Key Terms and Trends in Venture Capital Investments

Venture capital (VC), seed equity and growth-stage investing are terms frequently used 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. Seed equity refers to investors in early-stage companies, while growth-stage investing involves companies that are more mature (by comparison), have a more developed track record and have undergone one or two rounds of seed equity funding. Professional VC investors typically contribute their know-how, networks and expertise to their targets in addition to their capital.

VC has provided much-needed capital and expertise to business entrepreneurs in Latin America in recent years, and it will likely continue to play an increasing role in the growth and expansion of companies across business sectors and countries in the region.

Unlike Latin America, the United States and other more developed markets have enjoyed a long history of VC financings, and customary practices have been developed that are particular to dealmaking in that space.

The benchmark practice in this area has been developed by the National Venture Capital Association (NVCA), which has published certain established forms for the suite of shareholder documents typically involved in negotiating a VC financing, including:

• the investors’ rights agreement;
• the voting agreement;
• first refusal and co-sale agreements;
• certificates of incorporation or memorandums and articles of association; and
• management rights letters and regulatory compliance letters.^[2]

Latin American markets, which, in other areas of law such as traditional M&A and capital markets, often negotiate and enter into ‘New York-style’ documents governed by New York law, have generally embraced the NVCA-style documents in connection with VC dealmaking in the region. These NVCA forms, however, are frequently tailored to account for certain regional market standards, country-specific or regional practices, and consideration for the applicable laws and jurisdictions of the investment parties and investment target. VC investors and targets work closely with local counsel in the jurisdiction of formation and operation of the target to assess when local practices and other regional considerations deviate materially from US practice.

This chapter discusses the impact of VC investments in recent years in Latin America, as well as certain key terms of the NVCA transaction agreements. Given the increased presence of large international VC investors in the region that are comfortable with the NVCA forms, an understanding of their key concepts and structures is particularly important for Latin American start-ups, those seeking to become the next Latin American unicorn and advisers that wish to efficiently help their clients achieve a successful outcome.

VC investment in Latin America

In 2016, 2017 and 2018, VC investment in Latin America totalled US$600 million, US$1.1 billion and US$2 billion, respectively, representing an almost twofold increase year-on-year. In 2019, VC investment pace increased dramatically, reaching US$5.1 billion. Following a small decline in 2020 due, in part, to the uncertainties caused by the covid-19 pandemic (but still remaining at double the aggregate investment amount of 2018), investments in 2021 jumped to US$15.9 billion. Following multiple years of exponential growth, investment activity cooled off significantly in 2022 as a result of global and regional market conditions caused by inflation, economic uncertainty, local political changes and global geopolitical turmoil. However, even though the 2021–2022 data shows that VC investment declined by almost 50 per cent year-on-year, the amount invested in 2022 continues to represent nearly twice that invested in 2020.

This data suggests that, while it may be true, as some argue, that certain investors poured capital into Latin America in an opportunistic manner in 2021 and may have since left the market, VC investing in the region became a significant practice, and it involves the collaboration of many market participants, including entrepreneurs, investors, international and local counsel, and investment banks. It is therefore important for all players to understand the main terms in the NVCA transaction documents.

Investors’ rights agreement

The investors’ rights agreement, frequently referred to as the 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 and holders of preferred stock, which are typically the VC investors (defined as ‘investors’) and founders (defined as ‘key holders’), 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 chapter, the IRA typically includes:

• form S-1/F-1 demand registration rights, which enable one of more investors to force a company to consummate an initial public offering (IPO) in the United States;
• form S-3/F-3 demand registration rights for companies that are eligible for shelf-registrations; and
• ‘piggyback’ registration rights that allow an investor to cause a company to include shares held by the investor in a registration being carried out by the company.

Under the NVCA forms, VC financings in Latin America historically have not given investors the right to demand a company’s IPO in the region. Offshore VC investors may view the local capital markets as a less attractive exit option due to the higher concentration of growth-stage companies listed on US exchanges, higher trading volumes for companies listed on US exchanges, and the more robust and investor-friendly jurisprudence that US courts (particularly in New York and Delaware) apply to commercial disputes. Consequently, registration rights in Latin American VC financings historically have not been heavily negotiated departures from the IRA form. Nevertheless, an increased presence of regional investors in VC financings, coupled with certain downward pressures that foreign exchange fluctuations and global economic uncertainty may have on stock prices, may result in an increased appetite for investors to consider demand rights for local IPOs in the future.

To ensure marketability, when negotiating registration rights it is important to ensure that these rights will be available both at the holding company level, which allows for the most efficient exit from a tax perspective and provides comfort from a governance perspective to potential purchasers, and at the operating entity level. 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 in the US markets is itself analysed on a case-by-case basis and by no means has a certain outcome. That fact alone often requires significant departure from the NVCA form.

Information and observer rights tend to be more standard and less heavily negotiated, but there are certain key provisions to keep in mind. In the NVCA form, an additional classification of investor, known as ‘major investor’, joins the fray of investors, key holders and holders for certain purposes. The ‘major investor’ term sets forth a share ownership threshold over which shareholders are entitled to receive substantial information rights, including annual and quarterly financial statements, monthly financial information, customary key performance indicators and access to management. The threshold for receiving information rights is typically 5 per cent, but a lower threshold may be set to allow certain smaller institutional investors to qualify for these rights.

Many management rights letters further provide certain investors with a separate contractual right to continue receiving information rights even if they fall below the stipulated threshold and cease to be a major investor under the terms of the IRA.

A major investor could also lose its information rights if it is deemed to be a competitor by the company’s board of directors. An investor-friendly approach would be to carefully define ‘competitor’ to prevent these rights from being capriciously removed, to expressly exclude specified investors from the definition of ‘competitor’ or to list in the document certain competitors of the target; the investor would become a competitor of the target if it decided to invest in any of these companies. This is particularly important given the rise of pan-Latin American companies that grow following a major investor’s initial investment and negotiation of the IRA to cover a much wider geographic scope, potentially becoming competitors of other companies within the investor’s portfolio. 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 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 in 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 on the company, especially when the company is owned by a large number of investors from previous rounds. However, pre-emptive rights are mandatory in certain jurisdictions, stressing the importance of always reviewing the NVCA documents under the lens of local law and in conjunction with local counsel. 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. This provision is also typically resisted by other investors that join the cap table at a later stage and push to have enhanced rights removed (which is often successful if the beneficiary of this right is not leading the subsequent round).

Finally, the IRA can also contain a variety of covenants that affect or restrict how a company operates. These provisions may include veto rights exercisable by some or all of the directors appointed by holders of preferred stock, remedial provisions arising out of due diligence, tax compliance covenants, covenants to comply with anti-corruption laws, anti-money laundering laws, data privacy laws and cybersecurity laws, and covenants to obtain a certain minimum level of directors’ and officers’ liability insurance coverage and customary vesting parameters for employee stock options granted in the future.

Voting agreement

The NVCA form for voting agreements 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 as agreed thereunder 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 (including, in certain cases, approval by a majority of the preference directors), is not necessarily established in the voting agreement but rather in the relevant organisational documents (certificate of incorporation, memorandum and articles of association, by-laws, etc., depending on the target’s jurisdiction of formation). As such, the voting agreement will frequently not include a comprehensive description of board composition or board rights. Moreover, many important board (and shareholder) rights are established under or informed by local law, giving investors 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 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. One way in which this balance is achieved is by requiring the founder to satisfy certain ownership thresholds or conditions such as their continued employment in the company to allow them to nominate a certain number of directors. Finally on this point, local corporate governance practices or local regulatory requirements in relation to regulated entities (which may require that a certain number of board members be citizens of the relevant jurisdiction) 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 is typically triggered upon a ‘sale of the company’, which is often 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 (including a sale of all or substantially all the assets of a company or a sale of all or substantially all the licences or intellectual property of a company), which is approved by the board and the requisite majority of certain holders (as further discussed below), which may include an approval threshold higher than a simple majority. 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-along right to be ‘all or nothing’, meaning that they cannot be dragged unless the 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 the board, a majority or supermajority of the preferred holders, and a majority of the common holders will be required to trigger a drag. An investor may seek to protect its investment by negotiating a floor share price obtained in the sale of the company, beneath which it would not be forced to participate in the transaction (e.g., that an investor cannot be dragged if the price per share paid in the transaction is not at least twice the price paid by the investor). An investor may also seek the right not to be dragged within a certain period after the closing of its investment (typically between two and three years). 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. Given the recent shift in market conditions and the limited availability of capital in the VC landscape, investors currently have greater leverage over founders than in past years, and this provision has become highly negotiated.

First refusal and co-sale agreement

The NVCA first refusal and co-sale agreement form establishes the following rights:

• 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.

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, could compel the sale of the shares held by investors to the acquirer. 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 undesired investors. This right, however, can be a double-edged sword for an investor, as it would significantly restrict the liquidity of their 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 issues concerning anti-money laundering and the US Foreign Corrupt Practices Act can be negotiated and included in the agreements.

As new parties become shareholders in a company, they may be added to the first refusal and co-sale agreement, as well as 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 to include requests specific to the new round’s investors.

Charter

The charter (certificate of formation or incorporation in Delaware; memorandum and articles of association in the Cayman Islands; and by-laws in most civil law Latin American jurisdictions) is one of the most important of the suite of documents to review in connection with a VC investment. The charter defines the key economic terms of the preferred shares being issued in a particular round of investment, such as the liquidation preference upon the occurrence of a deemed liquidation event, anti-dilution protection in the event of a down round, and the events that trigger a forced or automatic conversion of preferred shares to common shares. In addition, the charter typically contains preference shareholder-level veto rights referred to as ‘protective provisions’ that protect the key terms of the holders of preferred shares, voting together as a single class or that protect the holders of a particular series of preferred shares from modification without the consent of the requisite majority of the series or class of shares.

A deemed liquidation event comprises a predefined set of events that, unless waived by a requisite percentage of preferred holders, would 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 remaining shareholders, pursuant to the distribution provisions or waterfall of the charter. This concept typically includes:

• the sale of all or substantially all of a company’s assets or subsidiaries (to the extent that most of the company’s assets are held by its subsidiaries) in a single transaction or a series of related transactions;
• the merger or consolidation where the company’s capital stock does not represent the majority of the combined capital stock of the merged company; and
• the sale of a company’s intellectual property or key intellectual property, which is particularly relevant for start-ups.

The liquidation preference waterfall is a highly negotiated topic. In certain cases, all holders of preference shares are entitled to receive proceeds from a deemed liquidation event on a pari passu basis, meaning that all preferred shareholders have the same priority in right of payment. If the proceeds of the deemed liquidation event are insufficient to pay all preferred shareholders in full, the proceeds shall be split among the preference shareholders on a pro rata basis. In other cases, particularly as companies become more mature and undergo multiple VC investment rounds, the liquidation preference may be on a per series basis, meaning that investors in the later round have priority rights to payment over investors in the earlier rounds (i.e., holders of the series D preferred shares are paid in full before the waterfall flows to the holders of the series C preferred shares, and so on).

This defined term is of crucial importance not just in the charter, but also as a cross-referenced term in the other NVCA forms, such as the voting agreement and the first refusal and co-sale agreement, where it can trigger drag-along rights and tag-along rights.

The conversion mechanics in the charter 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 IPO with:

• a price per share offered to the public greater than or equal to a certain threshold (typically some multiple of the previous round’s price per share);
• net proceeds to the company in excess of a certain threshold; and
• a listing on certain markets.

While IPOs have historically been a less likely exit from investment in Latin America than sales to strategic players or secondary funds, as increasing numbers of Latin American start-ups consummate successful IPOs, the specific components of what constitutes a qualified public offering are becoming more intensely negotiated, including to capture direct listings (in which a company becomes listed on a national exchange without an underwriting effort) and de-SPAC transactions^[3] (given that the popularity of ‘blank check companies’ soared in 2020 and 2021, although this structure has become less utilised in recent years). The definition of qualified public offering is all the more critical as the NVCA agreements typically terminate upon the occurrence of an IPO, meaning that all of the investor’s heavily negotiated contractual rights would disappear without their consent.

Debates often occur over what provisions of the NVCA agreements need to be duplicated conceptually into the charter to provide a greater degree of enforceability, particularly against third parties that are then deemed to be on notice as to the existence of these provisions.

Other documents and miscellaneous clauses

The NVCA share purchase agreement (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 commonly for tax and compliance liabilities in Latin American jurisdictions), it is usually handled via a side letter, and 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. Moreover, SPAs typically do not include 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 result in long pre-closing periods.

Side letters may be entered into by an investor and a company to address topics that have not been covered in the other NVCA agreements. The NVCA management rights letter form includes consultation rights, inspection rights and the right to receive minutes and board material. Another concept that is often included in the management rights letter is that of 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, or the transition from using independent contractors to using company employees). Because the NVCA SPA is tailored to US transactions, country-specific covenants are frequently included in side letters to avoid having to negotiate the NVCA form (e.g., covenants to comply with country-specific data protection regulations, to transition from an independent contractor workforce to using employees, or to take a different approach with respect to the tax characterisation of certain operations).

As discussed above, most of the NVCA agreements have termination provisions that are triggered by an IPO, a direct listing or a sale of the company, or pursuant to the amendment, waiver and consent provisions of each agreement. 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.

Conclusion

Almost five years after VC investing started to become mainstream in Latin America, the region has predominantly embraced the NVCA standard form documents, subject to adjustments that take into account regional or country-specific standards or practices, and consideration for the applicable laws and jurisdictions of the investment parties and investment target.

In creating these forms, the NVCA’s goal was to streamline terms and documents in the VC sector, reduce costs and increase contractual certainty for both founders and investors who could look to a standard set of documents to facilitate comparisons across deals. However, there are various factors that justify the need to deviate from the standard forms, including the following considerations.

• The priorities, risk appetite and level of sophistication of each set of company founders in different industries and different countries in the region vary greatly, so an investor’s approach to negotiating and documenting a transaction should also be tailored.
• As the NVCA forms 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 that have been adequately negotiated and documented in one agreement can be questioned or stifled by the approach to a similar topic in a different agreement, obscuring interpretation issues.
• Many of the NVCA forms are crafted with a US legal environment in mind, including the US Securities and Exchange Commission’s regulations and requirements for IPOs, when in fact a vast majority of businesses operating in Latin America may not have a feasible path to liquidity via an IPO listed on a US exchange.
• Often, topics covered by the NVCA forms will have a customary or even legal treatment under the local law of the jurisdiction in which a target is incorporated or operates, requiring adaptation of the documents that are likely better addressed from precedent shareholders’ agreements and by-laws, rather than via the forms.

In summary, the NVCA forms have become ubiquitous in negotiating and documenting VC investments in Latin America, particularly at the growth stage, which has contributed to contractual certainty, clearly defined and understood regional market standards and execution efficiency. Nonetheless, founders, investors and lawyers should continue to be mindful of regional and business needs that may warrant certain deviations from the norm.

Footnotes