Is Brazilian Corporate Law suitable for Venture Capital contracting?

It has long been ascertained in both the financial and legal literature that the relationship between venture capitalists (VCs) and entrepreneurs is prone to the emergence of complex conflicts of interests (see eg, Sahlman, 1990; and Bartlett, 2006). Venture Capital financings take place in a context of extreme uncertainty and informational asymmetry, and one way to mitigate these conflicts and discourage dysfunctional, opportunistic behavior, is through contracting. Therefore, transaction contracts allocate cash flow and control rights among the parties, and the potential distributions are a function of observable financial and non-financial signals, as well as the perceived risk of the investment (see eg, Kaplan & Strömberg, 2003; and Hellman, 1998). The progressive allocation of economic and political rights during the life cycle of the venture-backed company creates an idiosyncratic governance structure (see Pollman, 2019).

Accordingly, market participants have developed certain solutions (ie contractual clauses) through private ordering, which became market standards in the VC industry. Those comprise, among others, liquidation preferences, anti-dilution mechanisms, put options and redemption rights, founder vesting, veto rights over material corporate decisions, and drag and tag along rights. Unsurprisingly, these solutions and their formatting originated in the United States, where the VC industry is most developed, and their validity has been confirmed, especially in light of Delaware law.

Several VC markets have been modelled after the United States, including the Brazilian one. Private actors, drawing from the American experience, have adopted an array of those standard practices when it comes to VC contracting. Often, however, this introduction is not accompanied by an essential critical analysis: market participants, and academia, usually overlook whether (i) the underlying problem that justified the development of the solution in fact exists in the local setting; and (ii) considering cross-jurisdictional differences, the solution is optimal and replicable (ie, enforceable). When a solution is necessary, but the standard solution is not optimal or replicable, market participants can develop functionally equivalent alternatives (see Lin, 2020).

Recently, some commentators have devoted much needed attention to exploring if these market standards are compatible with different legal systems (see Giudici, Angster, Capizzi, 2022; Nigro, Enriques, 2021; and Nigro, Enriques, 2023). Nonetheless, despite the relevance of the Brazilian VC industry and the widespread use of the abovementioned clauses in the local practice, we are not aware of any such studies regarding this jurisdiction.

On the one hand, in Brazil, freedom of contract prevails in corporate law contracting. This means that, subject to certain legal restrictions, the parties have the possibility to regulate and shape their legal relationships as they see fit. The mandatory nature of a rule is usually dictated by the relevance and non-disposability of its subject matter, and the extent of the externalities produced by the contract. Thus, at least fundamentally, the parties have the flexibility to organize their relationship through investment agreements and shareholder agreements, two of the main documents typically executed in the context of a VC transaction in Brazil.

On the other hand, Brazilian corporate law follows a dual model system, through which the two most extensively used corporate forms (the sociedade limitada, modeled after the German GmbH and the Italian SRL, and the sociedade anônima, modeled after the German AG and the Italian SpA) are regulated in different statutes (the former by the Brazilian Civil Code and the latter by Brazilian Law no 6.404/1976). Both contain a number of norms that are mandatory, hence are not subject to private autonomy and freedom of contract, and likely can conflict with the standard solutions developed in the United States and even with their equivalents that prevail in local practice and have not been subject to in-depth scrutiny.

Some of these conflicts are not evident at first sight since there might not be a unanimous position between commentators and practitioners as to the mandatory or default nature of certain norms. Explicitly mandatory norms are, in fact, the exception; in most cases, interpreters must infer their nature based on high order principles of corporate law and the fundamental characteristics of a given corporate form, rendering the debate even more open to divergence.

Examples of widely adopted private solutions that should be tested vis-à-vis Brazilian corporate law are (i) liquidation preference clauses, which could potentially be deemed void if they protect specific shareholders against the risks and losses of the enterprise (article 997, VII, Brazilian Civil Code, and article 109, I and II, Brazilian Law no. 6.404/1976); (ii) anti-dilution clauses, which, due to their usual specific formatting in Brazilian practice, whereby down rounds (ie an issue of shares at a price lower than their valuation in the preceding round) should trigger the issuance by the company of new shares to the beneficiary, could subject the latter to hold-up problems (ie the refusal by other shareholders to approve the new share issuance and to waive their legal preemption rights in relation to those shares) and thus not be functionally equivalent to the standard solution (for more on functional equivalence, see Nigro, Enriques, 2023); and (iii) put option clauses, that might not be enforceable if the company is forbidden from purchasing its own shares, especially in the absence of a profit balance or reserves (article 30, §1º, Brazilian Law no. 6.404/1976).

These findings are part of our ongoing research, but we acknowledge that there is much to do. Whereas private ordering plays a key role in developing (or importing) and experimenting with different solutions, this process needs to be complemented by critical, scientific investigation. This comprehensive approach can help ensure the optimality and enforceability of market solutions, as well as suggest some of these be adapted and others completely discarded.

Raphael Andrade is a PhD in Corporate Law from the University of São Paulo (USP), and a Partner at Andrade Chamas Advogados.