Key differences between traditional M&As and venture capital
Contracts for mergers and acquisitions mainly look to spread the risk between the buyer and seller and to regulate shareholder relations within the company. The same occurs with venture capital, but the differences between traditional and venture capital investment bring a number of specific circumstances into play, as explained below, with specific examples from Latin America.
Investors put their money into companies for two main reasons: to generate a specific return, as commonly seen in investments by private equity firms, or to grow the investor’s own business. In both cases, the targets are generally companies that have reached a break-even point and are well positioned in the local or international market.
Entrepreneurship, however, has boomed in recent decades, and young people are increasingly looking to set up their own business ventures, which, like any undertaking, require hefty capital investment, particularly in the early growth stages.
The capital needs of these start-ups have led to a surge in venture capital investors. Venture capital investors fund fledgling businesses and businesses that have yet to break even once the target’s growth needs outpace what the entrepreneur and their family and friends are able to put into the project. Venture capital is less about adding specific value for the investor and more about taking a gamble on a prospect, an idea or a person, and the related growth potential and scalability.
As a general rule, in M&A deals, contracts look to spread the risk between the buyer and seller and to regulate shareholder relations within the company. This general rule holds true for venture capital deals, but because of the differences between the two types of investments and the risks to be covered, venture capital tends to deviate from traditional contract structures in a number of key ways.
This article looks at the main aspects of three of these differences. Since different national models and standards for venture capital investments have emerged, it is important to bear in mind that models and standards developed in other jurisdictions must be adapted to the specific provisions of each local legal system.
In traditional mergers and acquisitions, contracts are structured around the acquisition of shares, whether via direct investment in the target company or operating assets, through asset purchases, or through share purchase or subscription agreements, subject to certain conditions that tend to reflect regulatory requirements. It is relatively uncommon to see revenue or growth conditions in acquisitions or investments in well-established businesses, since prior to the acquisition, the buyer will have carried out an exhaustive evaluation of the target, using projections based on historic earnings and profit, usually coupled with a financial, legal and operating due diligence review.
However, these traditional methods do not serve for accurately assessing investment potential in a start-up.
Accordingly, we have seen the emergence of novel contract structures that allow backers to become financial investors before becoming shareholders of the business, using, for example, debt structures or the provision of convertible advance funds.
Examples include simple agreements for future equity or SAFEs, a model agreement specifically created for venture capital investment in start-ups, convertible debt notes and other alternative mechanisms for convertible financing that bring the target the funds it needs to drive growth. In turn, investors get the protections they need in terms of time and conditions for gradual entry as shareholders. The founding shareholders (i.e., the entrepreneurs) can also establish conditions in advance for a future – and tolerable – dilution of the company’s capital (cap table).
These arrangements, including the rights they carry, the legal means of becoming shareholder, and the warranties or mechanisms for seeking payment or conversion into shares vary depending on the particular needs of the target company and how far along it is in its market development. It is also important to note that while there are some standards in the VC industry regarding each of these instruments, they should be reviewed in line with the legislation of each country. To give some examples, the implementation in Peru of debt convertible into shares may have significant tax implications that should be taken into account when structuring the investment, while in Mexico it is important to carefully consider how these contributions are treated before being converted into capital for the purposes of tax reporting. In Colombia, in order to issue preferred shares or shares with special rights, start-ups need to have one of the corporate forms that allows for these types of shares.
When a traditional investor acquires a company, it is common to include mechanisms to incentivize or even lock in key personnel, to ensure they remain at the company. Examples include key personnel provisions and non-solicitation clauses, the main purpose of which is to encourage key employees to remain at the target. While these protections are common, they are not necessarily a fundamental part of the transaction.
In contrast, with start-ups, each venture is intricately tied to the entrepreneur: the person who created the idea and had the business vision that led to the creation of the target. Venture capital investors recognize and understand how critical the entrepreneur is when a company is just getting started, and therefore the deal documents tend to include specific clauses protecting the entrepreneur and ensuring they remain at the company.
These incentives can take the form of minimum stay undertakings, employee stock options entitling the entrepreneur to subscribe additional shares in the target, the creation of shares with special rights for the entrepreneur (with or without time limits), anti-dilution clauses or clauses that limit dilution in future funding rounds and, in general, ways to encourage entrepreneurs to stay while at the same time safeguarding their rights as shareholders and employees.
Shareholder agreements in traditional investment deals contain a series of provisions regulating the transfer of shares between shareholders or to third parties. These clauses may establish, among others, preemptive rights, drag-along rights and purchase options.
Given its nature, business failure is a real risk in early-stage investment, meaning it is important for investors to find formulas that allow for an easy exit without involving other shareholders or corporate bodies.
Accordingly, venture capital deals include similar protections for investors buying shares in the target. Moreover, additional safeguards should be included to allow investors to exit quickly if needed (for example, sale or put options triggered by certain events).
The rise in entrepreneurship has spurred growth in venture capital, which in turn has led to the search for contract structures that meet the specific needs of this type of investment, moving away from the traditional risk apportionment models in M&A deals. As lawyers practicing in this area, we must bear these complexities in mind when negotiating venture capital deals.