We have written before in this column about the challenges of angel investment in Brazil (see article published on 07.15.2013), especially regarding the risks beyond the loss of invested capital which may be followed by the subscription of quotas or shares in an investment in a company. Briefly, we highlight the banality in the disregard of the legal identity – which has been applied in many cases as a natural consequence of the inability of a company to pay its debts – as the main factor of concern.
At that time, we mentioned the training that has been conducted by various groups and associations of investors who manage to not only increase the chances of success of an emerging company, but also provide support for companies to mitigate risks that could ultimately turn out to adversely affect the equity of their partners.
In parallel with these initiatives, the legal community has imported instruments used by its fellow American lawyers to angels in the U.S., aiming to tropicalize the so-called “convertible notes”. In summary, the convertible notes are debt securities convertible into shares allowing the automatic conversion of debt into share upon the occurrence of a so-called liquidity event – known as Series A – which, in general, is the phase in the investment cycle in startups in which the company receives the investment of funds from venture capital.
Usually, a discount is established in the price of the shares that the angel will receive in relation to the price of the share to be paid by the investor of Series A, as a reward for the very high risk investment made by the angel before that investment round.
In Brazil, the legal instrument that most closely matches the convertible notes would be the convertible debentures set forth in Article 57 of the Companies Act (Law 6404/76), however, the use of this funding instrument requires the issuance of these securities by a joint stock company, which is a corporate type with a structure that is more expensive (for having more obligations to publish acts) and sophisticated to manage. Thus, few startups are able to “afford” to receive angel investment through the issuance of debentures.
Other structures that have been used to raise angel investment here have been loan agreements convertible into quotas or shares and the quota or share purchase option agreement.
Loan agreements convertible into quotas or shares usually include very similar provisions to the US convertible notes. In this sense, they are instruments that provide for the completion of a loan to the startup in which the other partners (investors) authorize the conversion and subscription into quotas or shares upon receipt by the startup of a new investment (at a predetermined minimum value) or the end of the deadline, which would be the maximum expected time for completion of the investment attraction round. In case no investment is made by a third party before the period ends, the angel investor may choose to convert the debt into interest or receive the amount of the loan back. Since angel investment does not have as a driver the remuneration on loan (quite limited when it does not involve a financial institution), the receipt of the amount usually stipulates the repayment of the principal without interest and unlimited conditions.
The purchase option, in turn, ensures the angel investor right to acquire quotas or shares of the startup for a predetermined price – calculated based on the valuation of the company, pre-round Series A, these conditions (price per quota/share) are overall more advantageous than the price per share to be paid by the venture capitalist. In relation to the convertible loan agreement, the purchase option differs in relation to the nature of the right of the investor, the loan agreement regulates a right to credit – with payment through the delivery of shares, while the purchase option can be seen as a right of future subscription.
It is important to note that none of these instruments – with the exception of convertible debentures – grant voting rights to investors who have not yet had their debt converted into share, even though it is common that instruments already specify the premises that should govern the shareholders’ agreement when investors join the company’s capital. Some convertible loan agreements may further specify limits to be followed by the entrepreneurs in the company’s management – especially in relation to investment or debt decisions – under the penalty of debt acceleration.
Despite the relative loss in terms of partnership rights, these instruments – because they are private and do not represent the entry of the investor in the capital at the time of the investment – end up bringing some safety to the angel investor in relation to the risk of contamination mentioned in the beginning of this article. They also allow the angel investor – when the startup does not report the expected result – to leave in a much simpler way, that is, not exercising the right of conversion or the right to purchase in the pre-established conditions, without having to seek other means to leave the company that, depending on the posture of the other partners, could even file a suit.
A big difference between the American and Brazilian practice, is that in the U.S., when entrepreneurs search for investments, they already know the instruments and contractual conditions through which angel investors will make the injection of funds. In Brazil, on the other hand, in addition to the range of possible structures, many entrepreneurs are unfamiliar with the investment process and the commitments to be undertaken from the moment they begin to seek investments.
Therefore, our angels here end up providing additional assistance to these entrepreneurs, in order to educate them regarding the process and fund raising cycles that may arise. To lawyers, in turn, it is worth understanding the peculiarity of this type of investment – which involves high risk and a relevant intangible, which is the experience and network of relationships of the angel investor, on the one hand, and human capital that the angel sees in the entrepreneur, on the other hand.
*Rosely Cruz, attorney, Buscapé Company vice-president Legal Affairs for Latin America, and neolaw. partner .
**Natasha Pryngler, neolaw. partner.
– See more at: http://neolaw.com.br/some-notes-on-the-format-of-angel-investment-in-brazil/?lang=en#sthash.YIDmFKK0.dpuf