Jared Roscoe and Stephen Pelliccia, SoftBank Group International
This is an extract from the first edition of The Guide to Mergers & Acquisitions published by Latin Lawyer. The whole publication is available here.
Venture capital (VC), seed equity and growth capital investing are terms used interchangeably to refer to investments in start-ups or early-stage businesses that usually entail significant risk compensated by a high potential for growth and profit. Professional venture capital investors typically contribute their know-how and expertise to their targets in addition to their capital. Further, it is often expected that there will be subsequent rounds of investments by the same VC investor or from additional sources. VC has provided much needed capital and expertise to business entrepreneurs in Latin America in recent years, and we are confident that it will play an increasing role in the growth and expansion of companies in more business sectors and countries in the region.
The Unite States and other sophisticated markets have enjoyed a long history of VC financings, and customary practices have been developed that are specific to deal-making in that space. Some practices are analogous to traditional M&A partial acquisition transactions covered elsewhere in this Guide, but some practitioners follow the National Venture Capital Association (NVCA) form documents. Those documents include:
- investors’ rights agreement;
- voting agreement;
- right of first refusal (ROFR) and co-sale agreement;
- certificate of incorporation or memorandum and articles; and
- management rights letters and regulatory compliance letters.
It is natural then that, as Latin American markets see increased VC investments, transaction parties and their counsel need to assess and implement the appropriate way to document these transactions, taking into consideration local practices and the extent to which US practices should be imported and tailored. It is typical for the investor making the largest investment in the company in the financing round – the lead investor – to negotiate with the company the documentation to which all investors participating in the round will subscribe.
In this chapter, we will analyse the key terms of the NVCA transaction agreements, the involvement and commitment of the target in the transaction agreements, and compare and contrast the complex suite of documents advocated by the NVCA, to the use of a tailored approach through one comprehensive shareholders’ agreement signed by all shareholders of the target and the target itself. Given the increased presence of large international VC investors in the region who are comfortable with the NVCA forms, an understanding of their key concepts and structures is particularly important for Latin American start-ups and those seeking to become the next Latin American unicorn.
Investors’ rights agreement
The investors’ rights agreement, frequently referred to as an IRA, is arguably the most important of the NVCA agreements owing to the breadth of matters it covers. The IRA typically establishes registration rights, information rights, the right to a board observer, contractual pre-emptive rights, matters requiring board approval and director veto rights, and, to the extent not covered in a regulatory compliance side letter, compliance provisions and other ongoing covenants of a company. The IRA is typically executed by the company, holders of preferred stock (typically the VC investors), defined as ‘investors’, and founders, defined as ‘key holders’, which are collectively referred to in the IRA as ‘holders’.
Registration rights make up the majority of the text of the IRA, and while the details of registration rights are beyond the scope of this article, the IRA typically includes:
- S-1/F-1 demand registration rights, for an investor to force a company to consummate an initial public offering in the US;
- Form S-3/F-3 demand registration rights for companies that are eligible to use such forms; and
- ‘piggyback’ registration rights that allow an investor to cause a company to include shares held by such investor in a registration being carried out by the company.
VC financings in Latin America may not give investors the right to force an IPO of the company in the region. Local capital markets are not typically seen as an attractive exit option for VC investors because of their lower levels of liquidity and the higher concentration of growth stage companies listed on US exchanges. Legal hurdles and less familiarity with the process of going public in certain local markets further decrease the attractiveness. Consequently, registration rights in Latin American VC financings are often not heavily negotiated departures from the IRA form.
When negotiating registration rights, it is important to ensure early on that these rights will be available at the corporate level and jurisdiction, including through a holding structure, that allow for the most efficient exit from a tax perspective and provide potential purchasers comfort from a governance perspective, in each case, to ensure marketability for a successful public offering. For example, registration rights that only apply to a Brazilian operating company but not to its Delaware or Cayman parent would severely restrict the effectiveness of this type of exit for an investor. Naturally, the extent to which a target will reach the performance metrics required to launch a successful IPO on the US markets is itself a case-by-case analysis and by no means a certain outcome. That fact alone often requires significant departure from the NVCA form. Relatedly, investing through a vehicle established under the law of an investor-friendly jurisdiction can mean that registration and other important rights will be enforceable under local law at the holding company level.
Information and observer rights are not typically heavily negotiated but there are some key provisions to keep in mind. In the NVCA form, an additional classification of investor, a ‘major investor’, joins the fray of ‘investors’, ‘key holders’ and ‘holders’. The ‘major investor’ term sets forth a share ownership threshold over which shareholders are entitled to receive information rights. The threshold to receive information rights is frequently set at a percentage that would allow the smallest preferred holder or institutional investor to not be excluded; however, 5 per cent is typical. One of the key components of most management rights letters provides certain investors with a separate contractual right to continue receiving information rights even if they fall below this threshold in the IRA and cease to be a major investor. A major investor may also lose its information rights if it is determined to be a competitor by the board of directors of the company. A more investor-friendly approach would be to carefully define competitor to prevent these rights from being capriciously removed or to exclude specified investors from the definition of competitor. This is particularly important given the rise of pan-Latin American companies that grow after the time of a major investor’s initial investment and negotiation of the IRA to cover a much wider geographic scope, and potentially come into competition with other portfolio companies of that major investor. This could put the major investor in a position where a company’s expansion into a new territory could trigger the ‘competitor’ determination and all information (and potentially other) rights would disappear.
One of the most common and most important provisions in the IRA is the pre-emptive right, referred to in the NVCA agreements as a right of first offer on future stock issuances, and informally as ‘pro rata rights’. This right allows shareholders entitled to it to participate in future equity rounds in proportion to their pre-round equity ownership, and thus provide an opportunity to avoid dilution by investing more into the company. In the NVCA form, pre-emptive rights are only extended to major investors, using the same definition and sunset threshold as used for the granting of information rights. Pre-emptive rights are typically not granted to all shareholders, to limit the burden on companies raising future equity rounds, running the process required by pre-emptive rights can entail a considerable administrative burden for the company, especially when the ownership of the company is held by a large number of investors from previous rounds. Counsel should be aware that pre-emptive rights may be mandatory under local law or provided under default rules, depending on the jurisdiction and the type of legal entity. For example, under the law of most Latin American countries, including Brazil, pre-emptive rights are granted under law for shareholders of certain types of local issuers, so as a matter of local practice they are often expected and extended to more shareholders than just the major investors, even if the issuer in question is not incorporated under local law. In addition, institutional investors making bets on early stage companies may ask for enhanced pro rata rights that allow the investor to take a disproportionately large percentage of the next equity round. This can be viewed by founders as a show of faith by an institutional investor or can be resisted by founders who do not wish to be wedded to the same investor in future rounds.
Finally, the IRA can also contain a variety of forward-looking covenants that restrict how a company may operate. These provisions can be as straightforward – though commercially sensitive – as veto rights for a particular investor’s appointee to the board or all directors appointed by holders of preferred stock. But they can also include remedial provisions arising out of due diligence and tax compliance covenants including regarding corporate anti-deferral tax regimes (including, in the case of VC investors with a US nexus, regarding controlled foreign corporations (CFCs) and passive foreign investment companies (PFICs)) and – if not included in a stand-alone regulatory compliance letter – covenants to comply with anti-corruption laws, anti-money laundering laws and, increasingly frequent, data privacy and cybersecurity laws.
The voting agreement NVCA form binds the preferred holders, referred to as ‘investors’, and holders of significant portions of common stock, typically the founders and occasionally other key employees or early investors, referred to as ‘key holders’, to vote their shares in unison for the election of directors nominated by a specific party and in favour of a sale of the company meeting certain criteria (i.e., a drag-along). When an investor is granted the right to appoint a director to the board of a company, the mechanism by which this is accomplished is a covenant from the other shareholders to vote their shares in favour of appointment (and removal) as instructed by the investor holding this right. The total size of the board and other significant rights related to the board and its directors, such as the list of specific decisions that require approval by the majority of the board, is not necessarily established in the voting agreement but rather in the relevant organisational documents (memorandum and articles, by-laws, estatutos, etc.). As such, the voting agreement will frequently not give a comprehensive picture of board composition or board rights. As many important board (and shareholder) rights are established under or informed by local law, investors have another reason to consider carefully the jurisdiction of the entity in which they are investing, as the ability to successfully enforce those rights under local law is an important protection for investors (for more on this point, see ‘Charter’ below). In addition to an investor’s right to appoint a director, investors should carefully consider the rights founders have to appoint directors, particularly when such founder appointees represent a larger portion of the board than is supported by the founders’ collective equity interest in the company. The parties will seek to balance the founders’ desire to maintain control over the company they have created with the investors’ desire to institutionalise the company as it grows with strong governance, including through the appointment of independent directors. Furthermore, local corporate governance practices may come into conflict with international investors’ expectations.
The drag-along right is of crucial importance to an investor as it is the only provision in the NVCA voting agreement form pursuant to which an investor can be forced to exit its investment against its will. A drag-along right in the voting agreement form covers a ‘sale of the company’, which is defined as a sale of more than 50 per cent of the voting power of a company or a transaction that would constitute a deemed liquidation event under the company’s charter or by-laws. It is important to closely review this cross reference to the company’s charter or by-laws to ensure that transactions that should not trigger a drag-along right are not unintentionally included. Whether a drag-along right may be exercised partially may also have an adverse impact on an investor, as it could allow the dragging shareholders to drag a majority of an investor’s stake, leaving that investor with an illiquid minority stake below the thresholds that would entitle it to basic rights (such as information rights or pre-emptive rights). As a result, investors will often push for the drag right to be ‘all or nothing’, meaning that they cannot be dragged unless such transaction would guarantee a full exit for the dragged investor. It is important to consider what block of shareholders can cause a sale of the company to occur, and ‘drag’ the remaining shareholders against their will. Typically, the affirmative vote of a supermajority of the preferred holders and a majority of the common holders will be required in order to trigger a drag. An investor may seek to protect its investment by negotiating a floor share price beneath which it would not be forced to participate in the transaction. These floors are often tied to a multiple of a financing round’s original issue price per share. An investor may also seek the right not to be dragged within some period after the closing of its investment. Finally, an investor will look to require a preferred supermajority vote to trigger the drag so that the investor’s interest in the company can exercise the maximum amount of influence, while founders will look to set the drag vote threshold below the point at which any one investor or small group of investors would have the ability to veto a sale of the company.
ROFR and co-sale agreement
The NVCA ROFR and co-sale agreement form establishes:
- a primary right of first refusal granted by the key holders in favour of the company;
- a secondary right of first refusal granted by the key holders in favour of the investors;
- a right of co-sale (tag-along) granted to the investors for any transfer by a key holder for which the company’s and the investors’ rights of first refusal are not exercised; and
- general transfer restrictions and customary exemptions thereto for permitted transfers.
The secondary right of first refusal for transfers by key holders in the NVCA form contains an ‘all or nothing’ limitation; namely, if investors agree to purchase fewer shares than all that a key holder proposes to sell to a third party, then the investors are deemed to forfeit their right of first refusal in connection with the transaction. The ‘all or nothing’ limitation favours key holders, who are more likely to be able to extract the full value of their stakes as a block, as a prospective buyer may attach greater per share value to the acquisition of a larger stake. A sale of shares by key holders of more than 50 per cent of the voting power of a company may constitute a sale of the company under the voting agreement, which, if supported by the requisite shareholders discussed in ‘Voting agreement’ above, could compel the sale of the shares held by investors to the acquiror. Such a sale would also trigger the requirement in the voting agreement that the sale terms must be open to all holders of preferred stock and the consideration offered must be structured to reflect the liquidation preferences of the classes of preferred shares of the company – thereby preserving investor value.
In some cases, the secondary right of first refusal for transfers by key holders is expanded to also cover transfers by investors. This allows investors to control the composition of the company’s shareholders to limit the transfer of shares to, for example, sanctioned persons, affiliates of competitors, or persons with reputational or legal issues. This right, however, this can be a double-edged sword for an investor as it would significantly restrict the liquidity of that investor’s stake. The scope of the right of first refusal should be carefully tailored at the term-sheet stage to avoid protracted discussions when drafting definitive documentation. Alternatively, a transfer restriction prohibiting transfers to sanctioned persons and persons with other AML and FCPA related issues can be negotiated and included in the agreements.
As new parties become shareholders in a company, they may be added to the ROFR and co-sale agreement and other NVCA agreements via joinder without the need for a full amended and restated agreement; however, in connection with a new equity raise, the entire agreement would likely be updated for requests specific to the new round’s investors.
The charter (certificate of formation or Incorporation in Delaware; the memorandum and articles in the Cayman Islands; and the by-laws in most civil law Latin American jurisdictions) is one of the most important of the suite of documents to review when considering a venture capital or growth equity investment. The charter or by-laws define the key economic terms of the preferred shares being issued in a particular round of investment, such as the liquidation preference, anti-dilution protection and the events that trigger a forced or automatic conversion of preferred shares to common shares, and establish the mechanics for deemed liquidation events and the conversion of preferred shares to common shares. In addition, the charter or by-laws typically contain shareholder-level veto rights referred to as ‘protective provisions’ that protect the key terms of a particular series of preferred shares from modification without the relevant investor’s consent.
A ‘deemed liquidation event’ is a defined set of events that, unless waived by a requisite percentage of preferred holders, trigger the distribution of a company’s assets to its shareholders, first to satisfy any applicable preferences held by the preferred holders, and thereafter to the shareholders pursuant to the distribution provisions or waterfall of the charter or by-laws. This concept typically includes:
- a sale of all or substantially all of a company’s assets or subsidiaries (to the extent that majority of the company’s assets are held by its subsidiaries) in a single transaction or a series of related transactions;
- a merger or consolidation where the company’s capital stock does not represent a majority of the combined capital stock of the merged company; and
- a sale of a company’s intellectual property or key intellectual property, which is particularly relevant for start-ups.
This defined term is of crucial importance not just in the charter or by-laws, but also as a cross referenced term in the other NVCA forms, such as the voting agreement and the ROFR and co-sale agreement, where it can trigger drag-along rights and tag-along rights.
The conversion mechanics in the charter or by-laws allow for optional conversion by an investor of its preferred shares into common shares at any time and provide for the automatic conversion upon the occurrence of a ‘qualified public offering’. The definition of qualified public offering is heavily negotiated because it is a public offering that triggers an automatic conversion of all series of preferred shares into common shares without the need for the consent of the preferred shareholders. ‘Qualified public offerings’ are typically defined as an initial public offering with a price per share offered to the public greater than or equal to a certain threshold, typically some multiple of the last round’s price per share, net proceeds to the company in excess of a certain threshold and a listing on a sophisticated market, which can be specified to avoid ambiguity. While initial public offerings have historically been a less likely exit from investment in Latin America as compared to sales to strategic players or secondary funds, as more and more Latin American start-ups consummate successful IPOs abroad the specific components of what constitutes a ‘qualified public offering’ are becoming more intensely negotiated. The definition of ‘qualified public offering’ is all the more critical as the NVCA agreements typically terminate upon the occurrence of an initial public offering, meaning that all of the investor’s heavily negotiated contractual rights would disappear without the investor’s consent.
A debate often occurs over what provisions of the NVCA agreements need to be duplicated conceptually into the charter or by-laws to provide a greater degree of enforceability, particularly against third parties who are then deemed to be on notice as to the existence of such provisions. Board appointment rights, board vetoes, pre-emptive rights and various other provisions contained in the IRA are typically the subject of this discussion. The parties seek to balance the investor’s desire for greater enforceability of these rights against the company’s desire to limit these key terms into confidential private contracts and not (in some jurisdictions) publicly available documents. Depending on the jurisdiction and the public availability of the charter or by-laws, the parties also seek to limit references to the NVCA agreements in the charter or by-laws as much as possible to avoid them being requested by the relevant government authority and made public (e.g., in England via Companies House).
Other documents and miscellaneous clauses
The share purchase agreement NVCA form (SPA) functions as a typical subscription agreement with some key differences. There is no indemnity for breach of representations and warranties, although there is an ability to recover for a breach of contract. To the extent an indemnity is included (most common for tax and compliance liabilities in Latin American jurisdictions, including Brazil), an investor should carefully negotiate the definition of ‘Losses’ and ensure that a gross-up provision is included. The indemnity provisions typically apply after closing, when the investor will own a share in the company; therefore, in practice, the investor will be indirectly paying itself a portion of every dollar indemnified by the company. In the absence of indemnity rights against the existing shareholders, the investor should consider the merits of addressing dilution or reduction of future capital contributions as an alternative to cash indemnity payments. Unless there is a cash-out component to the transaction, obtaining indemnity rights against the founders or controlling shareholders is rare in a VC investment. The SPA also does not include any provisions that address risk allocation or operations of the business between signing and closing, which in many Latin American jurisdictions can pose problems as competition and other regulatory approvals can cause long pre-closing periods. Frequently, these shortcomings of the form SPA are addressed separately through side letters.
Side letters may be entered into by an investor and a company to address topics that were not covered in the other NVCA agreements. The NVCA form of management rights letter includes consultation rights, inspections rights, the right to receive minutes and board materials, and it also includes provisions that aim to protect foreign investors from the Committee on Foreign Investment in the United States jurisdiction for investments in companies with operations in the United States. Another provision that is often included in the management rights letter are investor-specific ownership sunset thresholds for the receipt of information rights that are lower than the definition of major investor established in the IRA and applicable to the other shareholders. Remedial covenants for items discovered during due diligence can also be included in the management rights letter (e.g., the execution of intellectual property assignment agreements for key employees and founders that have not yet done so, or the transition from using independent contractors to actual employees fully included in the payroll). Since the form of SPA is tailored to US transactions, country-specific covenants are frequently included in these side letters to avoid negotiating the NVCA form (e.g., covenants to comply with country-specific data protection regulations, to transition from an independent contractor workforce to employees fully included in the payroll, or to take a different approach with respect to the tax characterisation of certain operations on a going forward basis).
As discussed above, most of the NVCA agreements have termination provisions that are triggered by an initial public offering, a sale of the company, or pursuant to the amendment, waiver and consent provisions of each agreement. As with the triggers for a drag-along in the voting agreement, investors should make sure the termination triggers in each agreement are sufficiently narrow and do not include unintended components of a deemed liquidation event to the extent that the defined term in the charter or by-laws is broader than normal. It is important to ensure that the termination and amendment provisions are consistent throughout the VC agreements to avoid ambiguities and potential disputes. Typically, the affirmative vote or consent of key holders holding a certain percentage of a company’s common stock and investors holding a certain percentage of a particular series of preferred stock is required for any amendment to the NVCA agreements, but it is not uncommon to see inconsistencies across documents.
Regardless of local preference and the potential benefits of using a familiar shareholders’ agreement versus the NVCA agreement forms, if a company intends to continue to raise additional rounds of capital from offshore VC investors, it is likely that at some point the company will be forced to adopt something similar to the NVCA forms. If a company has already adopted this framework in an early round, future investors will most likely not be able to force a change in approach for a later round as the previous investors and the company may not accept the cost and effort required to start from scratch.
Alternatively, founders in countries such as Brazil, that have access to capital from sources within Brazil, often propose a more traditional shareholders agreement and investment or subscription agreement. These founders, particularly those of earlier stage start-ups, may not have the same pressure to change their approach in order to make themselves more attractive to capital abroad as founders of later stage companies or those from countries with fewer ready sources of local capital. As such, the decision to use the NVCA forms (or something similar to them) is unique and the decision to use a particular suite of documents turns on many factors, including the size and sophistication of the investing parties, their experience with international and local investment documentation styles and each party’s negotiating leverage.
The intent of the NVCA in creating the NVCA agreements was to streamline terms and documents in the VC sector and reduce costs for both founders and investors who could look to a standard set of documents and facilitate comparisons across deals. However, in practice, various issues arise in the use of the forms without adjustment for Latin American transactions, including:
- The priorities, risk appetite and level of sophistication of each set of founders, in each industry and in each country in the region, varies greatly, so an investor’s approach to negotiating and documenting a transaction should also be tailored.
- As the NVCA form agreements address overlapping issues, there is significant potential for inconsistencies when each agreement is adapted to reflect the specific aims of the parties. Similarly, principles of risk allocation and certainty adequately negotiated and documented in one agreement can be confused by the approach to a similar topic in a different agreement, obscuring interpretation issues.
- VC investors can more easily monitor and compare one comprehensive shareholders’ agreement for each portfolio company transaction than five or six separate agreements with overlapping topics.
- Many of the NVCA form agreements are crafted with a US legal environment in mind – including, for example, the US Securities and Exchange Commission regulations and requirements for IPOs, when in fact a vast majority of businessmen operating in Latin America will not provide an exit to the investors through a US IPO.
- Often, topics covered by the NVCA forms will have a customary or even legal treatment under local law of the jurisdiction where a target is incorporated or operates its business, requiring adaptation of the documents that are likely better addressed from precedent shareholders’ agreements and by-laws, rather than the forms.
From the perspective of many lawyers active in this market in Latin America, the approach that would most minimise risk to an investor would be to create an initial draft shareholders’ agreement that covers all of the topics addressed by the NVCA forms in an all-encompassing agreement. However, owing to the prevalence of these forms in the US market and the fact that US investors in subsequent, larger rounds may refuse to work with a previously executed shareholders’ agreement and may request to implement something similar to the NVCA forms as a cost-saving measure and to ensure consistency and ease of comparison across their portfolio companies, the most practical approach for many may be to accept the NVCA forms and to engage sophisticated counsel with experience in both Latin American M&A and VC transactions abroad who can take a critical and focused approach to properly tailor the agreements to the deal in question, specifically considering the cross-border nature of the transaction.
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