Funding startups is a high-risk investment anywhere and in Brazil it is not different.
To mitigate part of the legal risks, Corporate Ventures, angel investors and accelerators use a “Convertible Loan Agreements” to document their investments, instead of direct equity acquisition.
Based on our experience, we list below 5 points to be considered by investors when negotiating Convertible Loans with target startups in Brazil:
1. Nature of Loan: If the transaction is a loan and not of equity, the contract must be of a loan nature, with provision for the loan amount, conditions precedent for disbursement, repayment terms, interest rate, monetary adjustment, among other terms applicable to loans;
2. Use of Proceeds: It is not uncommon for people and companies to make wrong decisions when they have funds at their disposal. For this reason, investors should, whenever possible, “stamp” the use of the loan’s proceeds strictly for strategic purposes previously negotiated with founders and senior officers, and inspect the allocation;
3. Granting of Share Option to Investor: Key clause in startup investments, the loan agreement must clearly establish the obligation of the startup and shareholders to convert the outstanding loan amount into equity, at the investor’s discretion, and within a period of up to “x” days;
4. Negative Covenants: Unlike equity investments where the investor may have veto rights for certain situations that decide the life of the invested startup, the Convertible Loan Agreement establishes a contractual relationship of creditor/debtor. For this reason, it is important that the investor provides in contract “negative covenants” for startups that, in order to carry them out, the prior written consent of the investor will be necessary. Examples are: sale/acquisition of equity interest, new loans, issuance of bonds or securities, joint venture, merger, spin-off, incorporation, strategic commercial and corporate partnership, among others of the same nature; and
5. Non-Dilution of the Investor: The investor may include in the Convertible Loan Agreement an anti-dilution clause where the founding shareholders agree that, in the event of issuance of new shares for subscription by a third investor based on a valuation of up to “BR$ XXX”, they must transfer to the investor the number of shares that preserves the percentage of equity interest originally agreed.
There are several other sensitive contractual provisions in Convertible Loan Agreements, with Corporate Ventures, angel investors and accelerators assessing what will be strategic to mitigate risks and increase the chances of a successful investment of funds.