A convertible loan agreement is an essential tool for investing in startups in Brazil, but its success depends directly on the quality of its provisions.
For the investor, a well-negotiated agreement is the main line of defense in protecting capital and ensuring potential returns.
Below, we detail 5 critical points that must be carefully negotiated to ensure the safety and effectiveness of the investment:
1. Allocation of Funds. It is prudent for the agreement to specify how the funds should be used by the startup. Linking the investment to strategic purposes, such as technology development or market expansion, and providing a mechanism for monitoring this allocation ensures that the capital will be used to generate value, not to cover unplanned operating expenses.
2. Early Maturity. This clause allows the investor to demand immediate payment of the debt, even before the contract’s maturity date, in the event of events that jeopardize the business. It is essential to clearly list these triggers, such as breach of contractual obligations, sale of control of the company without the investor’s consent, or the initiation of a judicial recovery process, for example.
3. Founders’ Liability. In early-stage startups, which often lack assets to secure debt, joint and several liability of founders is a crucial safeguard. This provision extends the obligation to pay the loan and any penalties stipulated in the agreement to the partners’ individuals, increasing their commitment to responsible resource management.
4. Covenants. Brazilian law provides that, unlike a partner, an investor (creditor) does not have veto power over company decisions. Covenants are a solution to this problem, as they stipulate which actions the startup cannot take without the investor’s prior authorization, such as taking on new debt, selling key assets, or approving a merger. This is a way to protect the investment from decisions that could dilute its value.
5. Anti-Dilution Protection. The anti-dilution clause aims to protect the investor’s future equity interest against unfavorable dilution events. Negotiating this clause goes beyond simply protecting against a round with a lower valuation (down round). It is possible, for example, to set a valuation cap for the conversion, ensuring that the investor benefits from a more favorable scenario, or to establish that the protection is valid for a certain period after the investment. The goal is to ensure that, at the time of conversion, the investor receives the equity interest percentage commensurate with the risk assumed in the initial stage of the deal.
A convertible loan is more than just a loan; it’s the foundation of a future partnership. Attention to these five points in the agreement ensures that the investment is made on a solid legal basis, protecting the investor’s capital and aligning expectations so that the startup can grow safely.
