Why Magma Partners Loves Corfo But Doesn’t Take Its Money

Walmart’s acquisition of Cornershop for $225M set off a firestorm in Chile. Everyone from politicians to investors, columnists to entrepreneurs has thrown in their two cents.

Why didn’t any Chilean VCs invest, when 2 of the founders were Chilean? The debate got hotter when Oskar and Dani, two of Cornershop’s founders, shared their perspectives on Twitter and in interviews, and a prominent reporter used the acquisition to bash wealthy Chileans.

Some have turned Cornershop into a referendum on wealthy Chilean businesspeople. I’ve written about the Chilean extraction vs. value creation mentality. That’s a part of it. Others have seized on Chile’s conservatism. That’s also a part of it. Others have blamed CORFO, the Chilean government agency that supports new businesses and venture capital. Others blamed Chilean VCs for missing the boat. They also deserve some blame, although a Chilean fund did invest $500k into the Cornershop founders’ previous startup Seahorse, and multiple Chilean angel investors invested in Cornershop.

I got multiple requests for my perspective from entrepreneurs, investors and family offices from around the region. What happened? They also asked why have Magma Partners been the only VC fund in Chile that hasn’t taken CORFO money? And why we haven’t taken any government money from anywhere, whether its the US, China or Latin America.

I love CORFO. CORFO created and supported Start-Up Chile, the world-changing program that brought me to Chile back in 2010. It indirectly showed me the opportunity to create Magma Partners in Latin America.

I also love CORFO because it’s made up of well-meaning, smart, dedicated people who are doing their best to change Chile for the better. Thanks to everyone involved. You’ve truly changed my life.

I also love CORFO because CORFO backed funds are blocked from investing in many of the best deals in Latin America. Since 2014, Magma Partners has invested in 42 startups across Latin America. And we found that CORFO blocks much of Magma’s Chilean from at least 40 of our best investments.

Misaligned Incentives

A few years after starting Magma Partners, I was sitting in an event put on by a CORFO-financed incubator at one of the nicest hotels in Santiago.

I was invited for lunch at the hotel’s expensive restaurant where the speakers and VIPs were treated to a spread of Chile’s amazing seafood, steak and wine.

I flashed back to 2014 when we first started Magma with $2.5M of our own money. I began to do some calculations…we’d likely spent less money in our first year of operation than this government-backed incubator had spent in one day to put on this event!

I flashed back to our first meetings with CORFO when we were trying to understand how it supports VCs, incubators, and accelerators and our decision not to accept any of their funding.

“Were we stupid?” I thought.

As I enjoyed the top-notch seafood and steak, washing it down with some amazing Chilean wine, I remembered one of my favorite quotes, “When you can’t figure out who the sucker at the table is, maybe it’s you.”

Skin in the Game: Why Magma Fund 1 Went it Alone

In November 2013, Diego Philippi, one of the first Start-Up Chile team members, introduced me to Francisco Saenz, a successful Chilean businessman who runs his family office.

Francisco told us he’d done well in business and wanted to give back to the next generation of entrepreneurs. He also wanted to diversify into tech.

We hit it off in our first meeting. Francisco agreed that we needed to create an early-stage investment fund that would support entrepreneurs with more than just money. He agreed to US-inspired, entrepreneur-friendly deals, quick turnaround times on investment decisions, real mentorship from operators, and connections to the US and Chilean business community.

It was the exact opposite of most of the well-meaning funds that I’d met doing business in Chile in 2010. Most investors were bureaucratic, old school, tried to control the company with a small investment and unintentionally killed their own deals they’d invested into.

After three meetings, Francisco agreed to put up $2.5M of his own money and wanted to hire us. Diego and I were adamant that we needed to have skin in the game. Francisco accepted, we invested and became partners.

We thought about raising a US-style fund with outside investors and a management company. But Francisco stuck to his guns. In the conservative, fear of failure, chaqueteo culture (Chilean for talking shit behind your back, and sometimes to your face, to pull you back down to the shit talker’s level), Francisco wanted to have 100% skin in the game and test the model before asking anyone else for a peso.

“How can I recommend investing in startups to my friends if I haven’t taken the risk myself first?” he asked.

I couldn’t agree more. We decided to go it alone, even though Francisco’s friends from other Chilean Family Offices would have likely invested. By January 2014, we were off and running, doing our first investment meetings, and later on, investing in some of those startups.

To CORFO or Not to CORFO, Magma I’s Question

When we started Magma Partners, we decided to meet with CORFO to see if we could work together. We’d heard about the famous 2×1 and 3×1 matching programs. For example, if you raised $1M in private money, CORFO would give you $2M or $3M on top of it. If you were successful, you paid off the money with interest. If you failed, CORFO forgave the debt. In addition, CORFO would give funds up to $150k per year for operational costs for up to 5 years.

It sounded too good to be true. And as with everything in life, it was.

There were strings attached. Restrictions. Structure was the first deal breaker. We started Magma I as a “Sociedad de Inversiones, SpA”, the rough Chilean equivalent of a US Special Purpose Vehicle LLC. Francisco’s family office, Diego and I were the only shareholders. It cost $1k to get incorporated. We were investing within in a week.

The CORFO executive told us that we could not access any CORFO VC fund money with this structure. We had to create a Chilean FIP, Fondo de Inversion Privado (private investment fund), which was regulated by the Superintendencia de Valores y Seguros (SVS). A Chilean FIP has to have at least 4 investors with at least 10% of the investment each and they can’t be related to the administrator.

It would cost at least $10k to get off the ground. It would take government approval, that would supposedly take 1-2 months. Note: Magma II’s Chilean vehicle took 8 months to get this structure approved by the SVS, but that’s another story for another time.

It was a clear no go, just based on the structure.

As we explored deeper, we realized we couldn’t accept, even if we had the correct structure.

We’d only be able to invest in companies incorporated in Chile, that were less than three years old, that had sold less than $250k in their entire history. We had to get each deal approved by a CORFO committee. We had to use their term sheets. Instead of doing deals in days, it would take months.

We could get around the geography by spending $7-15k per deal, but it would slow us down and potentially make us lose the best deals. We also saw opportunities for misaligned incentives. It just wasn’t for us. We talked to other government programs around the world, but none made sense.

But what we really could have used was the operating budget. Francisco is an incredible partner and agreed to a budget that would allow us to survive. If we had run Magma I as a fund, we would have had a 2% yearly management fee on the $2.5Mm or $50,000.

Chile is less expensive than the US, but not by that much! We had to pay me full time, Diego and Francisco part-time. Office space. Legal. Not to mention events, marketing, asados (BBQs). We made a budget, kept our salaries extremely low and spent ~$65k our first year.

Man, would it have been nice to have that $150k operations grant from CORFO! We could have hired a team, trained associates, created better processes and better supported the entrepreneurs we’d invested into. But in 2014, CORFO was adamant that we couldn’t access any of the grants to pay for our team unless we took the 2×1 or 3×1 and used their required structure.

We asked if we could be an incubator. These private entities award $60M (US$100K) CORFO grants to startups and help startups (to varying degrees), launch and scale. Some add value. Some are neutral. Others are a negative value, even with $100k grant.

But incubators have a CORFO-granted CLP$200M (US$350k) operating a budget. Plus they get to award 6-10 $100k CORFO grants per year, in exchange for 7% equity or a % of sales or profit, depending on how they would like to structure it.

“What could be better?” we thought. Magma Partners, a private fund, could award these grants and then follow on privately with our own money, and access a $350k operating budget.

CORFO told us that Santiago already had too many incubators (I agree!). We could create one outside of Santiago, but that didn’t make sense. We wanted to start investing and decided to go it alone.

Magma II: Half of CORFO’s Structure, But Still No CORFO Money

Over the next 4 years, we invested in 32 companies in Chile, Colombia, Costa Rica, Mexico, Argentina and the US. We opened a US entity to invest directly in our US incorporated companies. We built a reputation as a fund that shoots straight, moves quickly, and doesn’t have CORFO or other governmental restrictions. We proved our original thesis that most entrepreneurs would want to work with us if we provided real value. As of 2018, the $2.5M we invested is now worth $12M+. One of the portfolio companies we supported exited. And we’re confident that it was the first of many to come.

So many good entrepreneurs were applying that we saw an opportunity to be even more regional, build a real team and help more entrepreneurs across Latin America.

So we went into the market and started to raise money. If we were going to raise money from Chilean family offices, we knew we needed to have CORFO’s preferred FIP/Administradora structure. If we’re taking outside money, we should be regulated. Additionally, Chilean FIPs have significant tax advantages for Chilean investors, especially if investing abroad, which we fully intended to keep doing.

We wanted to be a US incorporated fund and administrator because it would make investing quicker, less bureaucratic. It would also allow us to accept US, Latin American and Chinese investors as LPs. Our Chilean fund would be a feeder fund into our US fund; it wouldn’t do any direct investments.

We’d also had experience co-investing with CORFO funds and incubators and the results weren’t pretty. Some were good, but others took 4-14 (yes 14) months from the first meeting to actually deposit the investment.

Our US-Chilean structure didn’t work if we wanted to receive CORFO money because the only thing our Chilean structure does is invest 100% of the money into our US fund.

We could have potentially created a sidecar $1M fund and gotten $3M on top of it to only invest alongside our fund in Chilean-only companies. But it required more paperwork, bureaucracy and headaches. It would also raise questions from our US, Argentine, Colombian and Chinese LPs. It just wasn’t worth it.

Eventually, we raised $7.5M from family offices in Chile, Colombia, Argentina, US and China. We’ve deployed $1.2M into 14 startups in Chile, Peru, Ecuador, Argentina, Colombia, Mexico and the US in 2018. It’s been amazing to see the startups we support to raise $30M+ in follow-on capital, have more than $35M in annual sales, and employ 500+ people around the world.

We have more deal flow than we can invest in. We could easily invest a $20M fund during the same period that we will invest our $7.5M.

But we still have the issue of a $131k operating budget. Even if we had a $20M fund, we’d be pushing it. We have a seven-person full-time team, supported by a 9 person part-time venture partner and scout network with presence Chile, Peru, Colombia, Mexico, Argentina, USA and China.

How’s it possible? We believe in our mission that we’re making a difference. We’re willing to earn 30%-90% below market value, for now to have a payoff when the companies we’ve supported exit.

This is the reality of running a small venture capital fund. Being this lean forced us to be creative. We saw that startups needed even more help, so we replicated the Andreessen Horowitz agency model to help startups grow

Feeding at the CORFO Trough: How a Fund Could Game the System

Here’s an example of how a fund manager who wanted to take full advantage of CORFO funding could do if they wanted to. I don’t know if anyone is actually doing this today, but I want to show what’s potentially possible.

Say you raise $2M in private capital for your new fund, Chancho Capital. Corfo will match 3×1, meaning that they’ll give you another $6M, $8M in total. You can charge up to a 2.5% annual management fee during the life of your 10 year fund.

That’s 25% of the fund. But if you want, you can charge your fee for the entire fund size of $8M, not just the $2M in private capital. What’s 25% of 8M? $2M, or 100% of the private capital invested by private investors. Where does that $2M go? It’s supposed to pay for a team, but it could go to high salaries and perks that go directly into the fund managers’ pockets.

Chancho Capital can also get ~$150k per year for ~5 years from CORFO, meaning that $2.75M goes to Chancho Capital’s fund managers. That’s 137% of the private capital!

Chancho Capital could also advertise that they will charge a 10% carry on returns, about half of the industry standard. Some family offices who may not be experienced in VC might see this as a good thing.

“They’re charging me lower fees,” they might say.

The cynic in me says “Chancho’s managers don’t think they’ll be successful!”

As a fund manager, I want the highest possible carry while still providing great returns to my LPs. The carry is where my team and I make the real money if we’re successful.

The incubators can play a similar game, but they don’t have to actually invest any of their own capital. CORFO gives them $350k per year, most of which goes into their pockets. They do have to match a portion of the grant, but it can go right back into their own pockets.

Skin in the Game: How CORFO Could Improve

CORFO could use their substantial resources and good intentions to take the next step and better support the ecosystem. If it were up to me, I would immediately offer $100k-$250k grants for operating budgets of private investors who invest more than $X million dollars per year into Y companies per year that meet specific criteria. I wouldn’t require a specific structure.

These funds would be 100% private capital. What better way to show that you have skin in the game than invest your own money or that of your LPs? Peru’s government looked at CORFO as an example and created a management fee matching program for funds. I would use a program like this in a second if it didn’t have massive strings attached.

CORFO could loosen restrictions on structure, bureaucracy and company stage like neighboring Argentina did. Argentina’s program invests into funds and has much looser restrictions on where the money can be invested. Chile is a small country at the literal end of the world. Latin American venture capital needs to be regional if it’s going to be successful. Chile’s market is too small to pour hundreds of millions of dollars into companies that are only in the local market.

I would change the 2×1 and 3×1 programs and make CORFO into an LP in funds. The Chilean taxpayers should get the returns that the best funds are going to generate, not just the funds’ losses or their money back. I know this is politically difficult, but it would help the country. If CORFO or the government can’t accept the returns, then the CORFO returns could be given out as equity free grants to fund small businesses and startups started by the Chileans who most need it.

I would take equity in incubator projects, too. I’d also force incubators to have a sidecar fund to invest in companies with their own private capital, not just administer government money.

CORFO has been a world leader in supporting startups and venture capital. And it’s worked. However, it can always be better and more efficient. If CORFO makes changes, it can once again lead the region, and the world, in creating world-class programs like Start-Up Chile and supporting the growing Chilean startup ecosystem.