specific product, with regard to long-term strategy.
Types of company
The main target industries for venture capital funds have varied over time. According to the survey prepared and published by Fundação Getúlio Vargas (FGV) (an education centre) in December 2010, currently the flow of investment focuses on companies in the following areas:
IT and electronics (15%).
Energy and oil (15%).
The percentages above are based on the number of investments and not the total amount invested (Second Census of the Brazilian Private Equity and Venture Capital Industry, published by GVcepe: Private Equity and Venture Capital Research at FGV: EAESP on 1 December 2010).
There are now many investment opportunities in Brazil, due to:
An infrastructure gap.
Income distribution and credit availability.
A lag in productivity.
The continued growth of the middle class. This is particularly important, since it is creating new consumers for existing products and services such as education, healthcare and internet (in particular, e-commerce).
However, venture capital investments are not equally distributed within Brazil, being concentrated principally in the:
South-east region (the states of São Paulo, Rio de Janeiro and Minas Gerais).
South (the states of Rio Grande do Sul, Santa Catarina and Paraná).
According to the ABVCAP research, the general partners of private equity and venture capital funds in Brazil indicated a multi-sectorial investment trend for the 2014 and 2015. However, 21% of the general partners of private equity and venture capital funds also indicate interest in investing in the clean tech and renewable energy sectors (www.abvcap.com.br/Download/Estudos/2716.pdf).
Tax incentive schemes
Tax free capital gains
The government is making efforts to incentivise direct investment in Brazil-based companies. An important law (Law 11.312/06) reduces to zero income tax on capital gains on investments made in Brazil by foreign investors through certain investment vehicles. In relation to investors in FIPs and FMIEEs, this is available if the taxed income is remitted abroad to a beneficiary that performs financial operations in Brazil, according to National Monetary Council (Conselho Monetário Nacional) (CMN) rules.
However, this benefit is not available to an investor that holds 40% or more of the fund's quotas or that, directly or indirectly, has the right to receive more than 40% of the fund's income. The indirect connections are:
For individuals: relatives (restricted to second degree), companies under an individual's control or under the control of one of his relatives (restricted to second degree), quota holders or directors of such companies.
For companies: their parent, subsidiary or associated companies.
This tax advantage is also not available if:
More than 5% of the fund's net equity consists of debt securities. However, neither public securities, nor the 67% of the fund's portfolio held in public company shares, corporation shares, convertible debentures and bonuses (see below, Reduced capital gains tax) are subject to this limit. In addition, dividends are not subject to tax in Brazil, even when remitted to tax havens.
The capital gain is remitted to a country deemed a tax haven under Brazilian law. For tax purposes, a tax haven is a country that taxes income with a tax rate below 20%, or whose corporate legislation does not disclose the corporate structure and shareholders of the company. Tax havens are listed under Brazilian law, and include the Bahamas, Bahrain, Bermuda, the Channel Islands, the Cayman Islands, Cyprus, Hong Kong, Singapore, the United Arab Emirates and the British Virgin Islands, among others.
Reduced capital gains tax
Brazilian residents can benefit from a reduced income tax rate on capital gains from the redemption of securities/quotas of FIPs and FMIEEs, including capital gains from fund liquidation. Such gains are subject to income tax at 15%, which is withheld on a positive difference between the redemption value and the securities'/quotas' acquisition cost (Law 11.312/06). Compared to the income tax rate applicable to other Brazil-based companies, typically 34%, the taxation of these funds is very favourable.
This reduced tax rate is only available in relation to funds that comply with the diversification limits and investment rules provided by the Brazilian Securities and Exchange Commission (Comissão de Valores Mobiliários) (CVM). In the case of FIPs and FMIEEs, at least 67% of the funds' portfolio must consist of public company shares, corporation (not limited liability company) shares, convertible debentures and bonuses. In the event of securities'/quotas' amortisation, the tax is levied on the amount that exceeds their respective acquisition cost, at 15%.
Given the low liquidity and high risk of venture capital investment, it appeals more to investors with a long-term investment horizon and a considerable amount of assets allowing for a risky portfolio investment, such as:
Institutional investors (pension funds).
Clients of private banks.
Successful entrepreneurs (many of whom received venture capital investment in the early stages of their companies).
Bank holding companies.
Due to their potential impact on the creation and development of new companies, which increases employment and stimulates innovation and technology, venture capital and private equity investments are considered important instruments of public policy and necessary to promote economic development in Brazil. As a result, venture capital investors also include development agencies, multilateral institutions and development banks (see Question 1, Sources of funding).
In 2013, 55% of the capital committed for venture capital and private equity investments came from foreign investors (www.abvcap.com.br/Download/Estudos/2716.pdf).
Venture capital funds can obtain considerable tax savings, depending on the way the investment is structured (see Question 3).
Before the creation of the investment fund regime, venture capital investments were typically structured using holding companies or limited partnership companies, based in Brazil or offshore. However, such structures were generally not tax efficient.
The CVM, which controls the capital market in Brazil, created investment funds to regulate private equity and venture capital investments. It first created the FMIEE (Normative Instruction 209/94) and later introduced the FIP (Normative Instruction 391/03). Each entity is used for both private equity and venture capital investments. The FIP structure, compared to the FMIEE, has certain advantages:
Investments by FMIEEs are limited to companies that have an annual net income up to BRL150 million. In contrast, FIPs do not have these limitations.
The law is unclear in relation to the ability of the investors and/or the manager of an FMIEE to have board representation, whereas this right is clearly established for FIPs.
The FIP's normative instruction gives a substantial level of transparency to investors (including corporate governance and disclosure of information). This is not present in the FMIEE's normative instruction.
Although a lot of new venture capital/private equity funds are being incorporated to take advantage of these more efficient tax structures, the most used vehicle is still the limited partnership/holding company, representing 41% of vehicles. The FIP and FMIEE only represent 26% (according to the FGV survey; see Question 1, Types of company).
Fund regulation and licensing
Venture capital funds have specific regulations in addition to the corporate rules applicable to other investors. A venture capital fund is governed by the CVM, and due to the associated risk only qualified/institutional investors can invest in such funds.
Except in respect of private placements to qualified investors whose status has been confirmed by a licensed broker, quotas of funds that have been distributed in a public offering can only be traded on the stock market or the over-the-counter market.
The CVM allows flexibility regarding the regulation and control of investment funds, depending on the category of placement of the quotas. The general rule is that the fund must prepare and register with the CVM all relevant documents for the fundraising (that is, placement agreement, prospectus, fund bye-laws, fund statute and so on). However, if the fund is marketed or advertised to no more than 50 institutional investors, and no more than 20 of these investors actually invest in the fund, the registration process is more lenient and certain documents need not be registered with the CVM (that is, the prospectus).
There are some venture capitalists, in special seed funds, that incorporate themselves as holding companies. In these cases, CVM has no authority over them and they are basically regulated by Brazilian corporate laws.
The relationship between the investors and the fund is principally governed by the fund's statute (regulamento), which provides the main rules applicable to the fund's activities, such as the:
Term of the fund.
Investment policy followed by the fund's manager.
Investors normally seek:
Disclosure of the fund activities, including investment overviews and analyses on which management investment decisions are based.
The right to vote in the fund's general meetings, to deliberate important changes to the fund's structure (for example, approving the administrator's accounts, amending the fund's statute, replacing the manager and issuing new investment quotas).
Periodical (monthly/quarterly) meetings to keep informed about the performance of the fund and its portfolio companies.
In Brazil, it is common to have limited partners (LPs) (in special Brazilian pension funds) requesting to be part of the investment committee.
Interests in investee companies
Venture capital investments can be made through shares, debentures, warrants or other securities convertible into or exchangeable for shares of the invested companies. Typically, the investment is made through equity, but depending on the scope of potential risks identified during due diligence, a convertible debt instrument may be requested by the investor instead of straight equity.
Valuing and investigating investee companies
As is typical in other jurisdictions, venture capital funds value target companies based on either:
A multiple of the earnings before interest, taxes, depreciation and amortisation (EBITDA) of the target (such multiple depends on the segment of the target company).
A valuation in accordance with discounted cash flow methodology.
Start-up companies generally have low revenues and often have negative EBITDA. Therefore, venture capital funds frequently calculate their valuations based on either:
Predicted future earnings, discounting the free cash flow with a high rate of return.
Alternative methods, such as using the forward EBITDA on an agreed date. In such cases, the investors typically negotiate an earn-out provision (see Question 16).
Venture capital funds usually perform financial, legal and tax due diligence on target companies.
As most investee companies are in early or start-up stages, funds also focus their analysis on the business plan presented by the target's owners and on the concept that the start-up is developing. Funds can also undertake market research to determine if there is a gap or an opportunity in the sector that the company is planning to enter and, consequently, if the company has a good chance of being successful.
Depending on the origin of the venture capital investor (for example, the US or UK) and the sector which the target company is in, some investors also perform limited anti-corruption due diligence (for example, US Foreign Corrupt Practices Act (FCPA) due diligence or UK Bribery Act due diligence).
Because Brazil is still an emerging market, venture capital funds also spend time analysing and investigating the external risks of the industry, and the environment in which the target company is operating.
During the first stage of negotiations, parties generally execute a:
Non-disclosure and confidentiality agreement to protect the exchange of information between the parties.
Non-binding letter of intent or term sheet, in which the parties establish the valuation of the target and the terms of the proposed investment.
After the conclusion of due diligence (financial, legal and tax), the parties negotiate a subscription agreement, the new terms of the bye-laws of the company and a shareholders' agreement. They also typically agree on the actions necessary to:
Restructure the target company, to make it more transparent from a corporate governance perspective.
Provide the investor with adequate protection, considering that in most cases the investor enters into the investment as a minority shareholder.
Protection of the fund as investor
The subscription agreement normally contains representations, warranties and covenants by the owners of the target company. In addition, the shareholders' agreement sets out, among others, the corporate governance principles that the shareholders adhere to, and specifies the reserved matters requiring investor approval. It also typically includes restrictions on share transfers, information rights and the mechanism for resolving conflicts.
The investment agreement often includes:
Downside protection provisions, including payment of the purchase price in tranches, whereby the investor pays a percentage of the price upfront and the remaining portion only when (and if) the company achieves certain milestones (revenues, EBITDA, profitability, market share, and so on).
A rachet, whereby if the company does not achieve the target results (defined in the agreement), the interests of the original shareholders will be diluted in the corporate capital and the investor will increase its portion proportionally, without additional capital contributions.
Forms of equity interest
Commonly, a fund takes preferred shares (see Question 18) with voting and veto rights for certain matters.
A fund, in its capacity as a holder of preferred shares, has the legal preferences applicable to preferred shares, which can be:
Priority in the distribution of fixed or minimum dividends.
Priority in the reimbursement of capital, with or without premium.
Both of the above preferences.
Priority in the reimbursement of capital is not generally very advantageous, because it will only occur when (and if) the company is liquidated and after paying other debts, such as labour and tax liabilities. However, it can be advantageous if either:
The company has a fixed term for its termination.
There is a corporate restructuring, and the preferred shares are owned by the creditor and the creditor converts its credit instrument into preferred shares, aiming to have its debt repaid before other creditors (other than labour and tax liabilities).
Preferred shares can also be used as an exit route by specifying in the bye-laws that such shares are redeemable, and clearly defining the conditions for redemption.
Funds frequently negotiate the right to appoint one or more members of the board of the target company. They also agree that certain matters requiring board or shareholder approval require the affirmative vote of the investor or its appointed board member, including:
Changes to the dividend policy.
Amendments to the corporate documents of the company.
Other material matters.
In addition, venture capital funds usually negotiate the right to appoint the chief financial officer (CFO) of the target company.
Share transfer restrictions
Common restrictions include a right of first refusal (that is, when a shareholder receives an offer to sell, either directly or indirectly, or transfer any of the shares issued by the company, it must give the other shareholders a right of first refusal to acquire those shares, at the same price and conditions as the offer received).
Other commonly contained provisions are tag-along and drag-along rights (see Question 21).
A right to tag-along can be negotiated. Under this provision, the controlling shareholder, receiving an offer to sell the controlling interest, includes the shares held by the minority shareholders in the offer, for the same price or for a certain percentage of the price offered by the third party interested in acquiring control.
Additionally, a shareholders' agreement can contain a drag-along clause, stating that if a certain shareholder receives an offer to sell the entire company, it can oblige the other shareholders to sell their shares. Depending on the way the deal is structured, and considering exit strategies adopted by venture capital funds, in certain cases minority shareholders, with equity between 30% and 40% of the company, can oblige the controlling shareholder to sell its shares.
The bye-laws of a company, or the general meeting that approved a capital increase with issuance of new shares, fixes a term under which the shareholders can exercise their pre-emption right, which cannot be less than 30 days.
In addition, investors typically require that the bye-laws include an anti-dilution mechanism, by which the investor is granted an additional term to acquire the shares from the other shareholder, to rebuild its portion in the corporate capital and avoid its dilution.
If the investor is structured as an investment fund, depending on the rules of the fund's statute, either a general meeting of the investors of the fund (limited partners and general partners) or the fund management approve the investment.
If the investor is structured as a holding company, shareholder approval is necessary to authorise the investment.
Founder and employee incentivisation
Founders and senior executives are incentivised through shares and stock option plans, in addition to a performance bonus. The maturity term of the stock options usually varies from two to four years (vesting period). Other key employees are eligible to receive bonuses. Stock option reservation usually varies from 5% to 10% of the capital stock of the invested company.
Converting the option into shares does not trigger any payment of taxes (it is tax neutral). If an employee decides to sell its shares, a 15% tax is payable on the capital gain.
In relation to bonuses given to employees, the applicable income tax rate is 27.5% of the gross amount of the bonus paid.
It is customary to say that the main assets of a company are the intrinsic characteristics and technology developed by its founders. It is important for the investor that the founders be committed to remain in the company, for such period as is necessary to develop and grow the business of the company.
Parties frequently negotiate a lock-up period on sales of shares by the founders. During this period, shares vest with the passage of time (monthly, quarterly, annually or otherwise). If the founders leave the company during the lock-up period, those shares that have not vested cannot be sold by the founder to a third party. In this case, the other shareholders have the right to acquire the shares at market value or book value. The price depends on whether the founder is a bad leaver (terminated for cause) or a good leaver.
With an unsuccessful company, the possibilities for exit are naturally reduced.
One option to realise a fund's investment is through redemption of shares. The bye-laws of the company would need to provide for this mechanism, or an extraordinary general meeting would need to approve its conditions. Redemption involves paying the value of a share to withdraw it permanently from circulation. The company itself acquires all shares from a certain class of shareholders. The advantage is that the fund can realise the investment, without finding a third party interested in acquiring it. The disadvantage is that the company must have profits or reserves to pay for the redeemable shares.
Another solution is a put option in respect of the shares owned by the fund. Under this mechanism, the fund can sell its shares to the other shareholders or to the company managers, who must acquire them at a pre-agreed price. The advantage is that the put option is not reliant on the distributable reserves of the company. The disadvantage is that the agreed price is often lower than the fair market value.
Another common option is to merge the unsuccessful company with other company(ies) in the portfolio that have a similar business to the company. This generates synergies and minimises losses assumed by the venture capital fund.
If none of these alternatives work, the fund can simply liquidate the investment and assume losses.
According to the latest survey published by FGV, between 2005 and 2009, 414 new investments were made by private equity and venture capital funds. There were 137 exits, with only 37 exits through IPOs.
Of the 109 IPOs in Brazil from 2005 to 2008, 34 of them were backed by private equity (Gafisa, ALL, Lupatech, Dufry, Dasa, Gol, Submarino, Totvs, Anhanguera, and so on). However, the number of IPOs drastically decreased from 2008. There were five IPOs in 2009, 11 in 2010, 11 in 2011, three in 2012, 11 in 2013 and just one IPO in 2014 (www.bmfbovespa.com.br/pt-br/mercados/acoes/ofertas-publicas/ofertas-publicas.aspx?idioma=pt-br), so currently, IPO exits are not a common form of exit for private equity and venture capital investments in Brazil.
One disadvantage of an IPO, from a venture capital perspective, is that the company must meet certain requirements to have its shares publicly traded. These are generally not achievable until the company is relatively mature.
Venture capital funds also commonly realise their investments through a secondary private sale or trade sale.
The advantage of an acquisition by a strategic investor is the synergy between the company and the investor, which can increase the valuation of the company. The disadvantage is that it may not be the most efficient option from a tax perspective, depending on how the parties structure the transaction.
Partner, Derraik & Menezes Advogados
Professional qualifications. Brazil, 2000; Portugal, 2006
Areas of practice. Private equity and venture capital; corporate transactions; finance and governance; M&A.
Senior Associate, Derraik & Menezes Advogados
Professional qualifications. Brazil, 2005
Areas of practice. Private equity and venture capital; corporate transactions; finance and governance; M&A.