Bloomberg Línea — Brazilian education company Arco Educação’s(ARCE) purchase of the 75.1% remaining stake of fintech isaac earlier this month has been viewed by the market as a down round in terms of the valuation that the latter startup had gained following its funding rounds, and which was carried out as a share exchange, with isaac valued at around $180 million, according to David Peixoto, isaac’s co-founder.
The deal caught the attention of the startup industry and venture capital firms because it involved two of the most promising companies in the education sector, one of which, Arco, is already listed on Nasdaq.
isaac had announced a $125 million Series B round in November 2021, led by General Atlantic, an investment split into two tranches: $43 million now and $83 million in the future, with no demand conditions, given that isaac did not need the cash.
The outstanding amount of capital may not be needed, however, as, in the event that the purchase proposed by Arco is approved by Brazil’s antitrust watchdog CADE, the second installment will be canceled at isaac’s request.
But if the deal does not receive approval, the money will arrive as previously planned.
With the transaction, which hands Arco 100% of the fintech, having already owned 24.9%, isaac’s shareholders will receive approximately 10.4 million Arco shares, equivalent to 15.8% of the company’s stock listed on Nasdaq (one million treasury shares and 9.4 million new Arco shares).
The deal represented a dilution of 14.2% for Arco’s existing shareholders, and did not represent instant liquidity for isaac shareholders, which are now subject to a lock-up period of three years, and will have one-third of their shares released each year.
Arco estimates that isaac’s revenues should grow about 85% with an EBITDA margin of -10% in 2023, and that the fintech should consume cash by 2024. The startup has a net cash position of 245.5 million reais (almost $46 million), which Arco considers “sufficient to fund isaac’s operations, without the need for additional funding”.
For analysts Daniel Federle and Victor Ricciuti, of Credit Suisse, however, paying the excess cash of isaac with shares will end up implying an increase in equity at a low value per share of Arco, whose shares are currently trading around 80% below their early 2020 peak.
For isaac’s co-founder, the valuation would be more important to look at if the transaction involved exchanging shares for cash, and meant giving up the company, he told Bloomberg Línea.
“In this case, there was no monetary transaction, it was a 100% share exchange. It is much more sensible, from our point of view, to look at the relative value of the companies,” he said.
“For example, two months ago, Arco’s valuation was 70% above what it is today [the difference was 64% on September 30]. It may seem strange for you to imagine that this company lost so much value in 45 days, [see chart below], not least because the macro movement has already happened, it was completely due to volatility,” Peixoto said.
“If we had announced the transaction at exactly the same ratio a month and a half ago, we would have a perception of the high market potential created. It’s just that we caught a valley moment,” he said.
isaac is a fintech that offers “guaranteed revenue” to private primary and secondary schools in Brazil. Through software, the startup manages billing and collection of tuition fees, digitizing payments that, in a large part of Brazilian schools, are still made by payment slips. In August this year, Isaac had 188 million reais (nearly $35 million) in annual recurring revenue.
Before the deal, the partner-founders of isaac owned 35.7% of the company, while Arco held 24.9% after investing in the startup’s Seed round in August 2020 and, in February last year, in its Series A.
General Atlantic had 21.1%; Kaszek, 11.7%; SoftBank, 4.5%; and other shareholders 1.9%.
Kaszek told Bloomberg Línea that it supported the founders’ decision for the Arco deal and is bullish on the combination.
SoftBank did not respond to a request for comment from Bloomberg Línea, while General Atlantic said it would not comment.
The business rationale
Peixoto said that if the deal had been in cash, no partner would have sold the startup.
“Individually, isaac was valued at 25% of Arco’s value, a company that has almost 40% margin and grows more than 30% a year,” he said. “When interest rates were low, Arco was worth as much as $3 billion. If we had done the transaction at that time, we would have had a super expressive valuation.”
Two months from now, when the transaction is completed, it may be that the share value will rise again and isaac’s implied value will be different, according to Peixoto.
He explained that the decision to merge the company with Arco was not because of the difficulty of raising money in private rounds, but because the businesses are complementary.
“Arco is a content platform for schools, which helps in the pedagogical part of the school, which has 9,000 institutions throughout Brazil. Isaac has built a platform that looks at the administrative and financial sides of the school. We have the same client, with complementary solutions,” said Peixoto.
For companies, it makes sense to join the pedagogical side with the administrative and financial side in an integrated platform, Peixoto added.
For isaac, which has 900 schools as clients, access to the Arco base brings great gains and with little redundancy.
“If I can use this relationship base and the pedagogical platform that Arco has already been building for years to offer my isaac products, I have the possibility of multiplying my growth tenfold with a proprietary distribution channel,” said Peixoto.
Betting on the future
A share swap was agreed upon because “everyone wanted to be part of this project of the combined companies, to capture the gains they can have in the future”.
“It was a request from us, from all the shareholders, for the transaction to be on a share-swap basis,” he said.
As a listed company, Arco has suffered from rising interest rates, which particularly affect so-called growth stocks - of companies whose expansion is more accelerated - and capital market volatility.
“For Arco it was also complicated to carry out a transaction at this time because, at the end of the day, their share price is below what is fair. We evaluated the assets independently, how much would be the fair value of Arco, how much would be the fair value of isaac, and in the end, we established an exchange ratio, how much one would represent in proportion to the other,” he said.
Peixoto will be the second-largest shareholder in the combined company and will participate in the management of isaac’s unit in Arco, along with partner Ricardo Sales.
Credit Suisse analysts said in a report that they view the transaction as “strategically positive” but “slightly negative from a financial perspective”.
“isaac offers synergistic financial products that should strengthen Arco’s offering for schools,” Credit Suisse assessed. According to the report, isaac’s net cash contributes to alleviating Arco’s leverage, which has weighed on net profit results.
“The 2x multiple of the transaction implies a small discount to Arco’s current valuation. However, in our view, the timing is not ideal for the acquisition of a company with negative cash flow,” Credit Suisse said.
A new moment for startups
Vitor Magnani, president of Movimento Inovação Digital, an association that represents a number of Brazilian unicorns, said he believes this is a new cycle for digital-native companies because of the global interest rate increase, post-pandemic economic oscillations, and the war in Ukraine.
It is an environment in which investment funds are more rigorous in selecting startups that will receive funding and in which the size of funding decreases, he said.
He believes that traditional companies that don’t own certain technology, or large digital companies looking to accelerate their growth, will be able to buy assets and startups “for smaller amounts, compared to the previous five years”.
Roberto Kanter, an economist and professor at Fundação Getulio Vargas, explained that the valuation of startups does not always follow a clear logic. For example, if one million reais is paid for 10% of the company, it would have a valuation of 10 million reais. However, if after a while, the other 90% of that company is acquired, the buying party would hardly pay more than 9 million reais.
“It will actually be paid what it is worth. If it sold one million a year, it is very likely to be worth four million,” he told Bloomberg Línea.
Therefore, the buying party would not, in this example, pay nine million reais for the company, but, but rather three million reais more.
“The value of 100% is always less than the value of the party. It’s a slightly distorted logic, but the tendency is for you to pay more for the fraction than you pay for the whole.”
Even though there is a market adjustment and fintechs today are valued at less than they were two years ago, for Kanter, isaac’s case had more to do with what 100% of the company is effectively worth.
-- This article has been updated to clarify Kaszek’s statement