Taking an Investment from Chile

Monday, March 7, 2011

Last year my cofounders and I joined StartUp Chile, an incubator run by the Chilean government and headquartered in Santiago (I wrote about that experience on Quora). We learned a lot, met some very interesting people, built a prototype and tried to do some fundraising in Chile.[1] This is a brief summary of what I learned about the Chilean investment landscape and how it differs from the one we knew better here in the Bay Area. As they say, venture capital is local, and Chile is no exception. Just as New York is different from San Francisco is different from London, Chile has its own idiosyncrasies and standards. The three main differences from San Francisco were in processes, experience, and government leverage.

There are few venture capitalists in Chile and they are all relatively new. Most raised their first venture capital fund in 2008 or later, although several were involved in later-stage investments in the past. While Chile has long had policies that were very welcoming to new business, much of their innovation has been driven by larger companies, firms entering the Latin American market, or companies started by independently wealthy individuals. A robust angel marketplace does not exist in Chile yet. While some wealthy individuals might invest in an entrepreneur, there aren’t standard terms and there certainly aren’t expectations like there are in Silicon Valley of convertible notes. A result of this newness is that decisions seemed to be taken slowly. We heard that an average timeline for funding was four to six months.

Most companies in the StartUp Chile program were incorporated in other countries and will need to create a Chilean subsidiary in order to take Chilean investment. More about why that is in the “Government Leverage” section below. The process usually takes at least a month (more if the company doesn’t have people on the ground in Santiago pushing the application forward).

Being in the VC business for a long time gives you experience with being a venture capitalist and lets you build connections to other VCs.

The venture capitalists we met with all seemed like very bright businessmen (all were men; we also met several wealthy individuals who considered acting as angels which included some women). While as of December 2010 none of the VCs had gotten to an exit or a Series B for any of their portfolio companies, we saw nothing to indicate that they weren’t managing their investments well. Everyone we met had significant business experience and was spoken of highly by their portfolio companies.

Chilean VCs have some connections to Silicon Valley (they invested in Bling Nation (opens .pdf), for instance), but as a result of distance they naturally are connected more to the Chilean marketplace than the San Francisco ecosystem. I really didn’t see many links to the New York media scene or the Boston biotech scene, but then again we weren’t pitching that kind of business so its natural that we didn’t see any evidence.

Government leverage
The Chilean government has several programs to encourage investment in innovation.[2] One program was called “F-3.” It provides a forgivable loan of up to three times a fund’s total value, provided its deployed within 24 months and used within Chile. So for instance, let’s say I create a new fund: Deadly Fine Wealth (DFW), get commitments for $10M and file paperwork with the government by April 2011. CORFO[3] will loan RockChile up to $30M. The money won’t be distributed to DFW until the investors cash has been invested and must be used within two years (by March 2013 in this example). So if I decide to invest $4M in a new tennis academy, I call in $1M of my investor’s money & CORFO provides the other $3M. The loans carry an interest rate of near, or slightly above prime. They must be paid back as the fund goes through exits, but can be forgiven if the fund does not make money. So, if DFW invest all $10M in tennis academies, a new talk radio station, and a new cruise line and all the businesses go bust, the fund doesn’t have to pay back anything. If the cruise line turns into a winner and they get a $5B exit, the loans must be paid back in full. If, however, the fund’s returns are something below the cost of the loans (including interest) all of that money goes back to CORFO. An additional caveat is that the money distributed through CORFO must remain in Chile. This doesn’t mean that the company couldn’t be based in the US, but it does mean that the company would need to have a presence (like a development office or a customer service center) in Chile that would spend the CORFO money.[4]

This creates some interesting incentives. The first (and most intended) consequence is that by giving VCs leverage they’re more willing to invest in businesses and willing to commit more money at higher valuations than they would otherwise. That, in turn, is meant to encourage more entrepreneurs to start companies. The second (possibly unintended) consequence is that the funds don’t get anything until their returns have exceeded the CORFO loan threshold. Venture capital is already a hit-driven business, and this makes it more so. The result is that they may push their portfolio companies to take bigger risks, even if it decreases the overall chance of success. The third (definitely unintended) consequence is that a fund could find itself ambivalent about the outcome of its last portfolio companies. For instance, suppose the DFW fund above invested $40M in 10 different companies for a 33% stake in each, and that nine of them went bankrupt over a period of five years. DFW could find itself on the hook for $40M in loans (the $30M with interest), which would mean that its last company would need an exit above $120M in order for them to make money. While rational, a decision to ignore an investment that might make a $100M exit is not what CORFO intended.

To try to address this problem, the government created a new program called K-1[5]. K-1 is a convertible equity instrument for up to 1.5 times the VC’s investment that can be turned into debt on the fund level. Let’s take DFW with $10M again. If they were to invest $2.5M in a new video delivery service at a pre-money valuation of $2.5M, their investors would provide $1M and CORFO would provide $1.5M. DFW would own 20% of the company and CORFO would own 30%. If the company sold a month later for $50M, DFW would get back $10M and CORFO would get $15M. However, DFW would have the option to convert all of CORFO’s equity into debt at ~prime, but only if the fund did it for all of its portfolio companies. This means that if most of the companies in a portfolio have gone bankrupt, the VC can still extract some value from its successes, but if one or more of the companies is wildly successful the VC can also capture most of that upside.

I hope this is helpful to companies in the StartUp Chile program or considering applying to it. I’m sure I’ve gotten some of the details of these programs wrong; my apologies. I’ll try to update this as I (others) identify mistakes.

[1] We talked to four venture capital firms, which I believe are the main ones:
  • Aurus http://www.aurus.cl/
  • Austral http://www.australcap.com/ (they also have an office in San Francisco: http://www.australcap.com/austral-california )
  • Copec-UC http://www.fondocopecuc.cl/ -- a fund of Universidad Católica in Chile
  • Equitas http://www.equitas.cl/
We also talked to about a half-dozen Chilean angels.
[2] I’m not a lawyer, and my understanding of the program is certainly incomplete. I’m putting down some thoughts here as a start.
[3] CORFO is the Chilean government agency that implements policies related to entrepreneurship and innovation. http://www.corfo.cl/ For instance, it is CORFO who funds StartUp Chile.
[4] It is unclear to me how strictly this rule was enforced.
[5] My understanding of these details is very weak. I think I’ve got the general form of the instrument right, but I could be wrong about major details.


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