Angel Investment: Advantages of the Convertible Shareholding Agreement

Angel Investment is the investment by which individuals or companies invest capital in early-stage startups, that is, at an early stage of development.

Such contributions generally range from $40,000 to $500,000 and are made in companies that need capital to invest in the initial operation of the company, such as development, marketing, among other activities necessary for the growth of the company. Investors rarely derive any short-term return on investment.

The Convertible Mutual

One of the ways to make this type of investment possible is the Convertible Mutual, which has been widely used in startup investment operations.

It is a loan (mutual) with the possibility of reversing the value of shares in the company (convertible), leaving to the parties the effective time for the transfer of shares to the investor and the criteria for this. 

By lending a certain amount to the company, the investor establishes how the amount should be undertaken, as well as the forms of repayment or not, which may, as stated above, be converted into shares for entry into the company.

The most important and attractive feature is the reduction of risks to the investor; after all, it is not necessary to talk about the equity responsibility of the investor, who only has a debt to society.

It should be noted, however, a tax on the capital gain of at least 15%, which is applied when the investor actually performs the conversion and then redeems his investment.

The Participation Agreement

The Complementary Law created a new type of angel investment and brought their respective instrument, the Participation Agreement, which has some legal requirements to be met, such as:

• The maximum period of 5 years for the remuneration for the contributions made;
• Remuneration may not exceed 50% of the profits obtained;
• The right of redemption of the applied amount can only occur after at least 2 years of the conclusion of the contract, which guarantees certain security for the entrepreneur;
• The investor may not have a stake in the management of the company.
• The main benefit of the contribution through the Participation Agreement is that the amounts invested by the angel investor will not be considered as income or capital contributions in the company and, in addition to this benefit, the new law established mechanisms to” shield” the investor’s risks — commercial activity, which serves to attract financial resources.

Instructions established that the amount of redemption by the investor would be limited to the amount of the investment adjusted by the inflation index defined in the investment contract.

In addition, the standard brought regressive taxation on income from contributions, which range from 22.5% to 15%, according to the term of the Participation Agreement, and the basis for the calculation of the redemption tax corresponds to the positive difference between the redemption amount and the amount of the capital contribution made.

The Critic

Taxation imposed by the IRS on the Participation Agreement has been widely criticized by investors, politicians, and players in the startup ecosystem, as it has not benefited from angel investment income, as was done by law and expected by the market.

In fact, the legislation could have been far more beneficial in encouraging investment in startups (micro and small businesses) rather than maintaining high rates that could drive capital away from these companies.

However, the criticisms are mainly based on taxation of income by investors, a not-so-common practice for angel investment.

The reality of the startup market demonstrates that the Participation Agreement is perfectly usable and advantageous, besides the fact that the imposed taxation does not, in the vast majority of cases, affect investment in startups that use this model. And this is what we will address from now on!

Responses to criticism of the Participation Agreement

1) Income taxation

Initially, the law and the regulation regulated the taxation of income from capital contribution, using regressivity over the term of the contract, starting at 22.5% and regressing up to 15%, according to the table below:

Deadline for Participation Aliquot

• Up to 180 days 22.5%
• From 181 days to 360 days 20%
• From 361 days to 720 days 17.5%
• Greater than 720 days 15%

However, this does not happen much in practice. In most cases, startups do not distribute dividends or bring returns to investors in the early years of operation, as all investment and revenue is used for the company’s own growth.

In addition, in most investments, what is combined with the investor is the possibility of buying equity interest of the company, if it appreciates, which already happens in convertible loan agreements and can also be done in Participation Agreements.

However, if there is no redemption or income to investors of early-stage startups, taxation matters little, because we will only take into account the taxes levied on the purchase and sale of shares and any capital gain, which is true for all modalities.

It is also noteworthy that the taxation of the convertible loan still depends on the payment of FTT, something that does not affect operations via the Participation Agreement.

2) Deadlines of the law

Another criticism that often does not hold concerns the deadlines set by the angel investor legislation.

In fact, the establishment of minimum and maximum terms brings limitations to the free market and the way these investment relations happen. However, the terms are reasonable within the logic of angel investment in startups and, in practice, end up adjusting to reality, which in principle does not justify not using the Participation Agreement model for investment funding.

However, the fixing of deadlines by the law ends up making private negotiations unfeasible in which different deadlines were negotiated, and the parties decide to adapt to legal deadlines or to use another model.

3) Investor Management

Another point of limitation of the standard and that generates criticism concerns the prohibition brought by the law in relation to the investor’s participation in the company’s management acts, as for the use of the Participation Agreement and Complementary Law, the latter cannot actively participate in the administration of the company.

Once again, we are facing a limitation that hardly occurs in the reality of angel investments in startups.

It is unlikely that an angel investor will be interested in participating directly in the management of the company, but only acting as a director and having some more sensitive issues in which he may have some participation, without necessarily acting directly with management. Investors will also not participate in the company’s daily life and management decisions.

In addition, issues agreed upon in investment instruments or prior to the entry of angel capital are considered contractual and may be predetermined conditions by investors for the investment to materialize without necessarily being consummated in management acts.

By way of example, veto clauses may be agreed for certain situations that give rise to a penalty (such as the termination of the business and return on invested capital to the investor) and do not necessarily correspond to acting as a manager, as these will be those formally indicated in the contract. Social, whether it concerns corporate matters or the management and representation of society.

Importantly, investor interference can disrupt the Shareholding Agreement, but could also disrupt a Convertible Mutual, as investors could act as “partners” outside the company and mask a relationship.

In practice, regardless of the model adopted, investor participation as a partner or de facto manager would already give rise to risks to those involved, so choosing the Convertible Mutual does not bring greater security.

4) Investor Responsibility

Another advantage to investors in the use of the Participation Agreement is the absence of liability in the event of company debt.

It is noted that other models do not have a statutory provision for non-liability, i.e. it is more advantageous to use a model where such issue is expressly in law.

We do not know how the judiciary (labor, for example) can understand in relation to investor participation, to characterize it as a partner and assign responsibility. However, we may think that the positive model provides a much stronger legal argument to defend the absence of accountability.

Conclusion

In line with the previously discussed, it is clear that one of the biggest advantages of the Participation Agreement is in the context of its biggest criticism.

Many of these criticisms are based on this type of investment due to the risks arising from the legal limitations imposed and the interference of the investor, the possibility of attributing responsibilities and even misinterpretation of the Participation Agreement.

However, its biggest advantage is that it is provided for by law, as there is a Complementary Law, national in scope, which brings the requirements and conditions expressed for this contract to be executed lawfully, also making clear the absence of liability of investors.

Thus, it is much more interesting to make a safe investment based on a modality provided for by law than to make use of adapted instruments to perform these operations, as they may generate more questions and doubts regarding the purpose of the business.

Risks arising from improperly performed operations, with investor interference in the management of the company or abusive practices, would be equal to or greater in Convertible Mutual Contracts than in Participation Agreements provided for by law.

Among others, there are the questions:

From the legal creation of the Participation Agreement, can the use of the convertible Mutual be understood as a simulated operation to distort the legal requirements for this type of investment?

Will the chances of investor accountability be greater in non-legal transactions?

Can receiving part of the loan amount above 50% of the company’s profit or without paying the Participation Agreement tax to give rise to tax problems?

Is participation in the management of the company by the investor a risk only in Participation Agreements?

Attention!

It is important to note that to use the Participation Agreement, the requirements of the law must be strictly adhered to, so in certain negotiations this may not be advantageous for the parties. In these hypotheses, other instruments may be more interesting to those involved.

In spite of this caveat, we should look more closely at this mechanism and consider its practical application as something relevant within the angel investment dynamics in startup.

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