Trends in Technology M&A in Latin America
The technological advancements of this decade, coupled with a young demographic across Latin America, have created a multitude of opportunities in the technology sector throughout the region. Before the COVID-19 pandemic, Latin America was already on track to becoming a hotbed for technology start-ups, fueled by a rapidly growing middle class and an influx of foreign investment. The pandemic further accelerated this growth as consumers shifted dramatically towards online and digital services, leading to a significant increase in the number of tech start-ups, especially in countries such as Argentina, Brazil, Chile, Colombia and Mexico, where the number of start-ups nearly tripled in the last five years.
The region boasts a large and young population increasingly connected to the global economy. Its middle class has reached unprecedented levels, with almost 30% of all households considered, by several metrics, to be a part of the middle class. These trends offer substantial potential for growth and scalability to innovative and disruptive technologies, making it more attractive for entrepreneurs and investors to deploy resources in this segment of the regional economy. Latin America has become a major player in the technology landscape, emerging as a leading destination for tech start-ups and technology M&A activity. It is now one of the most active regions for technology M&A in terms of volume.
The influx of institutional and financial investors worldwide into the technology field across multiple industries has led to the sophistication of the regional technology M&A sector. Legal and financial advisers are becoming more familiar with standardised legal documentation published by organisations such as Y Combinator or the National Venture Capital Association (NVCA) to implement these transactions. This democratisation of deal making has made sophisticated legal documents more accessible, a trend notably observed in Latin American countries such as Argentina, Brazil, Chile, Colombia and Mexico.
Deal Execution: Standardised Forms Facilitate Transactions
One notable trend in the technology M&A field in Latin America is the use of standardised forms to facilitate consistent implementation of M&A transactions in the tech industry. At an early stage, Latin American start-ups are raising capital using Simple Agreements for Future Equity (SAFEs) and convertible notes. SAFEs, initially promoted by Y Combinator, are concise, commercial agreements that enable early-stage companies to raise capital when valuation is challenging to determine and complex legal documentation is not feasible. Both SAFEs and convertible notes convert to equity at the next equity round or upon a corporate transaction resulting in the sale of the company. The use of SAFEs and convertible notes has reduced transaction costs significantly, and is the common norm for early-stage equity raises in the region.
International investors participating in more advanced equity rounds, such as series A and beyond, are more commonly using standardised legal documentation published by the NVCA. While these documents are more intricate, Latin American investors and entrepreneurs have embraced them. In general terms, the NVCA forms include:
- amendments to governing documents required for the creation of a new series of shares to be purchased by investors;
- certain anti-dilution and protective provisions;
- a voting agreement establishing the obligations of the founders and other investors to vote in favour of certain board designations and liquidation events;
- a right-of-first-refusal agreement restricting the sale by the founders and other “key holders” of their shares; and
- an investor rights agreement giving the investors participating in the round certain information, governance and exit rights.
While these agreements were originally designed for Delaware entities, legal practitioners regularly use them for non-US entities, such as Cayman limited companies.
The homogenisation of legal practices resulting from the adoption of these standardised forms presumably make it easier for investors to deploy capital and purchase equity in a start-up. This is because investors are familiar with these forms and feel comfortable with the rights afforded to them, allowing for prompt enforcement to protect their investment. Almost every growth capital transaction completed this year in Latin America involved investing in a Delaware or offshore holding company using NVCA forms or a close derivative.
The Infamous “Flip”
Another common trend in the Latin America technology sector is the conversion of a start-up into a Delaware or offshore holding company (most commonly Cayman). Almost every international investor exploring an equity investment into a Latin American start-up will condition its investment to the re-domiciliation (or as it is commonly known nowadays, the “flip”) of the holding company into a jurisdiction that will provide a more advantageous tax treatment for its investment upon a liquidity event, while allowing for the use of standardised documentation, such as the NVCA forms.
The flip requires careful tax analysis from different angles. First, the start-up and the founders need to have a clear understanding of the tax and accounting implications of exchanging their stock in the start-up for stock in the new holding company. Often, the transactions can be structured in a such a way as to achieve tax neutrality for the founders, but if the flip is not structured properly, the transaction could have serious tax consequences for the founders in their country of residence. Second, the advisers must carefully analyse the tax treatment for the business, the founders and the investors, following the flip and prior to the sale of the company or an initial public offering. For instance, companies that expect to have positive cash flow prior to a liquidity event may opt for a structure with a mix of equity and debt through certain treaty jurisdictions. However, companies that are in growth mode and do not expect any distributions to their owners until a sale of the business or an IPO may benefit from a leaner structure, through certain offshore jurisdictions offering a lower effective tax rate upon an exit.
While most times the interests are aligned, certain structures may yield different tax implications for the founders and the investors. When it comes to flips, not all sizes fit all. The trend in Latin America, however, is leaning towards using a Delaware or a Cayman entity. Both jurisdictions offer similar flexibility from a corporate standpoint, and practitioners can, with moderate effort, localise the NVCA forms to work with Cayman entities, if so desired.
By definition, founders and entrepreneurs are risk-takers; however, until a few years ago, there was always hesitation towards operating their business with an offshore or international corporate structure. Founders could not measure the risk of the unknown; and five years ago, flips were a rare sight.
Fast forward to 2023, and flips are the common norm in the technology sector in Latin America. In fact, many founders have proactively decided to start their business using a Delaware or Cayman holding company structure from the beginning, to avoid the complexities and costs of an eventual and inevitable flip. The ease and familiarity that founders now have with respect to these structures is remarkable, and the fear of having an offshore company and exposing themselves to jurisdiction of a foreign country has receded significantly.
The M&A Scene and Deal Structures
The standardisation of legal documents and the corporate flip, as discussed, are two very notable trends in equity M&A deals in Latin America. However, what about M&A transactions? Are they becoming more homogenous? Is the market experiencing an uptick of acquisition work as a result of the faster and easier implementation of equity transactions and capital deployment? The answer is most likely yes.
The flow of foreign investment into Latin America on the equity financing side and the resulting “flips” to Delaware or Cayman have led to increased Delaware and New York law M&A activity in the technology sector. Legal practitioners covering the region have become more familiar with the risk tolerance, nuances and issues common to technology transactions in Latin America. Entrepreneurs are also more versed in issues such as:
- 280G executive compensation;
- tax implications of stock option plans; and
- the importance of properly documenting intellectual property rights over the start-up’s inventions.
Whenever someone wants to acquire those companies, the transactions are often governed by US law, primarily because the target is governed by documents tracking the NVCA forms, which in turn were designed mostly attending to Delaware law principles. Because Cayman law resembles Delaware law in so many respects, it is also common for acquisitions of Cayman entities to be governed by Delaware law (with all corporate legal aspects of the deal governed by Cayman law and therefore driven by Cayman counsel).
However, perhaps the most interesting development from a transactional standpoint is the adoption of US M&A structures for those deals that, until recently, were not that common in Latin America. Nowadays, increasingly more technology transactions involving Latin American businesses are implemented through mergers, mainly because under Delaware law a merger could be affected by majority shareholder vote and the parties can still get the deal done even if there are dissenting shareholders. Such transaction structures often also offer tax benefits to the investors.
The likelihood of a minority founder blocking a deal or extracting hold-out value to sign the deal is significantly mitigated using a merger structure instead of a traditional purchase. In addition, depending on several factors, a merger may offer certain tax benefits that may not necessarily be present in a traditional purchase and sale arrangement. Those of us who have covered Latin America for decades know that mergers were not as common as they are now; and just as with the idea of setting up an offshore holding company, founders are now increasingly more at ease with exploring a merger structure or other similar acquisition structures under US law than ever before.
Market Opportunities, Velocity of Deal Execution, and Predictions
The author predicts that technology will remain one of the most active segments for M&A activity in Latin America during 2024, with financial and consumer services leading the charge. Regional fintech companies will continue providing clever and disruptive solutions such as mobile payments, access to electronic payment platforms, and micro-financing to an underserved and unbanked population. Consumer demand is driving strong M&A opportunities throughout the technology sector in Latin America, and the shift to digitally enabled experiences and services is stimulating investment across different segments of the regional economy. During the first half of 2023, the author observed a robust volume of growth capital, financing and M&A transactions, providing significant capital to some of the most successful technology companies in the region. The author expects this funding to drive M&A activity in Latin America during 2024.
The author also predicts the increased use of standardised legal documentation to facilitate deal implementation and velocity. Legal practitioners should familiarise themselves with the forms currently in the market, and be ready to react quickly and swiftly whenever clients approach them for a new equity financing or M&A transaction. While it is challenging to precisely determine the direct impact of the homogenisation of the legal industry and the adoption of standardised forms on recent activity levels, the popularity of these forms cannot be denied, and one can only expect their use to increase. The most successful start-ups have flipped their holding companies to the USA, Cayman Islands or other investor-friendly jurisdictions, and have adopted US-style transaction documentation. The author expects this trend to continue in Latin America, and to increase in the years to come.
This article has been reproduced with permission from Chambers and Partners.
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