Preparing Brazilian Businesses forVenture Capital Financing

November 2014

Why taking care of the legal stuff matters

• Before investing, most investors perform legal due diligence• Perceived legal risks may lead to:

– Reduced valuation – Delays in financing process– Indemnification from the company and founders– Decline in investors’ trust and confidence

• U.S. investors generally have a lower risk tolerance for aggressive tax, labor and IP positions

• KISS - Be creative with your business, not your legal structure

Forming a company

• Form a company early, i.e., as soon as you decide to pursue the business idea• Sociedade Limitada

– Commonly used by businesses that raise funding through an offshore holding company– Unlike S.A.s, limitadas are not required to publish financial statements until they reach

significant size• Sociedade Anonima

– Better choice when venture capital firms are expected to invest directly in the Brazilian company

– Shares can be publicly traded on an exchange– Managed by a board of directors– Can create an employee equity compensation plan

Offshore holding companies

• Be flexible– Wait to form an offshore company until you sign a term sheet for the first round of funding– Investors have different requirements and capabilities

• Reasons investors prefer offshore holding companies– Familiar corporate law– Perceived risks of being a director of a Brazilian company

• Delaware vs. tax neutral countries– Delaware corporations are usually tax inefficient unless the company plans to have

significant business activities in the U.S.• Conduct all business activities through the Brazilian subsidiary (or other local

subsidiaries), not the holding company• Brazil subsidiary should be 100% owned by the holding company, except for

qualifying shares

Capitalization and equity

• Founders receive common shares– Ownership percentages should reflect relative contributions and importance to the

company• Employees, advisors and consultants receive options

– Typically join the company at later point in time, when value has been created• Put everything in writing, in agreements reviewed by legal counsel

– Board approval (including number of shares, price, vesting schedule, vesting start date and location of recipient)

– Share purchase agreement or option agreement• ROFR• Vesting / right of repurchase• IPO Lock-up

Vesting

• Essential when there is more than one co-founder– Protection when a co-founder or employee leaves the company – Investors will insist upon vesting

• Founder shares typically vest over 4 years, sometimes with credit for time previously spent on the business– Company has right to buy back unvested shares at cost if the founder leaves

• Employee options typically vest over 4 years with a one-year “cliff” probationary period– Options may not be exercised until they have vested

• Founder shares may include change of control acceleration– Double trigger: Acceleration occurs if the founder is terminated without cause within 6 –

12 months after the sale (i.e., founder must agree to stay with the acquirer after a sale)– Single trigger: Acceleration occurs immediately upon the sale– Single trigger is more likely to be renegotiated by an investor or acquirer

Obligations to former employers

• Non-compete and non-solicitation agreements– Check the duration and scope of agreements with former employers– Assess your co-founders’ agreements, too

• Intellectual property– Avoid using technology that was created in the scope of previous employment– Pursue the new business idea entirely outside of working hours and on personal

computers and equipment (i.e., not belonging to employer)– Use personal (not work) email and communications

Protecting the company’s IP

• Document the company’s ownership of intellectual property from the start– Technology assignment agreements with founders for technology created before the

company’s incorporation– Proprietary Information and Invention Agreement (PIIA) with every founder and

employee for technology created after the company’s incorporation• Make PIIA a part of “new hire” paperwork• Typically includes non-solicitation and non-compete provisions• Enforceability of non-compete provisions may be limited under Brazilian law

– Consulting agreements for other service providers– Licenses from university or third parties for intellectual property owned by others

• Protect trade secrets– Use confidentiality agreements in discussions with third parties– Mark company documents “confidential”

Labor and employment

• Properly classify all workers and service providers– May be more expensive, but . . .– Failure to properly classify employees creates labor liabilities that investors will factor

into valuation– Also increases the risk of labor lawsuits

• Persons who work exclusively for the company should be treated as CLT employees

• Founders and officers of the company may qualify as pro labore workers• Ensure non-Brazilian founders have necessary work or investor visas

Foreign currency exchanges

• Venture financing that is raised through an offshore holding company will often be in a currency other than Reais

• Transfer funds from the holding company to the Brazilian operating company on a periodic basis to hedge against exchange rate fluctuations

• Holding company can use funds to pay its non-Brazilian legal, accounting and professional advisers

• All other business expenses should be paid by the Brazilian company– Register all funds transfers to the Brazilian company with the Brazilian Central Bank to

reduce future taxes if the holding company sells the Brazilian company

Financing structures

• Purchase of common shares– Typically not a good idea as it places value on the common shares, setting a floor on the exercise price of

employee stock options• Convertible notes

– Does not place an enterprise value on the company – Provides investors with a liquidation preference ahead of common shareholders – Notes convert at a future date at a valuation set by a future investor, with a discount to reward note holders for

the risks of investing earlier– Usually can be executed more quickly and less expensively than other financings

• Purchase of preferred shares– Places an enterprise value on the company and therefore locks in the investors’ and founders’ ownership

percentages– Amount invested is usually greater than with convertible notes– Generally costs more in legal fees (because of the greater number of documents to negotiate)– Investors gain greater control rights, such as a board seat and protective protections– Founders stock will likely be subjected to transfer restrictions, such as rights of first refusal and co-sale

Financing structures – Special considerations

• When negotiating valuation (including conversion price caps in convertible notes), consider the effect on founder ownership after future rounds– Most Series A and Series B investors will want the founders to continue to own a majority of

the company following their investment– Series C and later investors will want the founders to own a substantial minority interest– Giving away too much equity to early angel investors can turn off later investors or require a

three-part negotiation with the angels• The conversion price discount of convertible notes may result in a “gift” of additional

liquidation preference for the note holders.– The liquidation preference of the preferred shares received by note holders will be 100% of

their face value, even though the note holders pay 70 - 80%– In large convertible note financings, the company may want to honor the discount by

substituting common shares• In all financing structures, investors should be limited to persons who meet the

“accredited investor” standard under U.S. securities laws