M&A / Private Equity

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1 Newsletter ISSUE No 6 SEPTEMBER 2015 PIPE Transactions: Alternative Source of Capital for Brazilian Public Companies An overview of private investments in public equity, a possible solution for many Brazilian public companies in need of funds as Brazil s economy faces difficult times p. 2 The Brazilian Antitrust Commission s New Guideline on Gun-Jumping The CADE has recently disclosed important insights on how to mitigate the risk of gun-jumping in M&A transactions p. 3 Securing an Exit: the Use of Drag Along Provisions in Private Equity Investments A shareholder s right to force the other shareholders to sell their shares as a mechanism to make trade sales viable p. 4 Structuring Venture Capital Investments Legal and contractual arrangements to address the challenges in structuring venture capital investments in Brazil p. 5 The contents of this newsletter are intended to convey general information on mergers & acquisitions and private equity in Brazil and do not necessarily express the opinion of law firm Lobo & Ibeas on the matters presented. This newsletter should not be relied upon as legal advice.

2 PIPE Transactions: Alternative Source of Capital for Brazilian Public Companies As Brazil s economy goes through a rough patch, public local companies are facing difficulties in accessing more traditional sources of capital. Interest rates keep going up and banks are more selective in handing out loans. The Brazilian stock market does not seem to be open to public offerings. PIPEs, an acronym for Private Investment in Public Equity, could be a solution. From an investor s viewpoint, troubled times can mean good bargains. While private equity firms normally focus on private companies, there is a growing tendency of PE asset allocation in public companies, especially considering that their market prices have gone down significantly and the devaluation of the Brazilian Real renders them cheaper for investors holding hard currency. PIPE transactions are normally structured through a private placement of shares or other securities in an already-public company to selected investors. The great advantage of PIPE transactions is the fact that they can be accomplished expeditiously and for a lower cost. Since private placements do not fall within the realm of complex public offering regulations, registration with the Brazilian SEC, the CVM, is not required. In PIPE transactions carried out in the United States, investors are subject to initial resale restrictions. This means that the acquired shares carry a restrictive tag, preventing the purchaser from reselling them unless the tag is removed. The issuing company usually commits to file a resale registration statement within a certain time period to allow the investor to resell the shares. Investors assume a liquidity risk until the sale restrictions are lifted. To compensate for these restrictions, investors usually buy the shares in a PIPE transaction at a discount to their current market price. In Brazil, shares acquired in private placements are normally not subject to a restrictive tag; in principle they can be immediately traded in the stock market, although restrictions may be contracted. Such shares can be issued at a discount to their market value in light of the then existing market conditions; however, unjustified dilution of the company s existing shareholders is prohibited. An important aspect that needs to be considered in structuring PIPE transactions in Brazil is the preemptive right attributed to the company s shareholders. Even though such right can be suspended in public offerings, it is mandatory in private placements. As a result, in many cases a PIPE transaction will involve the assignment of subscription rights by the controlling shareholders (or other relevant shareholders). A problem that used to represent a hurdle to PIPEs in the past was the fact that the CVM required a public auction for apportionment of unsubscribed shares in private placements. In other words, if investors subscribed only a portion of the issued shares, the unsubscribed shares had to be sold in a public auction in the stock market. The CVM has recently reconsidered its position on this matter. Examining a case involving the construction company João Fortes Engenharia S.A. 1, the CVM s Board ruled that the partial subscription of private placements is possible, provided that the company establishes the minimum amount of shares that has to be subscribed, among other requirements. If such amount is reached, the capital increase is considered effective and unsubscribed shares do not have to be put for sale in a public auction, making it even simpler to implement PIPE transactions. PIPE transactions can also be accomplished through the so-called public offering with restricted placement efforts, which stands in the middle between a private placement and a regular public offering. They can be implemented through offer letters, being much cheaper than a full-blown public offering, but may only be targeted at accredited investors. Existing shareholders of the company will have either a preemptive right or a priority right (which is similar to the preemptive right but cannot be assigned). The shares issued in this special public offering, though, may only be traded in the first 18-month period between accredited investors, which is usually not an issue for PE investors. 1 CVM Proceeding RJ 2013/

3 The Brazilian Antitrust Commission s New Guideline on Gun-Jumping Until Federal Law 12,529 of 2011 came into force, the Brazilian Antitrust Commission (CADE), differently from its American and European counterparts, only reviewed M&A transactions upon the execution of a binding agreement, generally after the effective implementation of the deal. Back then gun-jumping was not a concern and the focus was mainly on whether a given transaction posed a material threat to competition. Law 12,529/11 has changed this scenario. In accordance with the best international practices, it has imposed pre-merger antitrust control for deals that meet certain criteria 1. Actions with potential to alter the parties original competitive positions are now prohibited until the CADE s approval of the relevant transaction, which has raised doubts about how to proceed to avoid the risk of gunjumping. A new guideline recently issued by the CADE provides important insights in this regard. In addition to the obvious directive for businesses to be run independently, the new guideline identifies three main elements the CADE will weigh in evaluating whether the parties to an M&A transaction incurred in gun-jumping: (1) the extension of the exchange of business information during negotiations; (2) the contractual rules agreed on to govern the parties relationship prior to CADE s approval of the transaction; and (3) the parties behavior before closing of the deal. With regard to information exchange, the guideline, despite acknowledging such practice is inherent to the negotiation of any M&A transaction, especially through the due diligence process, points out that competitivelysensitive data related to the businesses of the companies should not be disclosed. Examples of such information are: (i) marketing and pricing strategies; (ii) main clients and suppliers, as well as the specific terms of the commercial relationships held with them; and (iii) employees wages. Where the analysis of the transaction s viability depends on the exchange of highly sensitive commercial information or otherwise relevant antitrust concerns are involved, the guideline recommends the adoption of precautionary steps to mitigate the risk of gun-jumping, including the execution of an antitrust protocol and the set up of clean teams and an executive committee. The antitrust protocol will set out rules for the exchange of confidential information. Clean teams, in turn, are groups of parties employees or independent consultants tasked with classifying and treating confidential data, so as to avoid one party having access to very specific details about the other party s business. The officers responsible for negotiating the deal form the executive committee and cannot have access to confidential information not previously treated by the clean teams. All meetings of the executive committee should be held at a restricted parlor room and recorded. As to contract provisions applicable to the period prior to the approval of the transaction, the guideline alerts that the following do not comply with gun-jumping regulations: (i) clauses providing for total or partial payment of the deal s consideration on a non-reversible basis (deposits in escrow accounts and payments of break-up fees are allowed); (ii) clauses conditioning the execution of one party s strategic, business decisions to the other s consent (warranties against actions outside of the regular course of business are accepted); and (iii) clauses anticipating integration, regulating competition or imposing irreversible measures. Although admitting that each case will be decided in view of its own particularities, the guideline also provides illustrations of actions that, if taken before the CADE s approval, are likely to raise red flags with respect to gun-jumping. Such actions include (i) the joint development of new products; (ii) the licensing of exclusive intellectual property; and (iii) the interruption of investments in strategic areas. Given the harsh penalties applicable in gun-jumping situations which may be as high as BRL 60 million, it is advisable that dealmakers and their attorneys have the CADE s new guideline in mind when negotiating M&A transactions in Brazil. 1 Such criteria were described in Issue No 2 of our newsletter, which can be accessed here: 3

4 Securing an Exit: the Use of Drag Along Provisions in Private Equity Investments An IPO is normally the preferred exit strategy for private equity investments as it generally yields the highest returns. However, since launching a successful IPO depends on favorable market conditions, among other factors, investors must always plan ahead alternative exit routes. That s where trade sales come in. to facilitating an exit the drag along also enables the fund to share the added value that a buyer would otherwise pay only for the controlling shares. Since the sale of shares by all shareholders must be consummated under the same terms and conditions, the added value (control premium) is divided proportionally among all sellers. In short, the drag along right increases liquidity and value. Drag along rights are not necessarily attributed to all shareholders. Private equity vehicles may request to have drag along rights but will want to avoid being dragged out of their investment for a value below their expectations. In a trade sale, a buyer purchases the target company s shares. In some cases, such as when the buyer is a strategic player in the target company s business (e.g., a competitor, customer or supplier), the buyer will only go through the purchase if it is able to buy all of the target company s shares (or at least a number of shares that will secure absolute control over the target company). If the other shareholders of the target company are at the time willing to sell their shares to the strategic buyer, the problem is solved. Everyone sells their shares and the private equity investor has its desired exit. But what happens when only the private equity fund wants (or needs) to sell shares? How does it make sure that a trade sale exit will be feasible? The typical solution to this challenge is the provision of a drag along clause in the target company s shareholders agreement. Notwithstanding variations from one agreement to the other, the drag along clause usually has the following basic structure: it empowers the shareholder who wants to sell its interest in the company and has found a buyer willing to acquire the shares to drag and force the other shareholders to also sell their interests to the same buyer and under the same conditions. The private equity vehicle holding such drag along right is thus able to exit the company even where the buyer only has interest in acquiring all of the company s shares. Drag along rights are more commonly ascribed to the majority shareholder (or alternatively to all shareholders subject to the rule that such rights can only be exercised jointly by a group of shareholders representing the majority of the voting rights attributed to the company s shares). But, especially in seed and venture capital investments, it can also be granted to minority shareholders, especially private equity funds, which are thus allowed to compel the majority shareholder to also sell its shares. In this case, the provision is known as a reverse drag along clause. The drag along right also brings another benefit to the private equity fund, notably when it is a minority shareholder. In addition Naturally, the other shareholders may also have similar concerns. Even though the drag along clause usually aligns the interests of the private equity fund and those of the other shareholders after all, both will want to obtain the highest sale price possible for their shares in some cases misalignments can occur. The other shareholders may be unwilling to sell their shares at a certain moment because they believe the company s prospects will increase in the long run or are emotionally attached to it. They may also be concerned that they will be forced to sell for a price lower than the company s fair value if the private equity fund is under a deadline to be liquidated. Some of the shareholders apprehensions about being dragged can be addressed. A typical protective provision is the right of first refusal (ROFR) or the right of first offer (ROFO), which allows them to acquire the shares being sold and thus continue in the company. The ability to exercise a ROFR or ROFO, though, may not provide sufficient comfort. Even if the shareholders believe the offered shares are underpriced, they may not have readily available funds to acquire them. Or due to circumstantial economic conditions, such shareholders may not be able to raise funds in the market to buy the offered shares. The agreement can also establish a general lock-up period or that the drag along rights may only be exercised after a certain time period has elapsed. Concerns about underselling in many cases can be addressed if the agreement sets forth a minimum price for the shares subject to the drag along rights. This minimum price can be pre-determined upon the execution of the agreement or be established at the time of the sale based on an appraisal of the company s fair value or some other criteria. Carefully and creatively drafted, drag along provisions can provide a potential way out of an investment for private equity vehicles, while addressing concerns that the other shareholders may have about being dragged out of the company. 4

5 Structuring Venture Capital Investments Considering the high risks of venture capital investments, investors hope for outsized gains. To make that possible, the investment is normally structured in a way that gives the investor a preference in receiving back all or most of its funding and the right to participate in the incremental profits jointly with the other shareholders on a pro rata basis. In the United States this structure is usually achieved through the issuance of participating preferred stock or convertible notes (or a combination of both), or similar contractual arrangements. The participating preferred stock (also called double dip preferred stock) entitles its holder to an amount equal to the original investment (or its investment plus a specified yield) upon a liquidation event (merger, acquisition or liquidation). It also typically grants to its holder a pro rata share of the residual proceeds corresponding to the amount the preferred stockholder would have received on an as converted basis (thus the double dip nickname). Additionally, such preferred stock usually converts into a number of common shares in case of an exit through an IPO and in other specified events. The convertible note, in turn, is usually adopted in early stage investments because of the difficulty in agreeing on the start-up s valuation; or to provide a bridge loan where banks are not ready to fund the start-up. The conversion ratio is usually established taking into account a percentage discount over the valuation of the company in a subsequent financing round (in some cases, up to a negotiated ceiling). Both structures allow the investor to negotiate protective provisions. Under a participating preferred stock structure, the investor may enter into a shareholders agreement with the founders providing for the appointment of a number of directors, a certain level of control over subsequent rounds of financing and exit strategies. In a convertible note structure, the notes indenture can include negative covenants and early liquidation events. Similar structures may also be implemented in venture capital investments in Brazil. A Brazilian corporation (sociedade anônima) may issue preferred stock with full, limited or no voting rights 1, entitled to the priority payment of fixed dividends or minimum dividends (which allow the preferred stockholder, after receiving the minimum amount due, to participate in the residual proceeds), and a priority in the reimbursement of capital in case of dissolution or winding-up of the corporation. The startup s by-laws and shareholders agreements can secure the right to appoint a number of directors, veto rights, as well as several other protective measures similar to those that may be attributed in the United States to a preferred stockholder. The by-laws may also grant the preferred stockholder the right to convert the preferred stock into common shares. Also, akin to the convertible note structure used by U.S. firms, a Brazilian corporation can issue secured or unsecured convertible debentures. And the debenture deed can include negative covenants and early liquidation events. The majority of business enterprises in Brazil, though, are incorporated as limited liability companies (sociedades limitadas). The main reason for the widespread use of limited liability companies is their simpler organization. This simpler organization, combined with some restrictive rules imposed by law, prevents or puts forth more challenges for the use of the venture capital structures discussed in this article. A limited liability company s capital stock is divided into quotas. It is generally understood that the company cannot issue preferred stock. To circumvent this restriction, the company s articles of association can establish that the profits will be distributed disproportionately from the share of each quotaholder in the company s capital stock. However, this alternative may not be sufficient to accommodate all of the complexities of a venture capital structure. The broad rights conferred upon the quotaholders to withdraw from a sociedade limitada in general brings a high degree of instability. The law also establishes that a supermajority vote is required for the approval of certain matters in limited liability companies, which can in many cases immobilize the company. There is also a heated debate as to whether limited liability companies are allowed to issue debentures. Some of the main Registries of Commerce in Brazil hold the view that issuance of debentures by sociedades limitadas is illegal. 5

6 Finally, it is worth noting that the most used vehicles for venture capital investments in Brazil are the FIP Fundo de Investimento em Participações and the FMIEE Fundo Mútuo de Investimento em Empresas Emergentes. And the regulations applicable to both these funds do not allow investments in limited liability companies, only in corporations. Thus, while there are contractual arrangements that may be put in place in a sociedade limitada (e.g., issuance of a promissory note) to accommodate venture capital investments, in many cases it will be necessary to transform the start-up into a corporation before the investment is made so that the investor is able to have the appropriate degree of protection to enter into such a risky venture. 1 Preferred non-voting shares (or shares with restricted voting rights) may not surpass 50% of the corporation s total number of shares. 6

7 Editorial Team C.A. da Silveira Lobo Manoel Vargas Franco Netto Joaquim Simões Barbosa Pedro Paulo Salles Cristofaro Paulo Eduardo Penna Guilherme Leporace Gabriel Rios Corrêa Juliana Carvalho de Azevedo Vitor Silva Clark Nunes RIO DE JANEIRO Av. Rio Branco 125, 21 st floor RJ - Brazil Tel.: (+5521) São Paulo Alameda Santos 2300, 11 th floor SP - Brazil Tel.: (+5511)