Supporting venture capital funds in 2023 and beyond

Venture capital (VC) funds are flowing into the most innovative and dynamic Vietnamese startup companies as well as more established tech companies that are poised to become national champions one day.

Eric Johnson from FreshfieldsBruckhaus Deringer LLP

The government has done a good job of publicising the attractiveness and opportunity of the Vietnamese VC ecosystem. At the recent Vietnam Venture Summit in Hanoi, it was reported that over 40 VC firms pledged to invest over $1.5 billion in startups here over the next few years.

Looking forward, however, we cannot ignore the fact that the global VC industry suffered greatly during the course of 2022 as a result of rising interest rates, sharp decreases in the valuations of listed tech companies in major markets and a shift in institutional investor appetite from risk and growth to liquidity and capital preservation.

Vietnam was not immune to these global events and at the time of this writing, it appears that VC inflows in 2022 will come in lower than the record inflows that the country saw in 2021 with an uncertain 2023 ahead.

Despite these global headwinds, Vietnam is still well poised to attract VC investment during the downturn and after the recovery due to its strong fundamentals, including a vibrant and growing community of founders creating innovative companies, its relatively young population, high mobile phone/internet usage and what appears to be the highest GDP growth rate in ASEAN in 2022.

The fundamentals noted above are only part of the story though – a strong business environment for innovative startup companies requires not only talented entrepreneurs and good economic fundamentals, but easy and efficient access to capital, which in turn requires a strong underlying legal regime designed to make such capital raising as seamless and predictable as possible.

There are two frustrating issues that we see come up regularly during our work. These issues are not unique to VC funding, but they have a disproportionate impact on small companies raising relatively small amounts of early-stage capital where efficiency, speed and legal certainty without complexity are of the utmost importance to both early-stage companies without large legal budgets and the investors that fund them.

Preference shares

In the world of VC fundraising, investors are taking on significant risk by providing financing to an often new, untested and unprofitable company in return for participation in potentially explosive growth that cannot be easily replicated by more established businesses operating in more traditional sectors.

To protect their downside risk, which is substantial by nature, VC investors will often place funds in companies using a hybrid security which has aspects of a pure equity investment combined with debt-like aspects – preference shares. In its most basic form, preference shares allow the holders to participate in the upside similar to a pure equity investment but will typically have a liquidation preference which entitles the preference shareholders to, at a minimum, their money back before any money gets paid out to the ordinary shareholders or earlier preference shareholders upon the occurrence of certain liquidation events.

In other jurisdictions, companies and investors can generally agree on terms of preference shares among themselves, so long as all necessary corporate approvals are obtained and there is nothing contrary to law contained in the terms.

This flexibility allows VC investors and the companies they fund to agree to terms that suit the transaction in question and provides them with relative certainty that their funds will be protected, at least from a legal perspective.

In contrast, in Vietnam, Article 114 of the Law on Enterprises 2020 (LoE) lists out four permitted categories of preference shares – voting, redeemable, dividend, and the so-called “other” category which reads “other preference shares as stipulated in the charter of the company and in the law on securities”.

The reference to the law on securities above was added to the LoE has created confusion and uncertainty in the market, because the securities law does not refer to any specific types of preference shares.

Previously, many VC investors relied on this “other” category because the terms of typical preference shares are not fully covered by the first three categories.

However, following inclusion of this new language, some but not all practitioners have been taking the view that the “other” category is now essentially meaningless because any “other” permitted preference shares would need to be stipulated in both the company’s charter and the securities law.

As there are no specific types of preference shares stipulated in the securities law, we doubt this was the intention of the drafters in adding this language to the LoE. Regardless of the views taken by different practitioners in the market, what is certain is that the “other” category has become more uncertain, legally speaking.

Removing or clarifying this new language and generally increasing the ability of investors and companies to freely negotiate and agree on the terms of preference shares to suit their specific circumstances would streamline transactions involving preference shares, remove unhelpful legal uncertainty and encourage investment in Vietnam.

The recent downturn in crypto markets has made investors more selective, Photo: Shutterstock

Convertible loan guidance

The other common type of security used in VC transactions are convertible notes (or, in Vietnam, convertible loans). These are typically used for so-called bridge rounds in between equity rounds when the company raising money does not want to set a new equity valuation.

Generally speaking, the convertible loans will typically remain outstanding until the company completes a new equity fundraising round, at which point the convertible loan will convert into equity on the same terms as the new equity round but typically at a discount to the new equity valuation to compensate the bridge-round investors for their additional risk and cost of capital.

Looking forward to 2023, convertible loan bridge rounds will be a significant tool in the toolkit for Vietnamese startups as they look to maintain working capital while waiting for market conditions to improve before raising equity on a new valuation, if possible. However, there is an inconsistency with State Bank of Vietnam (SBV) regulations, which creates unhelpful uncertainty around the ability of foreign investors to receive dividends and sale proceeds on shares acquired by way of converting their convertible loans, making what should be a relatively quick and simple process into a more complex one.

At a very high level, on the one hand, Circular No.12/2022 provides that an offshore loan may be repaid by converting the loan into shares of the Vietnamese borrower. However, Circular No.05/2014 requires that foreign investors pay for shares of companies set up in the way most Vietnamese startup companies are set up using a special domestic bank account known as an indirect investment capital account (IICA).

Putting the two together, this means that a foreign investor may acquire shares via conversion of a loan under Circular 12, but in doing so will not be able to show its Vietnamese bank that it acquired such shares via payment through an IICA as required under Circular 05.

While it may seem obvious that the rule in Circular 12 should be read as an exception to the rule, the SBV has not issued guidance that this is the case. In practice, this inconsistency may result in difficulties in remitting dividends and sale proceeds offshore – a situation that most foreign investors are not willing to accept.

The fix here should be fairly simple – the SBV should issue guidance to Vietnamese banks to resolve the conflict and make it clear that it is permissible to process offshore remittances in respect of dividends and sale proceeds related to shares acquired via the conversion of a loan even though such shares were not initially acquired with funds passing through the foreign investor’s IICA.

Without such a fix, uncertainty will continue to complicate transactions that should ideally be as streamlined as possible, which discourages VC investment inside Vietnam.

South Korea venture capital funds latch onto Vietnam More venture capital funds from South Korea are considering Vietnam as an appealing investment destination, with a plan to ramp up funding in homegrown startups.