Formal, Informal, and Semi-Formal: Investing in Early Stage Latin American Ventures

Palm Greasing

Every Wednesday early morning, I get together with my investment partners over Skype to review the pipeline of investment opportunities. From my perch in San Francisco, California, where I have the opportunity to observe, advise, and participate in many Silicon Valley-style investments, I am awestruck by some of the differences I see between Latin American and Silicon Valley investing. Despite my decades of experience, I am always surprised how my apparently “superior logic” gets enhanced – or, better said, “tropicalized” – by my partners in Córdoba and Buenos Aires (Argentina). I say this not only out of great respect for my Alaya[1] partners, but also to acknowledge their critical local wisdom. Without this local wisdom, one can anticipate the almost certain failure of a Silicon Valley-style VC investment in any emerging economy.

While several important differences come to mind, the most significant is that most (if not all) early stage Latin American companies have significant parts of their operations in the informal economy. This informality is not limited to invoicing and profit reporting to the tax authorities, but extends to all aspects of the enterprise. Business functions particularly amenable to informality include the reporting of revenues and profits, personnel hiring practices,  extralegal internships and apprenticeships, missed social security contributions, building code and office space requirements, and permitting, to name just a few.[2]

While my partners and I at Alaya have borne witness to the Argentine informal economy, this phenomenon is not unique to Argentina. In fact, the informal economy is a phenomenon seen across emerging markets in Latin America and beyond. Why?

Some observers simplistically argue that the informal economy is emblematic of broader endemic corruption of emerging countries. Others argue that Latin Americans are more flexible in nature and therefore more prone to skim from the tax liabilities through informal structures.

I would like to develop a more concrete theory for why most early stage companies, and even fairly mature companies, keep significant portions of their business off-the-books:

1. This is the way business was conducted by parents and grandparents: emigrant parents or grandparents were often motivated by the economic success, hence as true entrepreneurs they created their own rules;
2. Ignorance and lack of education: often the complexity and lack of clarity and transparency creates an objective barrier requiring unreasonable dedication from the entrepreneur to become educated in compliance;
3. Lack of trust in government: government enforcers have historically economically benefitted from corrupt practices as they enforce byzantine regulations or obscure codes that often make it difficult (if not impossible) for the entrepreneur to comply;
4. Costs of compliance (time, money, and effort): full compliance by meeting the letter and spirit of byzantine and obscure regulations and outdated codes often require hiring costly legal, tax, human resources, and work-space advisors;
5. Unstable legal and regulatory framework: constant changes to the legal and regulatory framework to meet populist demand or appease voting blocks could make any current compliance effort useless tomorrow.

While tradition, ignorance, and lack of trust are often true, the entrepreneur does not have the time or resources to navigate the byzantine compliance requirements and changing regulatory environment. Therefore, the answer is clear: Delay any compliance effort and cost until it is absolutely necessary, leading to the well-known phenomenon of “just-in-time compliance.”

From the entrepreneur’s perspective, this informality can lead to “lifestyle companies.”  These companies have limited growth and scaling potential since their founders and owners want to be able to live comfortably and avoid “unnecessary growth,” enabling them to fly under the radar of government officials. This commitment to “lifestyle companies” means that entrepreneurs can lose the potential upside of greater valuations and its employees will miss the growth brought by the professionalization of the enterprise.

From the fund manager’s side, two guiding principles emerge:

(a)  We have the fiduciary responsibility to invest our limited partners’ funds and it would be misguided to invest in companies that operate in the informal sector; and

(b)  Every informality tolerated during the acquisition will be reflected in the exit valuation and hence paid with multiples.

To close this divide, one potentially helpful rule-of-thumb that has been central to Alaya’s investment philosophy is: It takes about the first year to bring the portfolio company, since the initial investment, into compliance. We do this with the full support of the entrepreneurs and the knowledge and understanding of our limited partners. Furthermore, we do not disburse the entire transaction amount up front, but rather phase-out payments depending the stage of compliance development, among other metrics.

While the status quo limits the development of a true entrepreneurial ecosystem, there are some encouraging signs. A new report from the World Bank[3] finds that 17 of 32 economies in Latin America and the Caribbean implemented regulatory reforms in the past year to make doing business easier for local entrepreneurs. Chile, Perú, Colombia, and Mexico remain regional leaders in improving business regulations by improving transparency, regulatory compliance, and access to information. Chile is the regional leader in the ease of doing business, ranking 39^th globally, and over the past six years, Colombia, Mexico, and Perú have ranked among the 40 economies worldwide that have best improved their regulatory environments for entrepreneurs.

In the final analysis, entrepreneurs will empower themselves to operate informally if such informality is deemed as the only “reasonable” option in their locale. To be an entrepreneur in an emerging market is extraordinarily risky. To keep the business operating informally is an incrementally small additional risk.

The solution is to reverse the paradigm by making the compliance procedure simple and stable, hence the risk of being out of compliance would become infinitely bigger. Such changes would  benefit entrepreneurs with their valuations, empower the professionalization of their staff, and liberate investors to focus on what they do best: growing and scaling businesses while helping the regions where they operate become more competitive and productive. Some Latin American countries have already seen the light, while others only provide lip-service to supporting the vitality of their Innovation and Entrepreneurial Ecosystem!

As for Alaya, we will continue to seek to better adapt Silicon Valley’s tried and tested approach to venture investment with the tricky realities of emerging market investment.

Until my next posting – Carlos B.

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[1] My partners in Cordoba and I in silicon Valley have formed Alaya, the first VC fund in Cordoba, Argentina. www.alaya-ba.com

[2] The world Bank publish every year the Doing Business Report. In particular a 2012 Latin America Regional Profile was published recently. You can download the complete report free of charge at: http://www.doingbusiness.org/~/media/FPDKM/Doing%20Business/Documents/Profiles/Regional/DB2012/DB12-Latin-America.pdf

[3] Doing Business 2012 – Regional Profile: Latin America

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