Access to the Internet in Latin America, despite comparatively low penetration rates throughout the region, is rapidly transforming the way in which local companies conduct their business. Simultaneously, the Internet has spawned the creation of hundreds of new businesses throughout Latin America which are seeking ways to capitalize on the commercial opportunities presented by the Internet, including on both a business-to-consumer and business-to-business basis. This rapid development of Internet-based businesses has been facilitated by free access to the Internet provided by the portal operators (including Universo Online, El Sitio and Star Media), despite significant impediments, including the unavailability of a convenient and accessible payment mechanism, and the absence of a regional infrastructure for the prompt delivery of items ordered online.
In a fashion that parallels developments in the United States over the last few years, a new class of entrepreneurs has arisen in the region in response to the opportunities presented by the Internet and the growth of e-commerce, who are actively engaged in organizing start-up companies that seek to provide services through the Internet. These start-up ventures, like their counterparts in the U.S. and elsewhere, require venture capital investment for their successful growth and development. However, unlike the United States, where venture capital investment is a mature form of financing, in Latin America venture capital financing (and private equity generally) is a relatively new form of investment. As a result, there is a scarcity of venture capital in the region available for investment in these new Internet enterprises. In response to this rapidly growing demand for capital in the region, U.S. (and, to a lesser extent, European based) venture capital investors, including Chase Capital Partners, Citicorp Venture Capital, Hicks, Muse, Tate & Furst, E.M. Warburg, Pincus & Co., and Bank of America, among others, have been active in making earlystage investments in Internet start-ups in the region. Nevertheless, for companies whose focus is Latin America, financing is more difficult to obtain than for U.S. Internet start-ups, since far fewer venture capital funds are dedicated to the region than funds whose principal focus is U.S. Internet investment.
The Internet has spawned the creation of hundreds of new businesses throughout Latin America which are seeking ways to capitalize on the commercial opportunities presented by the Internet.
The sharp decline of Internet and technology stocks that occurred in April of 2000 has only increased the difficulty for Latin America Internet start-ups in obtaining venture capital financing.
Although only a few Latin American Internet companies have been able to complete initial public offerings in the Unites States (most prominently AOL Latin America, StarMedia and El Sitio), a number have been through multiple rounds of venture capital financing, and have been successful in developing a panregional strategy that many venture capital investors consider important to financial viability, especially in the business-to-consumer sector.
For an Internet entrepreneur, access to financing is second only in importance to the entrepreneur's core business concept. Few start-up companies, regardless of the commercial demand for their products or services, can implement their business plans and achieve financial viability without venture capital. The relative scarcity of venture capital financing for Internet start-ups in Latin America makes it all the more difficult for entrepreneurs in the region to successfully obtain essential early-stage investment. The difficulty encountered by start-ups in obtaining adequate funding, and achieving their ultimate goal of a successful initial public offering (an "IPO") or sale, is illustrated by some statistical observations regarding U.S. high tech start-ups which are included by John Nesheim in the current edition of his book, High Tech Start Up1:
- only six out of 1,000,000 business plans submitted to venture capital firms ever reach the IPO stage;
- on average, venture capitalists finance only six out of every 1,000 business plans received each year;
- 60% of high tech companies that succeed in obtaining venture capital end up in bankruptcy; and
- mergers or liquidations occur in 30% of start-up companies.
As these figures reflect, only a very small percentage of start-ups succeed in obtaining venture capital financing, and among those that do, a large percentage are unable to survive financially.
Characteristics of Venture Capital Investments in Latin American Internet Start-ups
Early stage venture capital investments typically share the following characteristics: (i) the investment is made in a company (the "Company"), the equity securities of which are held initially by a small group of shareholders (the "Founders") who founded the company; (ii) the Company is engaged in developing or marketing new technology, and new product application possibilities; (iii) the investment is made by professional venture capitalists, or by one or more funds organized for the purpose of making venture capital investments (collectively, "Investors") who are likely to assume that their participation in the investment will add value to the Company, and will, therefore, expect to be granted some degree of participation in the management or, at a minimum, oversight of the Company; (iv) the investment is not intended to be held indefinitely, but is intended to be held for a limited period of time (in the case of Internet investments, usually two to four years), at which point the Investors expect to be able to dispose of their interest in the Company through an initial public offering, a sale of the Company, or the repurchase by the Company of their investment. Due to their limited time horizon, Investors— especially Investors in Internet companies—seek Companies that are perceived to enjoy high growth potential in the near and medium-term.
For the reasons discussed below, the Company's capital structure will customarily include both common and preferred stock. Venture capital investors (as opposed to "friends and family" and "angel investors") customarily expect their investment to be in the form of preferred stock, which will enjoy certain important preferences in relation to the common stock, will be convertible into common stock, and may (dependent upon the bargaining power of the Investor, and the Company's need for capital) be redeemable at the option of the holder.
Risks of Venture Capital Investments
Venture capital investments pose risks for both the Founders and the Investors, in addition to the business and valuation risks that all companies face. The factors which give rise to problems in venture capital investments in Internet start-ups generally, and those in Latin America in particular, include, among others (i) disagreements on the value of the Company, the purchase price to be paid by the Investors and the relevant valuation procedures; (ii) disagreements on exit formulae; (iii) the conflicting objectives of the Founders and the Investors; (iv) the resistance of the Founders to permitting the Investors to exercise significant influence over the management and direction of the Company; and (v) where the investment is made in a Company incorporated in Latin America (as opposed to an offshore jurisdiction), the potential lack of a clear and reliable legal framework to enforce minority rights, and the potential inability of the local judiciary system to resolve controversies efficiently.
As in any direct investment, there is the risk of changes in or disagreements with regard to either the goals of the Company or the interests and expectations of the Founders and Investors. Therefore, it is important that the parties negotiate clear and effective mechanisms to regulate the relationship among all shareholders, especially the terms and conditions dealing with governance, financial decisions, day-today management and exit strategies.
With respect to the Founders, a venture capital investment will often involve having to learn to manage the Company with certain restrictions on decision making. Investors frequently request representation on the Board of Directors and rights to veto actions relative to strategic and financing issues. While these restrictions may seem burdensome and restrictive to the Founders accustomed to exercising unfettered control of the Company, they are nevertheless important to protecting the interests of minority shareholders.
An additional risk faced by the Founders is the likelihood of dilution of their interests. Internet companies have aggressive growth expectations, especially in Latin America, where Internet penetration remains relatively low. As a result, Investors in Latin American Internet companies generally anticipate pursuit of a highgrowth strategy, which will impose significant and continuing capital needs on the Company. Since the Founders of Internet companies typically have limited resources, the Founders will experience dilution as Investors or other capital sources make contributions in excess of their ratable interest.
With respect to the Investor, the relative illiquidity of the Company's shares (the "Shares") purchased by the Investor generally represents one of the most significant risks in any venture capital investment. Accordingly, in order for the Investor to be able to realize an acceptable return on its investment, the Investor will insist upon negotiating an acceptable exit strategy at the outset of the investment. Such strategies, discussed in greater detail below, may include taking the Company public, selling the Company to a third party, selling the Shares back to the Company (pursuant to a put provision in the agreements documenting the venture capital investment) or selling the Shares to a third party.
Venture capital investments pose risks for both the Founders and the Investors, in addition to the business and valuation risks that all companies face
Where to Incorporate?
Individuals who are developing an Internet business in Latin America will, at an early stage in the process, need to incorporate their business in order to obtain capital, and therefore must make an important decision about where to incorporate their Internet start-up.2 The decision of where to incorporate needs to take into account at least two important considerations: first, the expectations of the predominantly U.S. venture capital and, ultimately, IPO investors, in terms of the predictable enforceability of their rights, and second, tax considerations.
While most U.S. venture capital investors would prefer to invest in a U.S. entity, they are also prepared to invest in an entity organized under the laws of an offshore jurisdiction (such as the Cayman Islands or British Virgin Islands), where they are confident concerning their ability to enforce their rights.
If the Founders incorporate the Company in, or have the Company maintain an office in, the United States, there will be important U.S. tax consequences.
- A U.S. company is subject to U.S. corporate income tax on its worldwide profits at graduated rates up to 35%, although U.S. tax law allows companies to carry forward losses, and apply them to reduce income earned during the next 20 years.
- In addition, a U.S. corporation will be required to withhold a 30% tax (or such lesser percentage as may be applicable pursuant to an existing tax treaty with the country in which the Founders reside) on any dividends paid to non-U.S. shareholders. However, where a U.S. corporation is utilized, the withholding tax is not due until dividends, if any, are actually paid, and most Internet companies do not pay—or plan to pay—dividends.
Alternatively, the Founders can initially incorporate the Company in their home country, or in a taxfree jurisdiction, and prior to implementing an initial public offering have the Company contribute its assets to a U.S. entity, which would be the issuer in the IPO. However, if the Company either is incorporated in, or operates in, a country which imposes an income tax, this approach runs the risk of incurring local tax liability on any gain (including goodwill) realized upon the transfer.
If the Company (once incorporated in a nonU.S. jurisdiction) establishes a branch in the U.S. (instead of incorporating a U.S. subsidiary), to accommodate its U.S. activities, in addition to being subject to U.S. corporate income tax, the U.S. branch may also be subject to a "branch tax" on its aftertax profits. The branch tax is assessed at a rate of 30% unless a tax treaty between the U.S. and the Latin American domicile of the Company reduces the branch tax to a lower rate.
A number of U.S. and foreign tax considerations, in addition to those discussed above, must generally be taken into account in structuring any investment. Founders should therefore seek appropriate tax advice before adopting any structure.
A number of U.S. and foreign tax considerations must generally be taken into account in structuring any investment
The Different Stages of Financing
Once the Founders have selected a jurisdiction of incorporation, the Founders need to determine how to finance the implementation of their business plan. The Founders need to realistically assess how much financing will be needed to fund adequately all of the Company's needs, from inception until the point of an initial public offering, or sale to a larger company.
There are three conventional sources of pre-IPO funding: " friends and family," "angel investors", and venture capital investors, typically through multiple rounds of financing. Seed capital from "friends and family" and "angel investors" will be insufficient to fund more than early development-stage financing needs: multiple rounds of venture capital funding will often be required to fund the Company's growth and development. One other source of pre-IPO funding may also be suppliers, customers and people with business relationships with the Company. Often funding is negotiated as part of a larger strategic relationship.
Friends and Family Financing
The initial "seed capital" for any start-up is typically obtained by the Founders through financing from "friends and family," who provide the initial capital, and acquire common stock representing only a small percentage of the equity of the Company typically not more than 510%. These investors will generally not be represented on the Board of Directors or have any contractual protection for their investment. As common stockholders, they will be subject to dilution as subsequent investment occurs.
"Angel investors" are typically wealthy individuals or funds that specialize in early stage investing who provide additional, development stage financing, ranging from $20,000 to $1million in exchange for a negotiated percentage of the Company's equity (typically up to 20%). Professional angel groups, which include small early-stage funds, may invest from $500,000 to $1.5 million. Angel investors may expect to negotiate a simple term sheet (and subsequently fairly simple contractual rights) that incorporates the terms of the investment. Subject to the percentage of equity acquired, an "angel investor" may expect representation on the Board of Directors, and is likely to insist on the right to receive parity in treatment with subsequent venture capital investors who provide first-round financing. Angel investors are often useful in providing practical business advice and financing contacts to entrepreneurs.
The Founders need to realistically assess how much financing will be needed to fund adequately all of the Company's needs, from inception until the point of an initial public offering, or sale to a larger company
Venture Capital Investors
Venture capital investors are generally sophisticated, professional investors whose financial support is critical to the success of any start-up. In general, venture capital investors will:
- form a close, working partnership with the Founders, and may bring in professional managers to be chief executive officer and chief financial officer;
- have certain customary expectations, in terms of ownership and control, expected return on investment (ROI), and the need for a clearly-defined exit strategy; and
- expect significant contractual protections and preferences.
The threshold issue for any venture capital investor will be the valuation of the Company. The first challenge to the Founders will be to reach agreement with venture capital investors concerning the value of the Company, which will determine the amount of their investment and the extent of their ownership interest.
Venture capital investors will typically request representation on the Board of Directors, and rights to veto actions relative to key management, financing and operating issues. Depending upon their assessment of the managerial competence of the Founders, the venture capital investors may condition their investment upon installation of new senior managers, and may seek direct participation in daytoday management of the Company.
The Process of Obtaining Venture Capital
Formulating a Business Plan
The first step toward obtaining venture capital financing will be the preparation by the Founders of a detailed business plan that describes their business concept and the contemplated scope of operations, summarizes their business strategy, and includes detailed financial projections based upon stated assumptions. In all likelihood, the Founders will have already prepared a summary of the business plan for delivery to "friends and family" and "angel investors." The preliminary draft of the business plan will be progressively revised by the Founders as they refine their views about their business concept and receive feedback from prospective Investors.
Engaging Legal Advisors
Prior to entering into negotiations with venture capital investors, the Founders will need to engage a law firm that is experienced in advising start-up companies in their capitalization and financing activities. The law firm will have responsibility for reviewing and negotiating with venture capital investors the terms and conditions of any investment, while seeking to protect the interests of the Founders. The Founders may be unfamiliar with this process and are often more focused on obtaining adequate early stage financing. As a result, the Founders may not take (or have) the time to fully understand and properly evaluate the significance of investment terms proposed by venture capital investors, and may make concessions that have the consequence of reducing their future rights and equity interest in the Company. Support from knowledgeable counsel can be important to the Founders in "leveling the playing field," elevating their awareness about the implications of proposed investment terms and preventing them from making significant and avoidable concessions.
Finding a Venture Capitalist
Perhaps the most daunting task in financing a new company is finding the sources of capital. There are directories of venture capitalists available, including through the Internet, and a Company seeking funding may send out business plans to each of the venture capitalists listed. However, most reputable venture capital firms receive literally dozens of business plans a week and may not be able to read all of these submissions or recognize the worthy business plans. A business plan received from someone with whom the venture capitalist has a pre-existing relationship, whether a lawyer, accountant or investee, has a much better chance of being read. Another way a Company can meet a source of financing is through industry conferences or financing conferences. Many cities in the U.S. have conferences at which companies seeking funding make presentations to an audience of venture capitalists.
Due Diligence Review
Once the Investor has made the decision to proceed with an investment in the Company and signed a nondisclosure agreement, the Investor will want to conduct an in depth due diligence review. The Investor will evaluate the Founders, the financial viability of the business plan, including the Company's financial model and assumptions, the perceived demand for the Company's services in the relevant market, and the likelihood of success in a competitive market. It is not uncommon for Investors to bring in third-party experts to evaluate the Company's technology.
Support from knowledgeable counsel can be important to the Founders in "leveling the playing field," elevating their awareness about the implications of proposed investment terms and preventing them from making significant—and avoidable— concessions
Term Sheets and Letters of Intent
Typically, after a potential Investor has performed its due diligence and has indicated a serious interest in making an investment, the parties will want to negotiate a term sheet or letter of intent which sets forth, in detail, the principal terms and conditions on which the investment will be made. (However, it is not uncommon for a term sheet to be negotiated prior to the performance of due diligence by a potential investor.) Those terms and conditions will be influenced by the amount to be invested, the level of ownership the investment represents, the type of business, the Company's financial situation, and the development-stage nature of the investment.
The single most important issue to be addressed in the term sheet is determining the value of the Company. This issue is the most sensitive matter at the initial negotiation stage, and the Investors will generally not go forward with a proposed investment unless an agreement is reached. Other important issues to be addressed at the term sheet stage include the amount to be invested, the level of ownership, the nature and terms of the investment and any so-called "warrant coverage" (the number of additional shares subject to warrants the Investors may purchase).
In most cases, the term sheet also addresses issues relating to Company governance and the relationship between the Investors and the Founders. The amount of negotiation on these issues and the extent of the detail included in the term sheet or letter of intent will influence, in an important fashion, the negotiation of the relevant agreements. To the extent the parties are able to reach a detailed agreement at the term sheet stage concerning these issues, there will be a corresponding reduction in the amount of time require to negotiate the documentation of the investment.
Typically, there is significant negotiation between the principals that occurs at the term sheet stage. Once the terms and conditions have been agreed to by all the parties, legal counsel will incorporate the terms into draft documentation. This generally includes both a stock and warrant purchase agreement (containing the price, the nature and terms of the Shares, the conditions to closing the investment, and the representations of the parties), preferred stock provisions (which may require a formal amendment to the Company's constitutional documents), a shareholders' agreement (often referred to as an "investors’ rights agreement"), which memorializes many of the Investors' rights (including registration rights) and a form of warrant. It will be the lawyers' responsibility to produce documents that set forth, in a clear manner, all the terms and conditions negotiated by the parties and provide a workable arrangement for the management of the Company.
Copyright © 2000 Mayer, Brown & Platt. This Mayer, Brown & Platt publication provides information and comments on legal issues and developments of interest to our clients and friends. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.