Venture Capital in Latin America: A Critical Look at the ‘Cayman Sandwich’ Structure
Despite Latin America’s rise as one of the fastest-growing venture capital (VC) markets, international investors often condition their investments in the region to a structure known as the ‘Cayman Sandwich’. Under this structure, the Latam startup is fully owned by a Delaware LLC, which in turn is fully owned by a Cayman holding. VCs favor this structure for offering higher legal certainty. Founders are compelled to accept it to access larger pools of capital. But is it really optimal for the development of VC markets in Latam? In this post, we take a critical look at this structure.
International Investors and the Rise of Latin America’s Venture Capital Market
According to the most recent data from LAVCA, venture capital investments in Latin America reached a total of USD 7.8 billion in 2022, distributed across 1,114 transactions, with Brazil, Mexico, and Colombia accounting for 77% of all investments in the region.
International investors are a significant force driving the growth of VC flows in Latam. The number of international general partners (GPs), those who establish VC funds and make investment decisions, has increased significantly in the last decade. International limited partners (LPs), who provide the larger bulk of the capital managed by GPs, have also increased their presence in the region, providing funds to local and international GPs. In fact, almost half of venture deals in the region are estimated to include at least one global investor.
Despite contributing to the expansion of capital available for Latam startups, international investors exhibit a comparatively higher aversion to systemic risks, particularly, those associated with the quality of the legal system. As an example, consider the latest Ease of Doing Business rankings published by the World Bank. Under the ‘protecting minority investors’ criterion, Mexico and Brazil ranked at the 61st position. In the ‘enforcing contracts’ criterion, Mexico was ranked 43rd, Brazil at 58th, and Colombia at 177th. These and similar estimations of the quality of the law are far from perfect, but they are generally uniform and frequently invoked by international investors to justify the design of structures aimed at hedging their risk exposure.
The Cayman Sandwich
One of the primary structures international investors designed to limit these risks is the so-called ‘Cayman Sandwich’. A premise with which Latin American entrepreneurs work is that, at some point in their journey, their startup may be compelled by a VC to adopt a corporate structure in which the operating company (incorporated in Brazil, Mexico, Colombia, etc.) is a wholly-owned subsidiary of an intermediary company, typically an LLC incorporated in Delaware, which, in turn, is a wholly-owned subsidiary of a holding company incorporated in the Cayman Islands (or in another equivalent jurisdiction, such as the British Virgin Islands).
In this setting, the entire operation of the startup, its intellectual property, employee registrations, and so forth occur within the company incorporated in Latin America. The first and second levels of the corporate hierarchy essentially function as shells. Investments take place within the Cayman Holding. The startup’s governance and all financing agreements are generally governed by Cayman Islands law, which investors favor, as it is heavily influenced by the UK’s legal tradition and bears significant resemblance to Delaware law. Moreover, unlike Delaware C-Corporations, Cayman holdings are not subject to double taxation.
Although it is unquestionable that all interested parties benefit from higher flows of investments, the ‘Cayman Sandwich’ effectively outsources the law governing Latam startup’s finance and governance. In balance, is this structure convenient for Latin American countries?
The Price of the Sandwich
We identify two concrete losses. The first one is borne by startups, who experience a reduction of operational efficiency, derived from increased structuring and maintenance costs. The incorporation of companies in other countries creates additional costs for services provided by lawyers, accountants, and back-office support, which are necessary for both the intermediary company and the final holding company to exist in good order. These additional administrative and compliance expenses can strain the startups’ resources, diverting funds and entrepreneurs’ efforts that would otherwise be invested in core business activities and growth.
Moreover, since in Latam most VCs exit by selling their shares to strategic local buyers, for tax and goodwill reasons, these buyers will require the target company to be incorporated in the jurisdiction where it operates. Thus, in practice, liquidity events involve the dismantling of the ‘Cayman Sandwich’ structure, which may negatively impact operations and certainly increase the costs for the startup.
The second loss, less tangible but potentially more meaningful in the long term, is suffered by local venture capital markets, which do not capture all the benefits derived from legal and contractual developments. Industry leaders often produce legal innovations in the form of contractual solutions to problems of incentive misalignment, moral hazard, and information asymmetries. Through experimentation, imitation, and certainty obtained by judicial review, the best contractual solutions become standard in a given jurisdiction. Because the ‘Cayman Sandwich’ structure effectively places the governance and finance of startups abroad, lawyers and other professional service providers miss out on a portion of the transactional experience that ends up occurring at the level of the final holding company, governed by foreign law. This could hinder the development of domestic legal expertise and jurisprudence in areas related to VC and complex corporate structures, which is necessary to support deals among local entrepreneurs and investors. Fewer and less efficient local deals may slow the development of VC markets.
Whether these losses are outweighed by the benefits of higher VC flows is a difficult but unavoidable question. Since the benefits have enjoyed remarkable attention, we hope our discussion of costs contributes to engaging policymakers, legal professionals, and VC industry participants in a thoughtful dialogue aimed at finding a middle ground.
Raphael Andrade is a PhD in Corporate Law from the University of São Paulo (USP), and a Partner at Andrade Chamas Advogados.
Alvaro Pereira is an Assistant Professor of Law at Georgia State University.
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