friday, 5 may of 2017

Stairway to heaven: Angel investment in Brazilian startups

Gabriel Rios Corrêa and Isadora Ramos de Albuquerque Lima

Given the stage of development of the startup industry in the United States, the main discussions around that topic focus on which offers should be exempted from the Securities Act registration (with some current interesting discussions related to equity crowdfunding); under what circumstances general solicitation, demo days and pitch contests should be permitted; as well as on who may invest in startups: if only "accredited investors" (persons or entities that are financially sophisticated and satisfy the SEC's net worth or income requirements) or if anyone up to certain limits1.

Among those that normally fall under the accredited investor definition are the so-called "angel investors". Although this term gained usage in the last decade or so, especially in connection with high-tech startups, this kind of investor is not new. It is said that such term actually comes from affluent patrons who financed Broadway plays in the early twentieth century. Currently angel investors designate wealthy investors who provide their own funds, as well as experience and knowledge, to small but highly promising companies before they are mature enough to obtain venture capital or private equity investment.

Not for as long and much less widespread, angel funding has also been present in Brazil. While in the US angels often invest in startups in exchange for convertible debt securities or preferred stock, in Brazil angels have had to adapt such investment instruments to make them compatible with Brazilian startup models. In Brazil, most startups are incorporated as limited liability companies (sociedades limitadas), a simpler and less costly organization, rather than corporations (sociedades anônimas), and some of the main Registries of Commerce in Brazil hold the view that sociedades limitadas cannot issue debentures or other debt securities. In addition, it is generally understood that sociedades limitadas cannot issue preferred stock2. As a result, angels have generally had to structure their investments in Brazilian startups as loans convertible into equity (rather than a convertible security) or through the acquisition of quotas (similar to common shares in a corporation), with all the obligations and risks resulting from such quotaholder status.

If the facts above were not enough to complicate angel investments in Brazil, where angels decide to invest in startups through equity, there is also a certain risk of them being held liable for the company's debts thanks to the unorthodox use by some judges, specially on labor and tax disputes, of the piercing the corporate veil doctrine. As a result, affluent individuals who would be willing to invest in startups end up giving up on such idea fearing to put all of their assets at risk. Also, the Brazilian law itself imposes some barriers on angel investment in startups that want to benefit from the simplified and more favorable tax regime (the Simples tax regime) established by law (LC) 123/06.

This favorable tax regime is available for microenterprises (microempresas - ME) – companies that have an annual gross revenue equal to or lower than BRL 360 thousand – and small enterprises (empresas de pequeno porte - EPP) – companies that have an annual gross revenue exceeding BRL 360 thousand but lower than (or equal to) BRL 4,8 million.

According to law 123/06, corporations cannot benefit from the Simples tax regime. Therefore, microenterprises and small enterprises are usually organized as sociedades limitadas. But not all limited liability companies can benefit from such tax regime, only those that do not have as a quotaholder: (i) another legal entity; or (ii) an individual who is already a quotaholder of a company that benefits from the Simples tax regime, or who owns more than 10% of the capital stock of a company that does not benefit from the Simples tax regime, or who is a manager of another legal entity, provided, in any of these cases, that the combined gross revenue of such companies exceeds BRL 4,8 million. These restrictions, combined with the fact that angel investors usually invest in dozens or even hundreds of companies, make it difficult for micro and small enterprises to obtain angel funding.

This scenario, fortunately, has evolved. At the end of last year, amidst other regulatory measures aiming at fostering the development of Brazilian startups (including the new CVM's rule on private equity funds, which created a special category for seed capital investment, and the proposed rule for equity crowdfunding currently under discussion), the government sanctioned law (LC) 155/16, which changes certain provisions of law 123/06 and creates a new type of angel investment in micro and small enterprises.

According to law 155/16, an angel investor – who may be an individual, a legal entity or even an investment fund – may fund micro and small enterprises through a participation agreement (contrato de participação). This agreement may be valid for a period of up to seven years and should set forth (1) that the funding is being made to promote innovation and productive investments; (2) the angel's remuneration in return for her investment, provided that such remuneration shall only be paid during 5 years and that the annual remuneration must not exceed 50% of the company's annual profits; and (3) the rules regarding the redemption of the angel's investment, provided that such redemption cannot be implemented prior to 2 years from the date the funding was made and that it shall be limited to the amount funded adjusted by an inflation rate. The contract may also contain an authorization for the transfer of the angel's investment. Absent such authorization, the transfer of the investment may only be made upon the consent of the company's quotaholders.

The Law also grants the angel a right of first refusal and a tag along right if the company's quotaholders decide to sell their quotas.

The uniqueness of the new Law is that it expressly provides that angel investments based on participation agreements will not be considered part of the company’s capital stock and, therefore, that the angel investor will not be considered a quotaholder of the company. These provisions give rise to at least two important consequences.

The first consequence, which is actually expressly stated in the Law, is that since the angel investor is not a quotaholder, she will not be liable for the company’s debts and will not be subject to the piercing of the corporate veil doctrine. Following this rationale, the Law establishes that the angel investor must not have any voting rights, nor hold any management position.

The second consequence, which may yet be the main positive outcome of the new Law, is that it will allow angel investors, both from Brazil and abroad (as the Law does not prohibit investments from angel investors resident or domiciled in other countries), individually or through angel groups, to invest in more than one micro or small enterprise at the same time, without the risk of such company losing the benefit of the Simples tax regime. If it were not for this new Law and the angel funding was treated as capital stock, the micro or small enterprises would face this risk due to the restrictions described earlier (either because legal entities and foreign investors cannot be quotaholders of micro or small enterprises, or because the global gross revenue of the companies invested by the angel would exceed the legal thresholds).

The new Law does bring about some uncertainties, which will have to be addressed in further regulation or, to the extent possible, in the participation agreement or other contracts. Some of the uncertainties regarding this new type of investment refer to the nature of the angel's investment, the tax treatment of the angel's remuneration as well as of the redemption and sale of the angel’s interest , the possibility of conversion of such investment into equity, and the possibility of the angel having at least some veto powers, even if structured as triggering events for the redemption of the angel's investment. It is also not totally clear how the Brazilian courts, specially labor courts and those with jurisdiction over tax matters, will uphold the new rules on protecting the angel from debts of the invested company.

Despite all of such uncertainties, law 155/16 is a big step towards fostering a more favorable environment for angel investing in Brazilian startups.

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1 For more details in relation to such issues, please refer to Rules 504, 506(b) and 506(c) of Regulation D, the Jump-Start Out Business Start-Ups Act and the Helping Angels Lead Our Startups Act, all available at the SEC's website.

2 For more details, please refer to the article "Structuring Venture Capital Investments" in Issue No. 6 of our newsletter, which can be found here.

3 A draft prepared by the Internal Revenue Service and which is still subject to comments by the public is available here.

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*Gabriel Rios Corrêa is a partner of Brazilian law firm Lobo & Ibeas Advogados and has a Master of Laws from the New York University.

*Isadora Ramos de Albuquerque Lima is an associate of Brazilian law firm Lobo & Ibeas Advogados and has a Postgraduation in Civil Procedural Law from Cândido Mendes University.


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