Written by: Giuseppe Mateus Boselli Lazzarini
Defining a Startup
Currently, the definition of the term “startup” can be manifold. Some may describe it as a company at an early stage while others, with a more elaborate concept, may refer to it a company seeking to implement and develop repeatable and scalable business models, working in contexts of uncertainty, as the search for opportunities to innovate unexplored or little explored segments of the economy. Due to this, it is oftentimes said that the risk involved in setting up a startup is very high. In this article we will approach the second concept.
Startup Investment Modalities in Brazil
To thrive in environments of great uncertainty and risk, startups need not only efficient business models compatible with the market demands, but also the capital to sustain their operations, especially in the early stages of implementation when a company has yet to find sustainability. It is at this point that the presence of the investor becomes important as a source of capital enabling the success of the company. Being risky investments, investors usually require certain guarantees in order to preserve the security of their capital. As a result, these investments are normally structured through some modalities involving different types of contracts, which we will explore below.
Participation Agreement for Angel Investors
This type of contract was created by Complementary Law 155/16, effective as of January 1, 2017, which, for the first time, explicitly introduced the angel investor concept in the Brazilian legal system.
Through this law, angel investors – either natural persons or legal entities – can make a contribution into micro-companies or small businesses, without the amounts contributed integrating their corporate stock so that the investor does not acquire the status of a partner, therefore holding some patrimonial protection, in addition to being prevented from exercising management activities or having voting power in the company.
The contract may have a maximum validity of seven years. The investor may withdraw its compensation resulting from its contributions two years after having entered into the contract. Income tax is withheld (IRRF) at rates ranging from 22.5% to 15% subject to the terms of the contract.
Through a convertible loan agreement, the investor makes a contribution in the company as a loan, thus becoming a creditor to such company. In the future, upon compliance with the conditions provided in the agreement, or upon expiration of the agreed term, such credit guarantees the investor the right to opt for one of two alternatives: receive the amount of its contribution back with possible interests and monetary correction or convert it into a stake in the company.
This model guarantees great contractual flexibility since the details regarding the conditions and term for which the investor makes a choice can be negotiated; as well as the method used to calculate the conversion of the amount contributed; the corrections and interests to be applied to the amount in case of opting for the return of the amount, among other conditions. In addition, it is important to keep in mind that until the moment of the conversion into equity (if it occurs), the investor is not considered a partner of the company, thus granted property security until its choice is made. Because of these advantages, it is this modality that investors have used the most.
Purchase or subscription option
Through a purchase or subscription agreement, the investor acquires the right, over a period of time provided for in the agreement, to buy or subscribe company quotas or shares at a predetermined price which is, therefore, independent of possible changes in the corporate stock or in the value of the company’s shareholding unit. This right may also be waived or terminated at the end of the stipulated term without any implication to the parties.
This model is commonly used by startup accelerators since, in general, there is no immediate financial contribution to the company at the moment of executing the contract. Rather, the accelerator provides the startup with support in the form of work space, mentoring, know-how, and networking opportunities for the possibility of acquiring a stake in the company at an advantageous price in the case of its success and growth.
Although there is usually no immediate contribution upon the execution of the option agreement, it is possible that the beneficiary of the option pay for the acquisition of such option in the form of an “option premium”. Such amount, however, is subject to income tax at the rate of 15%.
Upfront Payment for Future Capital Increase (AFAC)
An upfront payment for future capital increase, as the name suggests, consists of making capital available to the company, which will necessarily be converted into equity interest at the end of the contract. The essential difference of the AFAC in relation to a loan agreement is precisely its irreversibility, that is to say, conversion into company quotas or shares is no option. As a result, the operation is given a different tax treatment and the IOF (financial transactions tax) is not levied on the contribution.
In Brazil a small company can use equity crowdfunding as a way of public fundraising through an online platform where corporate equity rights are offered in exchange of capital. This modality was regulated by the Brazilian Securities and Exchange Commission (CVM) through CVM Instruction 588 of July 13, 2017.
The transaction classifies as a special regime of automatic exemption from registration with the CVM as long as it meets certain requirements, among which the following should be pointed out: (i) the company must be incorporated in Brazil, and have annual gross revenue of up to 10 million reais; (ii) the amount of funding cannot exceed R$ 5 million; (iii) the online platform must be registered with the CVM; (iv) the campaign must have a limit term of 180 days; (v) the maximum amount of contribution by each investor must be 10 thousand reais per period.
There are several possible modalities for investing in startups in Brazil, each involving different contracts and conditions. It is important to know their peculiarities in order to identify the most appropriate form of investment according to the profile of the company and the investor, and always be advised by experienced lawyers whenever negotiating and executing contracts.
Giuseppe Mateus Boselli Lazzarini – is a researcher at Baptista Luz Advogados, associates of the Chamber.