The Venture Capital Law Review: Mexico
Venture capital investments have had a marked increase in the past few years. Although it is difficult to provide a concrete number, given that most venture funds are private and do not disclose their investments, such investments have gained substantial notice and publicity in the past few years, with a couple of exits even making the news, such as Mountain Nazca's role in Kavak, among others.
Although providing hard figures is difficult, some estimates from well-known outlets claim that venture capital investments have increased 340 per cent in the first half of 2021, achieving an approximate value of US$1,426 million, while during the same period in 2020 we saw investments of around US$1,210 million, compared to the US$1,921 million seen in 2019.2
The marked decrease seen in 2020 when compared with 2019 is likely the result of market turmoil and economic slowdown resulting from the covid-19 pandemic, from which it is only recently that we are seeing any relevant comeback. However, although the pandemic did have a direct and palpable effect on most of the economic activities in Mexico, including venture capital, some risk takers seized this opportunity to create new economic pockets of activity and some venture capital investment did continue to support these new start-ups.
Some of the most relevant and dynamic players in the market include ALLVP Fund, Mountain Nazca and Alta Ventures, which represent some of the most trend-setting transactions in Mexico and, in some instances, Latin America.
Finally, recent trends have given rise to new venture capital investments, and we have seen increased risk-taking appetite from fund managers in a variety of industries, ranging from e-commerce to health products and, probably most notably, the financial technologies sector, which has arguably received the largest or one of the largest portions of available and deployed investment.
Year in review
During the past 12 months we have seen a couple of high-impact and high-value transactions from the venture capital market. Although these sorts of high-value transactions are still not the norm in Mexico, they have increased and we have seen more and more of these transactions being discussed and, in some instances, already closed.
Among the most notable recent transaction concerning or arising from venture capital into start-ups, we have seen the acquisition by Uber of Cornershop, which although it does not involve any Mexican-grown entity, did involve at least one major local player that had invested in Cornershop and was able to exit with an above-market multiple to distribute to its stakeholders. Another interesting transaction was the venture fund driven valuation of Mexican start-up Kavak, a used car sales platform that was recently valued at US$1billion, making it the first locally grown unicorn, and which includes local funds such as Mountain Nazca among its key supporters.
Apart from the above high-stakes transactions, which were undoubtedly quite successful, a few other start-ups have become increasingly relevant in the market, with new and exciting business ideas that have made them attractive targets for venture capitalists. Among others, we have seen start-ups such as Konfio, which is a digital bank services provider that has raised around US$586 million and is currently in its Series E financing round; and Valoreo, with a business plan involving the acquisition, streamlining and operation of e-commerce brands, recently initiated activities in Mexico and has already raised over US$80 million in just a few months, to name just a couple.
Legal framework for fund formation
Because of the relative novelty of the local venture capital industry, and its reliance on foreign investors to make the market, there is no ad hoc local legal framework that is actually intended to regulate venture capital funds. However, generally speaking venture capital funds rely on the Securities Market Law, the General Commercial Companies Law and the Tax Code to structure the funds and deployable investments in a reasonable, safe and efficient manner. Consequently, venture capital funds in Mexico are not thoroughly regulated and are not required to make public disclosures (such disclosures may be required if the fund is a foreign entity), and no licensing is required that could be subject to oversight from financial regulators.
As a result, most venture funds are actually incorporated using a structure that involves a foreign fund manager (generally a Canadian vehicle) that also acts as majority holder of the local entity, when such a local vehicle is created. A few foreign or international funds prefer to invest directly using their foreign subsidiaries, but such an option should be carefully analysed from a tax perspective to understand potential taxation pitfalls and the extent of bilateral investment protection treaties, if any.
Venture capital funds set up in Mexico, including local entities set up by foreign entities, tend to be incorporated as investment promotion corporations (SAPI), stock corporations (SA) or limited liability entities (SRL). The main reason for the SAPI being used is that it provides corporate flexibility similar to that of an American corporation, while retaining limited liability for its shareholders. SAs are the standard share corporations for simple structures. And on the other hand, SRLs do provide a reasonable degree of flexibility, although they lack some of the corporate governance afforded to SAPIs or SAs, but they are able to be treated as a 'pass through' entity for tax purposes for some jurisdictions like the US. As a general rule, tax implications are the main driving force that venture funds tend to follow when choosing the local entity to be used.
Concerning fund management and its managers, we tend to see a few alternatives used locally. As mentioned below, a big portion of the local venture capital market is driven by foreign entities investing in Mexico through their own corporate framework that tends to be set up to both generate tax efficiencies as well as to provide protection for the original holders and stakeholders. However, for purely Mexican venture funds, we have seen management options under different structures, including: (1) having a separate entity that houses managers and that, in turn, enters into a management services agreement with the actual venture fund (of which investors are a party to), receiving a variable compensation from the latter; or (2) a fairly straightforward structure that involves both the actual investors as well as management housed under the same vehicle, while there would be differentiated shares allowing for preferential or privileged shares to be issued by the investors.
Finally, as a general comment, users of financial services in Mexico are protected by a government agency called CONDUSEF (National Commission to Protect Users of Financial Services) that handles complaints against financial entities of any kind operating in Mexico. This agency will sanction any wrongdoings by imposing fines, whereas they may also adjudicate and issue an award on the merits if the consumer and the financial entity agree to submit to their special jurisdiction; otherwise, the consumer will need to sue through the commercial courts and take the CONDUSEF's ruling as prima facie evidence of their claim.
Generally speaking, agreements between funds and their investors may be governed under two distinct types of documents, depending on the corporate structure through which the fund has decided to operate.
When investors are able to participate directly in the same entity that houses the fund managers, then we usually see that the by-laws governing the fund will contain provisions granting the investors a preferred or privileged status vis-à-vis the managers (who would also be the founding members of the relevant entity), and they would receive a restricted series of shares that generally lacks any relevant voting rights that may affect the day-to-day operation of the vehicle, but will grant its holders with a preferential dividend and a preferential right to be liquidated upon a 'liquidity event'. These provisions would be baked into the by-laws of the operating entity and may also be documented through an investment agreement or similar documents that create further protection, recourse and supporting documentation for the investor.
In some instances, in which the operating entity does not directly allow for investors to participate in its equity, you tend to see investments documented through investment agreements that set forth in detail the reach and scope of the investment made. These documents provide for recourse to be created by the investor against the company, and also generally explain the yields, investment horizon, and so on.
Profit distribution is standard for these types of funds, and tends to follow the market standard of the United States, although the actual percentages or triggers for carried interest to fund managers may change depending on the track record, manager experience, etc. These distribution mechanisms are generally governed and documented in the same or substantially the same documents as explained above.
As would be expected, negotiation is intense concerning the representations and warrants made by the managers to the investors, while the economic terms and conditions tend to be reasonably straightforward and a matter of 'take-or-leave' by the investors. Another item that is generally the subject of intense negotiation is the dispute resolution mechanism and governing law, as sophisticated investors usually prefer to have access to arbitration in order to avoid having to fight in local courts that are notoriously slow and unsophisticated for these types of transactions.
As mentioned above, venture capital is not a highly regulated activity in Mexico and is generally left to be negotiated and regulated by the private parties involved in any given transaction. As such, there is no real governmental oversight over fund managers and, as such, they have no obligation of public disclosure.
Notwithstanding the above, fund managers are expected and mostly contractually bound to disclose the extent of their investments, including general terms of the investment and expectations. This is generally considered to be a statutory obligation for the management of all commercial companies incorporated under Mexican law.
As a recent matter of law, funds are not expected to engage in activities not directly related to their core purpose. Such limitation, although perhaps not provided by law, is generally either incorporated into its statutory corporate purpose or into the relevant arrangements. This is something that is almost always confirmed during the initial due diligence at the beginning of an investor deciding whether to invest in any given fund. In addition, funds rely heavily on their reputation, and hence successful funds are usually very strict about their corporate compliance, including strict corporate governance and clear oversight authority to give certainty for present and future investors.
Raising capital by start-ups
Although the Mexican start-up environment has a long track record, it is only recently that we have begun seeing relevant and well-publicised investments.
Local start-ups generally tend to offer preferred stocks at the earlier stages of their life cycle, moving to less privileged considerations after the initial rounds. We usually find that entities hoping to join the start-up frenzy seek a few of the most well-known and prolific venture funds (GBM, ALLVP, etc.) to initiate their offerings. These funds seek preferential exit rights and liquidity events that would trigger either an early exit or a buyout.
Once the target entities have matured within their investment cycles, it is common to see such entities offering lower-value and higher-risk options to their would-be investors. Among these options, we can see offerings of convertible options or privileged shares with less generous yields or exit options.
However, there is a wide array of structuring possibilities for both investors and funds, as most of the time these factors are contractually agreed with little to no regulatory restrictions, other than general restrictions applicable to all business activities.
In the past couple of years, the government has enacted some new regulations intended to better regulate the crowdfunding market. These new regulations have not really stifled or had any sort of chilling effect in the market and, in fact, the number of locally grown crowdfunding companies has increased slightly since the new regulations came into effect. These entities are regulated by the Fintech Law, which generally sets forth disclosure requirements, as well as corporate governance obligations and compliance rules and sanctions for those who breach them. Further, it is relevant that the law provides some curious provisions, such as a limit on how many fintech companies may fund a single project, the obligation to keep individual records for each single client, and the obligation to be able to immediately liquidate payment.
Most exist strategies used by local venture capital funds involve the divestments of their holdings in the relevant start-up or operating target entity upon the occurrence of a previously agreed liquidity event or another trigger.
Generally, trigger events such as liquidity events are structured around the idea that the investment has increased its worth and the target entity will be transferred to a third-party purchaser, or the target entity will resolve to pay out a special dividend to its investors against the cancellation of their holdings. Because the local market is not fully matured yet, there have not been a lot of exits that have been made public.
When talking about purely Mexican venture capitalists and targets, it is not common to find IPOs as an exit strategy. Unfortunately, the securities markets are highly regulated and impose heavy burdens (both regulatory as well as corporate and economic) to any would-be participant. The same general restriction or de facto limitation would be applicable for special purpose acquisition vehicles that may attempt to take public in Mexico a local start-up. In fact, an SPAC may find higher burdens in going public than its non-SPAC counterpart, as it would have to fully divulge its holding structure, source of funds, etc.
On the contrary, the M&A market is highly active for these start-up entities, and the volume and value of transactions involving start-up companies in Mexico has seen a marked increase in the past years, driven, among other factors, by foreign participants seeking new opportunities in a relatively new market that is able to provide high rates of return.
It is worth noting that local venture capital funds are increasingly ingenious when structuring exit strategies, so we would be hard-pressed to find a 'one size fits all' structure, as the trigger events as well as the investment structures themselves are negotiated in detail prior to the investment actually making sizeable investments.
As the country and the world look past the covid-19 pandemic, investors of all types, including venture capital funds, are finding new and unique opportunities to generate wealth, drive innovation, and explore jurisdictions in which they were not fully used to doing business or were reluctant to do so.
While the usual go-to markets will surely retain the majority of investments and innovation, we have noticed a sizeable new portion of liquidity flowing into Mexican start-ups through either foreign or local venture capital funds.
Although it is hard to anticipate with a high level of confidence what the local venture fund landscape will look like within the next year, we are seeing noticeable trends that seem to indicate an increasing number of players in the start-up environment receiving ever-increasing amounts of investment for a broadening array of institutional and non-institutional investors.
Similarly, recent years have re-energised the Mexican venture fund industry, as key players have seen that successful exits are indeed possible and highly worthwhile under proper fund management.
1 Juan Francisco Torres Landa Ruffo is a partner and Pablo Corcuera Bain is a senior associate at Hogan Lovells.