Highlights
The market is down and hitting low with each passing day of lockdown but the investment firms known as venture or angel firms are utilising the time to make sure they are in better position once this all end. There is a leverage they have gained by this recent development and they seem to use it with full response.
Introduction
Transmission of the flu-like coronavirus snowballed into what WHO termed as – THE PANDEMIC! It has engulfed over 100 countries, and the world economies are in shambles with no end in sight. From travel restrictions and supply chain disruptions to rising safety and privacy concerns, businesses are experiencing a multitude of problems. This uncertain downturn has hurled many businesses in a deep liquidity crunch bordering a closedown while opening up opportunities for some brave-heart venture capitalists.
The direct outcome of these disruptions is – scarcity of capital. As a result, businesses especially start-ups are slashing operational and fixed costs to survive the virus-induced economic slowdown. Valuations are down – estimated range from 10% to 40% – further reducing the bargaining power of start-ups.
High Investor Leverage
For a while, entrepreneurs, of strong start-ups especially, have had a solid foothold in setting the terms and conditions with investors. It is easy to be founder-friendly in times of exuberance, but the pandemic will be an enlightening experience for entrepreneurs in identifying opportunist venture firms.
Further, India’s protectionist Foreign Direct Investment (FDI) amendments putting a blanket ban on investments coming from China, Pakistan, and Bangladesh through the automatic route in addition to the subsisting FDI restrictions have exacerbated the cash crunch among start-ups and small businesses. Also, the present crisis has reduced the quantum of investors willing to make a bet on a start-up.
The collective effect of restriction on foreign investments and reduced number of investors is – limited options for investment seeking start-ups. This invariably affords brave-heart local venture firms and investors an upper hand in negotiations. Basically, tables of negotiation have turned – with power lying with the investors. This implies more ‘investor-friendly’ terms being etched into term sheets, from downside protection to terms for increasing investor control over start-up companies.
Higher Investor Control
As investors push terms of their preference over budding entrepreneurs, they will exercise far more control over the companies and subsidiaries invested in. In such times, core values of the investor come to the forefront dictating the terms of investment. While some investors may afford freedom to the fortunate few, others are likely to push terms in their favour, which could be overly restrictive and suffocating for company growth.
Some prominent leverage the investors are trying to grab can be listed as follow:
- Liquidity Preference: Investors are trying to gain a liquidity preference in the investment they are making to make sure that if the idea fails and company went into liquidation they would have a better prospect of recovery than other investors or creditors and sometime even a number of times more than they actually invested.
- Full Ratchet: Through agreeing on terms of full ratchet investors are trying to secure a fixed percentage of ownership right in the business that would not be diluted by any further fund raising financing scheme thereby giving a sense of security that there control would never end no matter how much the company grow.
- Pay to Play: Through this clause the non-participating investors are penalised while others are awarded. This is done to ensure that all the investors contribute when called for and is certainly easy for giants like venture firms but harsh clause for new start-up entrepreneur short with funds. Thus they lose their control even further with declining share percentage.
- Bridge Loans: It is a system of loaning out where on the account of non-payment the loan is transformed into equity and that two double the amount of loan itself or any other such performance as decided in the contract. It is another way to ensure loan is secured and disadvantageous to new entrepreneur.
- Anti-dilution provisions: With higher leverage on the part of investors, they are likely to impose anti-dilution provisions over start-ups, especially in instances where a company is raising money at a high valuation, but the investor still wants in. Such provisions arrests the growth of companies and are compelled to raise funds at lower valuation.
Sprouting Opportunities
Despite opportunistic behaviour exhibited by venture firms and investors at large, it is not all dull and gloom for start-ups. Experts believe that social distancing and work-from-home may become the new normal and provides unconventional opportunities to entrepreneurs. One of the most promising sectors in this regard would be reliance on drones for services like delivering goods. Moreso, the advent of technology in traditional jobs like banking, legal and sales, to name a few, may help businesses flourish despite strict social distancing measures. Realizing this, Domino’s – a popular pizza delivery chain – has made its business lockdown-proof with No-Contact Deliveries and regular sanitization of employees. Some fashion designers have jumped at the opportunity to publicise masks as a stylish, comfortable accessory while keeping their businesses afloat!
Evidently, some entrepreneurs will successfully identify opportunities during this adversity but most ideas are brought to fruition through investment, which viciously circles back to the preliminary problem of being wary of opportunist investors. In the interim, start-ups must up their game by addressing COVID-19’s impact on their business, its advantages and disadvantages, and the way forward in their executive summary and pitch deck.
Although a nascent ecosystem, the start-ups have enduring consequences. Changes ushered in by the pandemic has lead to the a double edged sword in the venture capital market. While it appears that the investment mechanism has not come to a standstill, the economic slowdown is real, and investors are looking for assured returns on their investment, thereby pushing investor-friendly terms which invariably lead to a loss of control by the entrepreneur himself.
Author- Sonam Chandwani, Managing Partner, KS Legal & Associates
