The unprecedented crisis caused by COVID-19 is having a major impact on all economic activity. Investors in startups, like everyone else, are impacted too. Angel investors will likely be distracted from doing deals. VCs might feel pressure not to deploy capital – particularly as their limited partners will start to be overexposed to venture capital as the value of their other assets falls. All this can lead to less cash for startups.

But what if you are a startup in the middle of capital raising transaction?  We’ve done a quick round up of things to consider, depending on what stage of the fundraising process you’re in.

if you’ve got a term sheet

The most important thing to remember is that a term sheet is non-binding. Whilst investors do not typically sign term sheets and then withdraw for market reasons, we are in unusual times. Investors can in theory walk away without any reason which can cause major disruption to a capital raising process.

If you are in the process of receiving and negotiating term sheets, a good tip is to keep any exclusivity period in the term sheet to a minimum (e.g. not more than 30 days) so if an investor does start to waver, the company can move on quickly to other opportunities.

Another tip is to structure the deal to close it quickly. Consider limiting the number of investors and keep existing shareholders up to speed so paperwork can be executed without delays.

if you’ve signed an investment document but the deal has not completed

Whilst investors are legally bound to close the deal and fund the company once they have signed up, share subscription agreements always include a clause that the investment is subject to the fulfilment of certain conditions.

These conditions often include a ‘material adverse effect’ clause – which means that no event has occurred or is continuing which has a Material Adverse Effect (MAE) on the business.

A typical definition of a MAE might look like this:

“Material Adverse Effect” shall mean any change or effect (including but not limited to change in applicable Law) that would have (or could reasonably be expected to have) a materially adverse financial impact to:

• the business, operations, assets, condition (financial or otherwise), or operating results of the Company, or
• the ability of the Parties to consummate the transactions contemplated herein, or
• the validity, legality or enforceability of the rights or remedies of the Subscribers under the Transaction Documents.

This might sound complicated, but essentially a MAE clause allows investors to withdraw from a fundraising deal if there is a change which impacts on the business or its financial performance in a material way.

Whether COVID-19 would be a MAE depends on how the provision is drafted. MAE clauses do not just cover deterioration in the financial performance of the business, but almost anything which materially affects its operations.  This could be a termination of a key license, law change, or just an inability to deliver services as before. COVID-19 is of course impacting not just economic activity but also forcing governments to implement new measures on a daily basis.

how big a deal is a MAE in a fundraising transaction?

Possibly not that major in the case of startups and fundraising deals. Unlike M&A transactions which often have longer periods between signing and closing, on financing deals, investors and startups tend to wrap things up quickly so the founders can get back to their day job. Signing and completion are usually simultaneous or within a few days of each other. That means there is little or no time for an investor to withdraw on the basis of an MAE anyway. The exception to this is where there is a rolling close on financing deals, i.e. further money invested after a period of time. Even if investors are legally bound to fund as part of a later tranche, the MAE could come into play at that time, and allow investors to withdraw.

For an investor to pull out of a transaction on grounds of an MAE occurring, the event clearly needs to have occurred after signing the deal.  Given COVID-19 is already known to everyone, an investor would therefore have to demonstrate that there was some specific change that occurred after signing. One way that could happen is if the MAE clause specified that it was triggered if the earnings of the business deteriorate by a certain percentage after signing, e.g. 10-20%.

At this time, it may be fair for startups to exclude general market deterioration in the definition of MAE to exclude the overall economic impact of COVID-19 including any measures implemented by governments in response to the crisis.

other tips to consider when fundraising during COVID-19

review warranties carefully

Warranties provided by the company or founders on a fundraising should only cover the period up to closing. However, certain warranties may in effect look forward if they refer to the business plan.

For example, warranties covering the business plan often include the following:

Business Plan

• The Business Plan has been diligently prepared by the Warrantors in good faith and each of the Warrantors believes that, as at the date of this Agreement, it represents a realistic plan in relation to the future progress, expansion and development of the Business
• The financial forecasts, projections or estimates contained in the Business Plan have been diligently prepared, are fair, valid and reasonable and have not been disproved in the light of any events or circumstances which have arisen subsequent to the preparation of the Business Plan up to the date of this Agreement.
• The assumptions upon which the Business Plan has been prepared have been carefully considered and are believed to be reasonable, having regard to the information available and to the market conditions prevailing at the time of their preparation.

In the current economic climate it is virtually impossible for a startup to accurately project its future trajectory even over the next 6 months. Therefore, these kind of warranties may not be appropriate right now, and startups should avoid giving them if possible.

avoid tranched investments and KPIs

Now is the time to get money into the business to give it runway for a period. Investments which include deferred money conditional on financial performance are best avoided by startups at the best of times. But right now, it is impossible to forecast traction in the next 12 months or so. Startups would likely better off raising the full amount at a slightly lower valuation now than going with tranches and KPIs.

watch out for redemption / buy-back rights

Investors sometimes include redemption or buy-back rights which entitle them to get their money back from a startup in certain circumstances. Usually this is where there is some kind of event of default by the company or its founders.

However, occasionally, we’ve seen deals where investors have redemption rights which can be enforced in other scenarios (e.g. failure to complete a restructuring or obtain a new licence to operate, financial performance deteriorates, or perhaps being unable to deliver under a separate commercial arrangement). In this uncertain period, such rights bring considerable uncertainty and risk to startups and should be avoided.

what’s next

Sequoia Capital has released a report saying that COVID-19 is the ‘black swan’ of 2020, and to brace for coming economic shocks. But the developing economic environment shouldn’t put off startups who are looking for money – it’s a case of being wise about the fundraising process, and knowing how to deal with the changing times, and perhaps in time the changing transaction terms.

If you’d like to speak to us about your fundraising situation, get in touch.