What are the most likely sources of start-up funding right now?
Many high-growth companies need to raise funds to counterbalance the detrimental effects of the coronavirus pandemic, yet some of Wiggin’s clients have experienced significant challenges doing so in recent months, including investors pulling out of signed term sheets, difficulty in attracting new investors, pressure on start-up funding valuations and the emergence of more investor-friendly terms.
In addition, most high-growth companies cannot access government business interruption loan schemes, as many are pre-revenue and/or pre-profit. Currently the most likely sources of funds are:
- existing investors looking to protect their investments
- friends and family
- new investors tempted by attractive lower valuations
- the £250M Government Future Fund for high-growth companies. However, the scheme is not eligible for S(EIS) reliefs, significantly restricting the target pool of investors for many high-growth companies. The current size of the Future Fund also means only a relatively small pool of companies can take advantage (though the chancellor has indicated that it will be expanded if there is excess demand which, on the basis of £453M worth of applications on the scheme’s first day, appears likely).
John O’Malia of Wingman AI Agents told us: “We see early-stage companies moving to survival mode, raising rounds at modest valuations, and bootstrapping their way to the next product iteration.
Later-stage companies with proven revenues and business models will receive strong continued support, but early-stage companies hitting the market now without much tangible traction are going to struggle to get attention from investors, who are preoccupied with ensuring that their other investments are sufficiently well funded”.
With some economic commentators expecting to see V or U-shaped recovery there is hope that, while the market may be subdued in the medium term, it may pick up towards Q4 of 2020. It remains to be seen, however, what the longer-term effects may be for deal volumes and what is considered “market standard” in term-sheets.
What is the future of start-up funding?
In recent years, founders of the most promising high-growth companies have been in a strong position in terms of raising capital. Historically low interest rates have meant certain investors are awash with cash and tax-advantaged investment schemes have attracted high net worth individuals, creating competition for the best assets and driving up valuations.
Weaker economic conditions may bring a shift in this, and in what is considered a “reasonable” term sheet. It is therefore more important than ever that stakeholders are familiar with some of the more investor-friendly terms that can re-emerge in significant downturns.
Equally, founders who are looking to raise start-up funding should do so as early as possible to try to create a competitive investment environment in order to get the best terms possible for their company and shareholders.
We see six trends for start-up funding going forward.
#1 – Pressure on valuations
Estimates suggest that current valuations on investments are down anywhere between 10 per cent and 40 per cent on 2019 (depending on the maturity of the company) – and this trend is expected to continue in the medium term.
Lower funding valuations also result from a likely drop in M&A activity and in the IPO market (meaning increased time to exit and lower exit valuations).
Additionally, many commentators believe that this would be an overdue adjustment to recent overvaluation of high-growth companies.
Lower valuations also mean investors will get more equity for their money, and, conversely, founders will have to carefully consider:
- how much more of their company they are prepared to give up to achieve their funding targets?
- the effect on control of their company
- if less funding is raised as a result, how burn rates and scaling plans can be adjusted accordingly?
#2 – Down-rounds
Pressure on valuations may also lead to an increase in down-rounds, where a private company raises funds at a reduced valuation to previous rounds of funding.
Down-rounds can raise a number of considerations for the company/the directors and can potentially increase the risk of shareholder litigation if not handled correctly. Understanding these issues in advance can help a company and its directors significantly mitigate the potential risks.
Directors should be able to demonstrate that they have carefully considered their duties as a director when pricing a funding round, by making key decisions at formal and properly recorded board meetings. In particular, directors should be wary of possible conflicts of interest (for example, they may come under scrutiny if they directly or indirectly participate in a down-round they have priced) and seek the appropriate conflict waivers.
Consideration should be given to existing investors who may be diluted, either because they choose not to participate or because of anti-dilution provisions in favour of other existing shareholders. Such diluted investors should ideally be kept informed throughout the process to avoid alienating them – their co-operation may be needed in the future.
In addition, employees who see the value of their share/option awards decreasing may be disincentivised. Consider issuing additional awards to key employees to counteract the dilution.
Down-rounds sometimes carry a certain stigma, but many companies have been through the process and subsequently thrived – if handled transparently with all stakeholders, down-rounds can help companies grow and ultimately succeed.
#3 – Liquidation preference
The liquidation preference is the preferred return that preferred shares typically attract on a liquidation or liquidity event (a sale, IPO or winding up).
A 1x nonparticipating liquidation preference has been quite common for early-stage investors in recent years i.e. on a liquidation event, the investor can choose between recouping their initial investment (plus interest) or, if greater, can elect to participate in total returns on a pro-rata basis (along with the ordinary shares). This is typically seen as a reasonable approach, reflecting the principle that one of the primary purposes of the preference is to protect the investor’s initial investment.
However, the 1x nonparticipating preference wasn’t always the norm. During the dotcom downturn participating liquidation preferences of 2x or 3x were common (particularly in the US) – the investor would be entitled to first get 2x or 3x their initial investment back (plus interest) and participate in total returns on a pro-rata basis.
Investors less confident of a positive outcome may seek additional protection in the form of multiple or participating liquidation preferences in order to put their capital at risk – this is usually one of the most important provisions in a term sheet and it is key that all parties understand exactly what is being agreed.
#4 – Anti-dilution
As mentioned above, articles of association of companies often contain anti-dilution protection in favour of preferred shares (typically held by institutional investors), which grant additional shares to the preferred shareholders to compensate for the reduced value. A greater frequency of down-rounds could result in investors increasingly asking for particularly investor-friendly forms of anti-dilution protection, based on the uncertainty of growth in the future.
Anti-dilution ratchets are seen in a number of standard formats:
- the “broad-based weighted average” (based on a blended pricing between the two rounds) is seen as the ‘fairest’
- the “narrow-based weighted average”
- the “full-ratchet” (which completely negates the down-round’s dilutive impact on the existing investor by giving them the number of shares which they would have held had their original investment been made at the down round price) is seen as the most onerous for the founders and the other shareholders and can mean significant dilution for them on a down-round – this has been much less common in recent years.
It will be important for founders to be mindful of these provisions and understand the dilutive effect they may have if triggered.
#5 – Pay-to-play
In prior economic downturns, pay-to-play provisions became more prevalent, generally driven by later-stage investors looking to ensure that earlier shareholders with preferential rights are required to invest on a pro rata basis in subsequent financing rounds, or else lose some or all of their preferential rights.
Existing investors who have negotiated preferential rights in earlier rounds should therefore be mindful of the potential resurgence of pay-to-play, particularly if they do not have deep pockets and do not plan on investing in future funds.
#6 – Tranches/milestones
Uncertain economic conditions may lead to more frequent use of tranche investments as investors seek to hedge their risk by splitting investments into parts, dependent on certain milestones being reached by the company.
It is important on any tranche investment that the milestones are very clearly defined and can be determined objectively (e.g. achieving a certain revenue target or number of users) so there is no ambiguity for any of the parties as to their obligations. Vague or subjective milestones should be avoided as they can lead to a difficult relationship between investor and company, and potentially disputes.
Companies also need to be mindful of whether the investor has sufficient liquidity to meet its obligations to fund later tranches, conducting appropriate due diligence where necessary.
4 things you can do for start-up funding
The UK may be heading for a recession and accessing investment is likely to become harder, so companies will need to “consider how best to manage cashflow and show flexibility in arranging resources”, according to Danny Goh of Nexus FrontierTech, which will be “key to survival and is what investors are looking for”.
In order to maximise prospects of success in this climate, companies looking for start-up funding should:
- plan – funding rounds may take longer
- identify funding sources as early as possible – companies may not be able to access some of their usual funding sources
- prepare for some unfamiliar and possibly more onerous terms
- consider alternative options such as convertible loan notes which can be quicker to implement (valuations and long form documents do not need to be negotiated) and may allow companies to avoid a down-round, in the hope the valuation may recover in the future.
Ciaran Hickey is a partner in the corporate team at media, entertainment and technology law firm Wiggin LLP. Benjamin Simon is an associate in the Wiggin corporate team