1. Introduction
Entrepreneurship and investments in innovation are essential for economic development, generating new companies, solutions, and jobs. In this context, startups play a fundamental role in creating innovative solutions with speed, something very difficult to accomplish by consolidated companies, which need to follow more mature corporate governance rules and deal with slower and more bureaucratic decision-making processes for analysis and approval of these new businesses.
In recent years, startups have been responsible for innovations that have transformed several sectors, such as financial services offered by fintechs and digital banks, online shopping platforms, and on-demand delivery services, which add convenience to everyday life.
However, to be constituted and developed, these startups depend on investments, which can occur in different formats and stages of maturity, offering investors a new type of asset with the potential for financial return for those who believe in the theses and products developed by entrepreneurs.
In this chapter of Doing Business in Brazil, we will address Venture Capital investments in their different stages of maturation. We will analyze the investment journey, the most used legal models and instruments, as well as the essential precautions before liquidation, aspects that are essential for the investor to understand the scenario before participating in an investment round.
1.1. Venture Capital in Brazil
Before understanding the specifics of Venture Capital, it is important to point out the difference between startups in Europe, the United States of America, and Brazil. The former has greater maturity, due to structural and historical issues that provided the pioneering spirit, such as the technological hub of Silicon Valley, which created an environment conducive to innovation and investment. The American model, in this way, spread and was adapted to the reality of each country. In Brazil, for example, there is no such prototype, but the entrepreneurial environment has evolved, with great encouragement not only for technological innovation, but also to overcome local inefficiencies.
In addition, Brazil has a relevant competitive advantage for the distribution of new products and services due to its large population base, which exceeds 200 million inhabitants. This expressive domestic market, combined with socioeconomic and regional diversity, offers a favorable environment to test, adapt and scale innovative business models. Startups that can adapt their solutions to the needs and consumption habits of this population have greater potential for growth and investment attraction, in addition to creating a competitive advantage for later international expansion.
1.2. Investments Rounds
Understanding the investment journey is essential to understand the behavior of Venture Capital investment, from its funding to potential liquidation.
FFF. The first investors in startups are people close to the entrepreneurs, the so-called FFF, that is, Family, Friends and Fools. At this stage, the business is still simple and underdeveloped, being supported by people closer to the founder, who encourage him with low-value financing to offer initial support for the development of the minimum viable product to be offered to future customers. From this small contribution, the founders improve ideation and development.
Angel Investors. In the next stage, the investments are made by the “angel investors”. They are individuals, usually experienced entrepreneurs or executives with a history of operating in the market, who invest their own financial resources in startups in the early stages of development. In addition to capital, angel investors usually offer strategic support, mentoring, and networking connections, contributing to accelerating the growth and consolidation of the business. Generally, angel investors act in isolation, through organized groups of angel investors or through equity crowdfunding platforms.
Seed Money. The next stage of investing is seed money investing. It presents this denomination in the market being an investment made in the early stages of a startup, usually after the contribution of the founders’ own resources (bootstrapping) and, in some cases, angel investors. The main purpose of seed money is to fund the initial development of the company, such as creating the minimum viable product, validating the business model, testing the market, and structuring a team, before the company has significant revenues. Generally, seed money investments are made by investment funds specializing in Venture Capital and have total investment values higher than those presented by angel investors. They are, therefore, professional investors.
At this stage, the risk for the investor is high, as the company does not yet have a consolidated financial history or proven traction. On the other hand, the potential for investment appreciation is high if the startup achieves success and advances to larger investment rounds.
Investment Rounds. After the maturation phases and previous investments, the startup will be able to raise funds through investment rounds denominated in their chronological order by the letters of the alphabet. The first round of investment is Serie A, held when the startup has already validated its business model and presents traction and growth indicators (customers, recurring revenue, or strong growth in the user base). The capital raised in this phase is used to optimize the product, expand the team, expand the operation and consolidate the presence in the market. The amount invested is usually higher than in seed money and investors expect a clear plan for scalability and monetization.
In Series B, the startup already shows consistent growth and is looking for capital to significantly expand its operations, whether by expanding into new markets, diversifying products or investing in large-scale marketing and sales. Series B investors analyze more robust performance metrics, such as unit economics, customer acquisition cost, and lifetime value, as well as proven scalability.
In Series C, the startup has already achieved a strong presence in the market and seeks resources for aggressive acceleration, such as international expansion, acquisition of competitors, or development of new product lines. Investors in this phase include not only venture capital funds, but also private equity, investment banks, and, in some cases, strategic companies (corporate venture). The risk is lower than in the initial phases, but the capital contributions are much more expressive.
Exits. They are the ways in which investors and founders make the financial return on the capital and time invested in a startup, converting their equity interest into liquidity. In other words, it is the moment of “exit” of the investment, when the company’s shares or quotas are sold, in whole or in part, to third parties. The exit is a strategic moment both for the investor, who seeks to maximize his return, and for the startup, which can gain new partners, capital, and expansion opportunities. The main types of exits include: (i) purchase and sale (M&A), which occurs when the startup is sold to another company or investor, either to incorporate its technology, team, customer portfolio or, strategically, to eliminate a competitor from the market; (ii) Initial Public Offering (IPO), occurs when the startup reaches the maximum level of maturity and goes public on the stock exchange, allowing the sale of its shares in the market; (iii) secondary sale, occurs when investors sell their stakes to other investors, funds or strategic partners, without the startup necessarily changing shareholder control; and (iv) buyback, occurs when the startup itself buys back investors’ shares, usually to concentrate corporate control or adjust its captable.
This entire investment cycle typically requires a maturation period of 5 to 10 years to mature and complete. This interval reflects the time needed for the startup to validate its business model, scale operations, gain relevant market share, and generate the expected return for investors. While some one-off cases reach liquidity faster, most venture capital success stories require long-term vision, strategic patience, and the ability to sustain growth over the years.
1.3. Investments Contracts
The legal investment instruments used in startups and early-stage companies can take different forms, according to the investor’s profile, the company’s momentum, and the objectives of the operation. They are divided, in general, between investments made directly, through contracts signed between the investor and the startup, giving the investor a direct participation in the startup’s quotas or shares, and indirect, through contracts that grant the right to convert into equity interest in startups.
1.3.1. Direct investment
In the case of direct investment, the investor himself enters into an investment or purchase and sale agreement directly with the startup and/or its founders to receive quotas or shares of the startup in exchange for the capital contributed. After the investment, the investor becomes a partner of the startup, fully assuming the risks of responsibility of the startup’s commercial activity, and the potential benefits arising from the contribution. In this mode, the contract tends to be more complex and less flexible, given that the investor must negotiate mechanics and indemnity limits for any losses outside the normal course of business.
Unlike indirect investment, which confers the right to convert into equity interest in the event of a liquidity event, mitigating the risk of liability for losses incurred by the startup during the conduct of its business.
1.3.2. Indirect Investment
Indirect investment is formalized through contracts that grant the right to convert into equity interest in startups, in an amount proportional to the amount contributed and the estimated valuation of the startup. The traditional instruments for this structure are the Simple Agreement for Future Equity – SAFE and the Convertible Loan.
SAFE. It is a contractual instrument originally created in Silicon Valley, by the accelerator Y Combinator, to simplify investments in startups in the early stages. It works as an agreement by which the investor contributes funds to the startup in exchange for the right to receive equity interest in the future, usually in the next qualifying investment round or in a liquidity event.
Unlike a convertible loan agreement (as explained below), SAFE is not a loan agreement, i.e., it has no maturity term, early maturity clause, or interest payment. The conversion of the amount invested into equity interest occurs according to pre-established conditions, such as valuation cap (maximum limit of valuation of the company) and discount rate (discount on the price per share in the future investment round).
The main advantage of SAFE is its simplicity, reducing complex negotiations, high operating costs and exposure of responsibility for the operations carried out by the startup, allowing the startup to receive the contribution quickly and focus efforts on growth, while the investor ensures preferential conditions for future participation in the capital.
Convertible Loan. It is a loan agreement in which the amount contributed by an investor in a startup can be converted, in the future, into equity interest, instead of being returned in cash. This instrument is widely used in the early stages of fundraising, as it allows postponing the exact definition of the company’s value (valuation) to a more appropriate time, usually when the startup is more mature and with clearer performance metrics.
The contract establishes conversion conditions, such as a percentage of discount on the price per share in the future round (discount), or a maximum limit of the company’s valuation (valuation cap), as well as defining terms and, in some cases, the incidence of interest until conversion into a liquidity event. If the liquidity event does not occur and, consequently, the conversion also does not occur within the deadline or under the conditions provided, the investor may choose to demand the amount back, plus the stipulated charges.
However, it is worth noting that investment in Venture Capital is considered a high-risk investment and that the entire amount contributed will be used by entrepreneurs in the development of the startup’s products and operations. Therefore, the probability of the investor demanding the amount invested and actually receiving it back is very low.
While SAFE and Convertible Loan have the same goal, they differ in their legal nature and practical implications. SAFE is not a loan agreement, it does not provide for maturity period or interest charges, being simpler and more flexible, focused on reducing bureaucracy and accelerating the contribution. The Convertible Loan, on the other hand, is formally a loan agreement, with a defined term and the possibility of returning the capital plus interest if the conversion into equity does not occur, offering greater protection to the investor. In practice, SAFE is more agile and widely used in more mature ecosystems, while Convertible Loan is more common in Brazil because it is aligned with local corporate and tax legislation.
1.4. Pre-Investment Care
Before making any contribution to a startup, it is essential that the investor adopts a series of precautions prior to the investment to mitigate risks and increase the chances of return. Among these precautions are the detailed analysis of the business model, the founders’ history, the company’s financial and accounting situation, intellectual property, contracts in force, and potential legal liabilities. Additionally, it is important to understand the ownership structure, investor rights and duties provided for in investment agreements, and to assess the strategic alignment between the investor’s goals and the startup’s growth plans. This due diligence allows you to identify hidden risks, clarify responsibilities and make more informed and safer investment decisions.
This pre-investment step usually involves checking critical factors, such as:
- Cap table: the cap table represents the corporate structure on a fully diluted basis, which can be considered bad or poorly structured when disorganized or excessively diluted. This is due to the presence of many investors and strategic advisors, low participation of founders, making it difficult to make decisions and future investment rounds and reducing the return on capital investments, since there is little room for new investors to enter.
- Hidden information: The lack of transparency in the information provided by the startup to potential investors can lead to poor investment decisions. This breaks the investor’s confidence, as it can compromise his investment due to a lack of transparency.
- Founder not fully committed: occurs when there are founders who are not dedicated full-time to the business, generating low commitment to the development of the startup, considering that the founder is a central figure in the conduct and development of the enterprise and the absence of it directly compromises its growth.
- Irregular intellectual property: occurs when the startup’s intellectual property is not properly registered with the competent government agencies and, consequently, this intellectual property is not protected. This lack of registration or absence of contractual protection can represent a legal risk in the investment, since it compromises the exclusivity of the startup’s product and the ownership of the innovation developed, which can create long and costly legal disputes. It is worth noting that the most important asset of an innovative and technology company is precisely the invention behind the solution presented by the startup and a flaw in its intellectual property can directly harm the startup’s economic evaluation.
- Inadequate tax framework: the tax framework is a fundamental and strategic element for any company, as different tax regimes can generate significant financial impacts depending on the activity developed. An incorrect classification can result in unnecessary tax costs, which could be avoided with the appropriate choice of regime. In addition, this failure can highlight a deficiency in the company’s financial planning, since efficient cost management is essential in any venture and avoidable costs are always undesirable.
- Problematic contracts entered into in the past: poorly structured, poorly negotiated, or unfavorable contracts previously entered by the startup can generate unwanted obligations, corporate conflicts, or restrictions on the company’s healthy growth. Analyzing these contracts during due diligence is essential to identify risks and protect investors from harmful commitments made by founders that could jeopardize captable, valuation, and future investment rounds.
- High level of indebtedness: financial statements that show high indebtedness represent a relevant risk for the investor, as they can compromise financial planning, liquidity, business sustainability, and the possibility of contracting new strategic debts that may be essential to the company’s scalability.
1.5. Relevant Contractual Clauses
Contractual clauses play a central role in the structuring of Venture Capital operations, as they define rights, duties, and guarantees for both investors and the founders of the startup. They regulate essential aspects such as equity participation, governance, protection against dilution, exit conditions, investment conversion mechanisms and financial reporting obligations. Understanding these clauses is essential to mitigate risks, align expectations between the parties, and ensure that the investment is structured in a safe and strategic manner. See below some examples:
- Monitoring of management: this clause establishes the mechanisms by which investors can monitor the management of the startup, ensuring transparency in the use of capital and the performance of the business. This monitoring may include the requirement for periodic reports, the right to appoint advisors, and the possibility of requesting independent audits, ensuring that strategic decisions are aligned with the interests of investors.
- Valuation, conversion and index: deals with the definition of criteria for evaluating the company and the parameters for converting the investment into equity interest. Valuation refers to the process of determining the value of the company; conversion consists of the transformation of the investor’s credit into quotas or shares; and the index is the index used to monetarily update the value of the investment over time. These elements are essential to pre-determine the value of the company at the time of conversion, calculate the equity interest to which the investor will be entitled, and protect the amount invested against inflation or devaluation.
- Early maturity and fines: this clause establishes the conditions that can lead to the early maturity of contractual obligations and the corresponding penalties. Among these situations are breach of contract, the insolvency of the company or the misuse of resources, for example. The objective is to protect investors, ensuring reaction mechanisms if the company does not comply with essential commitments provided for in the contract.
- Governance, quorums, affirmative vote/veto: this clause establishes the rules for decision-making at company meetings. Governance defines the management structure and decision-making processes; quorums indicate the minimum number of participants necessary for a resolution to be valid; and the affirmative vote or the right of veto allows the investor, even as a minority shareholder, to approve or block certain strategic decisions, ensuring the protection of his interests.
- Drag along: it is a clause that establishes the obligation of joint sale, allowing majority shareholders to oblige minority shareholders to sell their equity interests in certain liquidity events. This situation usually occurs when the majority shareholder decides to sell the company in its entirety, and not just their own stake. Without this clause, minority shareholders could refuse to sell, negotiate different conditions or resort to the judiciary, making it difficult to conclude the transaction.
- Tag along: unlike drag along, tag along guarantees minority shareholders the right to follow the sale of the equity interests of the majority shareholders, under the same conditions. This mechanism protects minority shareholders against possible losses arising from the exit of a large investor, allowing them to also sell their shares on the same basis negotiated by the majority shareholders.
- Lock-up: this clause establishes restrictions on the sale of shares before the fulfillment of certain conditions, which may be based on a deadline or specific goals. It is generally applied to founders, with the aim of ensuring that they remain in the corporate structure and fulfill the commitments set before they can dispose of their shares.
- Follow-on: this clause guarantees investors the right to participate in future investment rounds, to preserve their equity interest in the startup. It protects against equity dilution, which occurs when new shares are issued to attract new investors in subsequent rounds.
- Anti-dilution or down round protection: this mechanism protects investors in cases of new investment rounds in which the valuation is lower than the previous round (down round). The clause adjusts the price of investors’ shares downwards, ensuring that they receive more shares and thus preserve their proportional equity stake in the company, avoiding the dilution caused by the lower valuation.
- Option pool: corresponds to a percentage of the startup’s captable reserved to offer to key employees, consultants and advisors as part of its compensation or incentive. This mechanism aims to attract and retain talent, aligning the interests of employees with the company’s success, since they start to participate in the growth of the business.
- Liquidation preference: gives the order of priority in the distribution and settlement of funds to the startup’s investors in liquidity events, such as sale, merger, or closure of activities. This clause ensures that certain investors receive their invested capital first, protecting them in scenarios of limited returns.
Author: Rodrigo Paes de Barros
Candido de Oliveira Advogados
Rua Santa Luzia, 651 – 23º andar – Centro
BR-20030-041 Rio de Janeiro – RJ
Tel (21) 2240 7746