Evaluating Startups in Latin America: Risk Management Considerations

November 18, 2019

 

Amid reports of increasing investment, activity, and growth in Latin America’s startup ecosystem, it’s important to keep in mind the relevance of pricing and mitigating local risks when evaluating Latin American startups both for the purposes of transactions and valuations. In the case of Latin America, local startups may share risks common among startups in general, but they may also exhibit risks specific to their industries, home countries, and the markets in which they operate. 

 

On a global scale, recent disclosures and controversies involving larger startups, such as WeWork and Uber, have highlighted a number of risk areas that could easily apply to risk management assessments of Latin American startups. These include, inter alia:

 

  • The accuracy in valuation models used to evaluate startups. 

  • Costs associated with the startup’s business model. 

  • Long-term business model viability (including business verticals).

  • Corporate governance concerns, which may be of particular concern in Latin American startups. 

  • Regulatory risks. 

  • Startup ecosystems flush with venture capital inflows that may create perverse, unintended incentives for startups to utilise cash in unhealthy ways. 

 

While the above risk areas may just as easily apply to startups in markets outside of Latin America, it’s instructive to keep them in mind when engaging in a risk management strategy or valuation vis-a-vis a transaction or acquisition of a Latin American startup. But there are also risks specific to Latin American markets, which should be considered. These include, inter alia, the following:

 

  • Regulatory Risk: Regulatory risk is a broad category, but is particularly important to consider in Latin America. In broad terms, the regulatory system in Latin American markets tends to be slow, burdensome, and ill-suited to dealing with the sometimes novel and unfamiliar business models of startups. 

    • This area would be particularly important for, for instance, fintech startups. Highly concentrated, entrenched, and powerful banking sectors are present in many markets in the region. While a significant proportion of the regional population remains unbanked or underbanked, and some countries have made admirable strides in attempting to create certainty by introducing regulations for the fintech sector, many problematic areas remain. Many regional financial markets simply lack an efficient infrastructure in which startups can operate. In some markets, regulatory bodies struggle to understand rapidly changing digital banking and the attendant risks. Fintech startups remain concerned about regulatory costs and burdens set by authorities without an adequate understanding of their services and business models. As a result of the regulatory uncertainty, there remain markets where fintech companies are operating in legal “grey areas,” thus increasing uncertainty and risks for those considering transactions with such companies. Finally, in several Latin American markets a much-needed push for anti-money laundering/terrorist financing regulations can affect financial market players, including fintechs, which may be viewed, from the outset, with some degree of apprehension by regulatory bodies. 

    • Labour regulations could also be included in the category of regulatory risks. Writ large, labour regulations in Latin America tend to be, on the whole, much more burdensome for employers as compared with markets such as the United States. This can prove especially problematic for startups whose business model includes labour arrangements unfamiliar within the Latin American regulatory framework. In fact, labour relations issues have already brought on the introduction of new labour regulations in several Latin American countries due to controversies vis-a-vis startups with with “peer-to-peer” or “quasi-peer-to-peer” business models.

  • Infrastructure: Infrastructure quality is sorely lacking in Latin America. It’s a category in which the region ranks fifth out of six regions (only ahead of Sub-Saharan Africa). The lack of adequate, ports, roads, energy grids, and telecommunications infrastructure affects all businesses in the region, including startups. These issues must be considered with a view towards the target startup’s business model and how effectively it can manoeuvre around such gaps. Another problematic area for startups operating in Latin America is the ability to find local talent in a region where over 40% of firms report difficulties finding employees with the right skills; the region ranks as having the largest skills gap in the world, and this affects both established firms and startups seeking to hire talent in order to scale quickly.

  • Corporate Governance: In the area of corporate governance, Latin American markets exhibit issues such as lack of awareness of its importance in the private sector; the dominance of family-owned firms in some countries; and, regulatory gaps. Corporate governance issues can often be exacerbated in startups as pressure from investors drives management to burn through cash in the pursuit of a rapid growth scaling strategy while leaving governance issues on the proverbial “back burner.”

  • Political/Geopolitical Risks: Political and geopolitical risks, as evidenced by the recent social disruptions in many countries across the region, abound in Latin America and constitute a topic that merits its own blog post. They include, inter alia, “extortion” of companies by regulatory bodies and government agencies; the penetration of government/regulatory bodies by organised crime, social instability/disruptions, “creeping expropriation,” and other local and regional political/geopolitical considerations specific to particular markets. These sorts of risks inevitably affect regional startups in different ways depending on the markets and industries in which they operate. 

  • Reliability of local experts: To the extent those evaluating startups rely on local experts, such as auditors (including audited financial statements), accountants, or lawyers, they should be wary. Local standards of work may not be the same in Latin America as they are in more developed regions and corruption/kickbacks can be a much more significant concern even if the local experts are affiliated with “brand name” service providers. 

  • Cybersecurity: This is an area of continuing vulnerability in Latin America and it can affect even large state-owned entities as well as startups. As such, it should be evaluated in any important pre-transactional assessment of a Latin America-based startup.

  • Reputational risk: It goes without saying that reputational risk events can significantly affect the value of startups just as they can mature companies. As such, the startups reputation (and those of its principals) should be thoroughly evaluated and monitored. Finally, significant risk events, including those that occur with regard to any of the above areas, may easily become significant reputational risk events in their own right. 

 

Latin America’s startup ecosystem has been on a reported growth trajectory in recent years as investments pour into the region while certain governments take steps to promote startup growth. While Latin American startups may share certain risks with their counterparts in more developed regions of the world, there are also structural, region-specific, country-specific, and industry-specific risks to consider and seek to mitigate in diligence/risk management exercises where Latin American startups are concerned. On the whole, the potential investor should have a solid, iterative risk management approach to the transaction and should evaluate Latin American targets through that lens in the pre- and post-transaction stage. 

 

 

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