ArpexCapital

 

Last September, I posted on whether Brazilian startups should incorporate in the US and, if so, whether they should incorporate in Delaware.

This week, the Latin American Private Equity and Venture Capital Association had a definitive post by Juan Pablo, a shareholder in the Greenberg Traurig law firm, on whether to form an LLC (like a limitada) or a C-Corp (like an SA) in the US.  

It is one of the first posts I have seen that leans towards forming an LLC (depending, of course, on the details).  Most venture capital lawyers in the US will tell you immediately to form a C-Corp, because this is the standard practice in the US.  As a foreign business, however, that maybe not be the best advice.

I advise a good read of Juan Pablo's post.  

 

Last week I wrote that, out of the universe of good companies, only a tiny percentage make a good investment because most companies lack the potential for rapid growth.

That said, here are some exceptions/qualifications to the "rapid growth" requirement.

 

1.  Growth Is Insufficient — a Company Needs "Scale".

Rapid growth implies speed but "scale" implies speed, breadth and efficiency.  For example, a popular restaurant can "grow" extremely quickly — as quickly as a web-based business — but most VCs don't invest in restaurants.

Why? Because restaurants don't "scale": it's complicated to open new restaurants — to identify the right location, renovate the physical space, hire a new staff, etc.  Each new restaurant requires a significant investment.

On the other hand, internet-based businesses can expand rapidly, efficiently and broadly with relatively little additional investment.  Another way of saying it is that internet businesses have much less "friction" than offline businesses (e.g., restaurants).

 

2.  Market Size Matters.

It is possible for a business to have excellent growth and a scalable infrastructure but still not make a good investment.  For example, a company that drop-ships books written in the Tongan (south-Pacific) language can grow efficiently and quickly — assuming a sufficient demand for books in Tongan.

The business, however, will never get large enough to achieve a significant exit because the market for books in Tongan is too small (there are about 200,000 Tongan speakers).   The small market size prevents the company from being investible, despite the potential for rapid efficient, growth.

 

3.  Gross Return Matters

This point relates to #2.  Let's assume that a $50,000,000 fund makes a seed investment of $30,000 in the Tongan bookseller. 

In two years, the bookseller is acquired for $90,000.  The investment achieved a 83% IRR — excellent — and yet the investment was a complete waste of time and money. 

Why?  Because an investment that returns $90,000 for a $50,000,000 fund is meaningless.  It represents 0.18% of the fund. The investor would need 555 of these investments just to "return the fund", i.e., to generate $50,000,000.

Most VCs look for an investment to return a minimum of 50% of the fund. Any investment that, even if successful, would return less than 50% of the fund is not considered.

This is not always true but it is a good rule of thumb.

 

4.  Risk Matters.

Simply put: the higher the risk of an investment, the higher the IRR required in order to compensate for that risk.  The lower the risk of the investment, the lower the required IRR.

A social network that has already captured 50% of its addressable market is a lower risk — and therefore demands a lower IRR — than a clean energy startup that wants to turn coconuts into jet fuel.  

That said, early-stage VC investing is inherently risky and therefore, in my opinion, a minimum anticipated IRR of 50% is required to justify almost any investment.