Zombies are about to invade Latin America

Editor’s note: This is a guest post by Juan Pablo Cappello, an investor in more than twenty early stage companies. Rather than ignore the undead startups in Latin America, he explains why these companies have not succeeded and what can be done to save at least some of them.

They were popular in movies and books a few years ago, but if you are like most people over 20, you haven’t thought about zombies for a long time. Nevertheless, if you are involved in venture capital in Latin America, you are about to find the VC landscape littered with zombie like companies –angel-backed enterprises that are neither dead nor alive.

A generation of Latin American based companies, launched in the past three years, faces the reality that they have burned through their seed financing (usually between $100,000-750,000) and that they are caught in the middle of the “Valley of Death” with no clear path to any further financing.

Rather than pull the plug, as might happen in the United States, many of these Latin entrepreneurs are quietly reducing their company’s burn rate to next to nothing (while they begin to look for consulting work to make end’s meet).  Beyond LatAm’s social pressure not to admit failure, in most of the region, local bankruptcy rules and laws expose a company’s management to personal liability. Ergo, many of those Latin entrepreneurs would rather put their projects on life support and to keep them there indefinitively, rather than pulling the proverbial plug – leaving Zombie-like companies.

Origin of a zombie

How did we end up with these zombies?  It has become fashionable to criticize LatAm entrepreneurs as spitting out too many copy-cat companies and then blame the regional ecosystem’s woes on the failure of its entrepreneurs to generate enough ‘disruptive” ideas. These critics ignore the fact that many of the most successful venture-backed companies in LatAm were never truly ‘disruptive’ —think great companies like MercadoLibre (now a US$5 billion “clone”), Netshoes, Baby.com.br and others.

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The lack of exits via IPOs or strategic sales in the region has created these zombies. The current wave of startups in Latin America were inspired by the venture investments that Tiger Global, Accel, Redpoint, Sequoia and others began making (initially Brazil-centric) in 2009-2010.  Throughout Latin America we have seen incredibly few exits in the past three years.  The Latin American Private Equity and Venture Capital Association (LAVCA) reports only 144 exits in the region over the past three years.  That number includes venture  as well as private equity transactions-the vast majority of those exits are private equity deals.  I will not cite the same figure of exits for Silicon Valley based companies. It is too depressing.

It is a terrible sign that Playdom/Disney’s purchases of Three Melons (Arg.) and GroupOn’s acqui-hire of ClanDescuento (Chile) are still being mentioned in the region. These were great transactions, but they took place in 2010. We need to be seeing moderate exits like these every month, if not every week.  We have accelerators in the region that have invested in literally hundreds of companies/projects in the past three years and are lucky to have seen one exit in their portfolios.

Without exits, the whole VC ecosystem starts to shut down and we start to witness undead companies — zombies.

Of course some deserve to either die or remain in Zombie-like status. But, what should we do to save those worth saving?

Saving the zombies

First, the entrepreneur has to engage the angel investors who backed their companies.  Too many TechnoLatinos are looking at their shoes waiting for something to happen.  An honest assessment of the current state of affairs is needed.  The situation is not going to get better by waiting.  Further, many of the Latin American companies where I am invested have not have sent an investor update in six months. The first step to solving a problem is admitting there is a problem.

Secondly, the angel investors must decide if they are willing to bridge the company more money.  Most of the time the answer will be “no”.  As the saying goes, “capital is a coward.”  Investors are concerned about funding a “bridge to nowhere”; an additional capital injection that just puts off the inevitable.

Thirdly, Carpe Diem — it’s time to get creative.  Oddly, the confirmation that the angel investors are unwilling to fund more money creates an opportunity.  Almost any solution seems like a good one.

Investors are hoping-against the odds- to hear from an entrepreneur that she has secured a term sheet to raise another $2mm at a five-time multiple to the seed round.  Before proposing a solution, the entrepreneur needs to strip that pretense from the investors’ minds and get them open to realistic proposals.

Creative solutions include merging companies.  The rash of clones has meant that in some sectors the field of local competitors is rather crowded.  Usually there is one market leader that does have a realistic chance of securing a next round of financing.  We have seen cash-less mergers where the acquiring company gives up 5-20% of its equity to acquire a less well-positioned competitor.

Interregional mergers should become the norm and many zombies could be interesting targets for US based companies that want a foothold in Latin America.  For instance at Idea.me we were able to acquire Movere.me, the second leading crowdfunding platform in Brazil-a market we desperately wanted to enter-with minimal dilution.  It was a win-win transaction.

Also zombie companies could be interesting and very low cost acquisition targets for local media groups interested in digital businesses.  These can be viewed as cheap acqui-hires (acquisition where the main asset being purchased is the management team), if the company has built a credible team.  For the angel investors recovering 33% of their investment might be an interesting alternative.

Another approach is to raise a modest amount of additional money to support scaled back business plan.  Many early stage companies in LatAm raised their seed financing at $1-$2 million valuations.  Now may be the time to consider raising another $50,000-$100,000 at a $300,000-500,000 (where startup valuations were in LatAm pre 2010) to fund a business plan where there is a clear path to profitability with that $100,000.  Investors are much more open to a down round after they have collectively confirmed they will not be putting in more capital.

The zombies are coming, whether we like it or not.   The best approach is to not let a company with a true and promising future fall into that state  Now is the time for the entrepreneur and the angel investors to come together and think creatively about alternatives.  Time is not on our side.

Image credit: Dawn of the Dead via That Film Guy