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Despite Stumbles, a Promising Path for Start-Ups in Brazil

24 May 2013

(The New York Times DealBook) RIO DE JANEIRO – Brazil’s Internet start-ups were once the darlings of emerging markets, attracting venture capitalists from around the world. But after two-plus years of growth, the sector is facing tougher times.

Numerous young companies, even those with prominent investors, are struggling to show sustainable profitability despite early rapid growth in revenue. A case in point: Shoes4You, an e-commerce site selling designer footwear, decided to close down last month, despite being backed by the prominent United States investment firms Redpoint Ventures, Accel Partners and Flybridge Capital Partners.

Many in the industry consider its failure a harbinger of things to come. “I expect a lot of shut-downs, and that a lot of companies will be firing people,” said one of the site’s backers, Fabrice Grinda, a prominent French angel investor.

Some blame the business environment and the costs of doing business. In the case of Shoes4You, costs like legal and tax matters along with underdeveloped e-commerce logistics made operations difficult, Olivier Grinda, the company’s founder and Fabrice Grinda’s brother, told DealBook. Ultimately, the company’s subscription-based business model did not prove sustainable.

Brazil’s deteriorating macroeconomic conditions are also not helping entrepreneurs. Economic growth, for instance, slowed last year to 0.9 percent, compared with 2.7 percent in 2011. On April 17, the central bank raised its benchmark interest rate for the first time in almost two years in response to rising inflation. But despite the difficult environment, Brazilian start-ups still have supporters.

The consensus among investors and entrepreneurs in Brazil is that the short term will be difficult, but that long-term prospects remain highly favorable. And even Silicon Valley investors who have seen ideas fail are still willing to make large bets. Accel says it has invested more than $25 million in Brazil over the last few years and expects to find more opportunities. Redpoint, including the Redpoint fund, put in almost $40 million in 2012.

“Silicon Valley’s expectations were higher than they should have been in terms of the reality of the opportunity down there,” said Jeff Brody, a founding partner of Redpoint Ventures. Yet he expects to maintain the same pace of investing this year, citing improved deal-flow and noting that “one of the things we have learned is that you need to invest steadily through the cycles.”

Together with San Francisco-based, the firm raised a $130 million fund Last year run out of São Paulo. Even those critical of the sector are not yet replacing Brazil with other markets. At the Founders Forum, an annual gathering here in March, few investors spoke of shifting their investments to other Latin American markets like Mexico, Latin America’s second-largest economy after Brazil.

“People realize that Mexico is less developed in the Internet space and that raising follow-on capital is even harder,” said Jose Marin, a partner at the IG Expansion investment firm in Madrid and a host of the Founders Forum meeting.

Local and regional firms also increased activity. Kaszek Ventures in Buenos Aires says it invested close to $30 million last year, and Monashees Capital, a São Paulo-based early stage fund, put just over $25 million in start-ups, according to a person with direct knowledge of the investments.

All these firms and other resources like incubators helped make initial financing easier, but subsequent financing is still difficult, and investors are already warning founders to tighten their belts.

“Companies will have a tough time raising money and do so more by begging and groveling with current investors,” Fabrice Grinda, the investor, said. “It’ll be a year of retrench and consolidation.”

Initially, most investments made here by foreign venture capital firms were in a narrow range of Brazilian Internet or technology companies, sometimes called copycats because they replicate existing consumer Web business models in the United States or Europe.

Investors assumed Brazil’s market was large enough to support multiple successful companies in each e-commerce vertical: for example pet supplies, fashion or taxi services.

That turned out to be wildly optimistic. As a result, there was excessive competition for limited market share.

Many of the complaints about Brazil “have very little to do with the market and more to do with our self-inflicted dynamics,” said Kevin Efrusy, partner at Accel Partners, referring to hyper-competition in a narrow range of companies such that their success depends solely on execution rather than ideas.

Still, Brazilian entrepreneurs have several trends in their favor. Overall e-commerce grew by 20 percent in 2012, according to the Brazilian consulting firm e-bit, and mobile represented only 2.5 percent of transactions, making it ripe for growth.

Numerous sectors remain overlooked, like health care and education, and innovation in Brazil remains woefully underfinanced.

Yet that is starting to change. For instance, Intel Capital, the venture capital arm of the Santa Clara-based chipmaker Intel, recently invested in Geofusion, a São Paulo-based software company. Finding more innovative companies that can leverage Brazil’s market is not easy for foreign investors, but it can help reduce woes.

Accel Partners, for example, made a later-stage growth investment in 2011 in the education company MindLab, but only after introduced to it by an earlier investor, Monashees Capital.

Mr. Efrusy said Accel would not have invested in MindLab’s earlier financing rounds because what the company did was “not a pattern we recognized as successful in the U.S.”

But Monashees Capital helped convince them that the company had value. Accel is now focused on finding more such companies here.

Chinese Internet companies are also showing interest. Mr. Brody of Redpoint, who has invested heavily in China, said he expected strategic partnerships involving Chinese firms this year to bolster Brazilian start-ups.

China’s Internet sector itself experienced overhype more than a decade ago, but that was later followed by exits and hefty returns to investors; that could be a pattern duplicated in Brazil.

The prevailing mood, although less euphoric, may actually help bring on more sensible growth in Brazil, investors say.

Mr. Efrusy, who is living temporarily in Rio de Janeiro, said that he was seeing “less flooding by M.B.A.’s and consultants from all over the world,” a move that is affording entrepreneurs here “a more serious and authentic community.”