By Alexandra de Haan, Managing Director, Ideiasnet
When we mention Governance or Risk Management, most of us will typically associate the topic with large corporations and conglomerates. When we mention the subject to most startup entrepreneurs, they are likely to dismiss the issue as something not applicable to the stage of their company. Nevertheless, Venture Capital investors seem to be increasingly focused on the subject – why is that?
When we think about Venture Capital, we envision a financial investor who partners up with an entrepreneur in order to help them develop the business model and scale the business. The VC firm brings its connections, expertise, and funds to the table and the entrepreneur implements the business model and operates the day-to-day activities. Together they build strategic value, which, with any luck, in three to seven years will yield an exit at a desirable return for all involved.
However, VC firms and entrepreneurs in Brazil alike are facing a new reality: despite having created enormous strategic value during the investment period, they most likely have also, unbeknownst to them, destroyed value. The realization of this usually comes much too late: in the midst of negotiating the exit transaction.
What are we talking about? Well, everyone has heard about the “Custo Brasil” or the cost of doing business in Brazil. In short, we are talking about TLLCs – Tax, Labor, and Legal Contingencies. Prior to 2009, TLLCs were the “unknowns” that made many of fly-in foreign investors shy away from doing business in Brazil – only those with long standing presence in Brazil were comfortable with these “unknowns”. For example, Brazil has municipal, state, and federal taxes with many conflicting and contradictory legislation resulting from the “fiscal wars” between different jurisdictions. These “grey” areas in tax legislation interpretation can become extremely problematic for companies when jurisdictions start enforcing conflicting tax laws in order to close the gaps in their budget deficits.
However, much has changed since 2009. The introduction of electronic invoicing and tax filing, conversion of Brazilian GAAP to IFRS and general tightening of rules by the Brazilian regulators and tax authorities, are just some of the changes that have increased the level of oversight and transparency previously not seen in Brazil. Additionally, large Brazilian law firms and big four accounting firms have started to demystify these TLLCs by simplifying the Due Diligence process for strategic and financial investors.
The fact is that the negotiation process at exit is increasingly more focused on the impact of the TLLCs on the strategic value and that the discussions around the size of the discount applied for these contingencies are becoming lengthier. The vesting periods for those liabilities vary between two to five years, which typically leads to escrow accounts with a significant portion of the equity value retained at exit.
Entrepreneurs often do not realize the impact of their day-to-day decisions – their focus on such things as surviving cash flow seasonality or diverting resources to invest more in development – have, in some cases, a severe impact several years down the road. Without any malice on their part, they are making decisions that make sense for their business today, but are likely to regret when they are ready to sell. Although TLLCs are an extensive subject, which we cannot address in full here, some of the examples are:
(i) Using labor regimes that do not comply with the applicable law;
(ii) Applying the wrong tax regimes with lower tax rates without sound legal grounding; and
(iii) Not controlling lawsuits and appropriately provisioning for them.
Penalties and compounded interest on unpaid burdens are high in Brazil, so a small mistake today can turn into a massive contingency five years down the road if not caught quickly.
The reality check for Ideiasnet came in late 2010, when we tried to sell one of our assets to a foreign strategic buyer. At the start of the negotiations, we were able to quickly establish a sale price amenable to both sides. The problems started during the due diligence process – armed with a reputable local law firm and a big four accounting firm, the list of potential contingencies started to grow rapidly and the price started to diminish. In the end, we had to withdraw from the transaction because it no longer represented an acceptable IRR. Disappointed, it quickly became clear that we had to change the way we were managing our portfolio: not only did we have to become actively involved in the implementation of governance and risk management in each company – we had to become the internal auditors! We began by implementing some very simple monthly routines that would allow us to identify the potential risk factors in each business, such as checking the good standing of each of the portfolio companies with the tax authorities, verifying payroll practices and legal proceedings. Since then, we have also implemented more complex processes, such as active tax planning and internal governance auditing. Today we have an internal audit team whose only objective is reducing contingency risk in our portfolio. The work is an ever-evolving process – the volume of new legislation and tax codes requires that we remain dynamic – each month we introduce a new variable onto the checklist of the internal audit report. The result has been astounding – recent transactions have included contingency discussions that are much less stressful: the majority are tail end contingencies known to us rectified three years ago that are about to expire.
Entrepreneurs can be quite resistant to the process, as it is likely to add cost and work in the short term. However, most of them are easily swayed when presented with concrete examples or the experiences of other entrepreneurs. Once converted, they never go back. However, it is imperative that the Governance and Risk Management discussion begins prior to investment in order to eliminate the stress of implementation. Today, hands-off venture capital investing no longer works in Brazil. In order to preserve value, VC firms must become actively engaged in the governance, compliance, and risk management of the companies they invest in.