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Making hay during a crisis

Making hay during a crisis

Venture capitalists are seeking stronger deal terms as the leverage has shifted back to investors during the pandemic

The countrywide lockdown has dealt a severe blow to the economy of the country. The consequent fall in stocks, which in turn has affected the private equity (PE) market, has resulted in conspicuous devaluation of companies. Start-ups are currently in a strong presence of leverage on the side of investors as the weakness in the market has led to a fall in fund-raising by 78.6 per cent as compared to last year. In such a scenario, it is smart to conserve energy otherwise expended in fund-raising to manage liquidity and the current cash flow. As monetisation of assets through exit activities will see a consequential hold before their prices recover and economic activity returns to normal, investors will want to protect their assets through insertion of restrictive covenants. Owing to the pandemic, venture capitalists are seeking stronger deal terms as the leverage has shifted back to investors.

For the purpose of hedging the risk that presents itself during this time, it is important that both the investors and the start-ups cooperate to maximise efficiency and solve the liquidity crisis that has hit the market currently. The contractual clauses so drafted depend upon the factual matrix of each start-up, made up of the bargaining power of either side. Often, it is a tussle between either side to include clauses that are more favourable either to the start-up or the investor. Such bargaining power resides in the potential of the assets that the start-up creates. There is an inverse relation between the strength of the company and the bargaining power of the investors to introduce such clauses that hedge the risk faced by the lender at the cost of the company. For those companies that are doing well amid the Coronavirus pandemic, these investor-friendly terms come up less. The strongest companies don’t see those tough provisions.

Such methods that hedge the risk by cannibalising the control of the start-up and inserting provisions that dilute the risk for the investor are detrimental to the relations between the two parties. Mostly, the survival of the firm shall be determined by various factors. Among them is the low burn rate through liquidity, adaptability and the basic strength of the start-up and its baseline health before the pandemic hit the world.

However, unique times require unique solutions and the same is reciprocated by legal measures so sought to reflect the mood of the start-ups and the venture capitalists. Conservative measures are on the rise across various industries to either protect the existing values/assets or to drive the economic activity up once the lockdown ends. Therefore, the conservative protective clauses that were prevalent during the dotcom phenomenon are rising again.

Full ratchet anti-dilution protection: This prevents the dilution of the shareholding of the investor in different scenarios. It is a form of protection against the dilutive events that the companies might face, as it completely protects the value for the investors by new stock issues at a price that is lower than the investor’s original investment. It changes and updates the price of conversion in order to maintain the investor at the same level of ownership stake in terms of the percentage owned.

Liquidation preferences: This gives one class of shareholders the right to be paid back first in the event of an exit. Though investors exiting during this time period will be exceptionally harmful but the fact remains that many firms will not survive this pandemic. Then in the case of exit by the investors such a provision would be an area of conflict, especially in this scenario.

Pay-to-play provisions: This enables a firm to penalise investors that don’t invest in later rounds. It is done to assure an investor that his/her firm isn’t the only investor in future rounds.

Pull-up provisions, discounts on bridge loans: Similar to the pay-to-play provisions, these are designed to provide a strong incentive for existing investors to participate in future financing.  Heightened rewards are only affirmative of the unequal bargaining power of the investor against the start-up.

Blocking rights on exits: This gives investors more control of a company so that they can block an acquisition of a firm. This can be used if an investor thinks his/her firm isn’t making enough money in an exit.

At this stage of the Coronavirus pandemic and its resultant impact on the economy of the country, it is imperative for the investors and the firms to amicably cooperate in order to effectively guide the firm out of troubled waters. The devastating effect that the pandemic has had on the bottomlines of firms, especially start-ups is not something that can be wished away overnight.

It will take a concerted effort, on the side of the investors, the start-ups and all stakeholders to steer companies out of the current storm. More measures aimed at reinforcing the moral fabric of the company by providing the right treatment to the employees should be adopted and the firm should not be seen as a lamb being fattened up only to be slaughtered at the apt time.

(Writer: Sonam Chandwani; Courtesy: The Pioneer)

Making hay during a crisis

Making hay during a crisis

Venture capitalists are seeking stronger deal terms as the leverage has shifted back to investors during the pandemic

The countrywide lockdown has dealt a severe blow to the economy of the country. The consequent fall in stocks, which in turn has affected the private equity (PE) market, has resulted in conspicuous devaluation of companies. Start-ups are currently in a strong presence of leverage on the side of investors as the weakness in the market has led to a fall in fund-raising by 78.6 per cent as compared to last year. In such a scenario, it is smart to conserve energy otherwise expended in fund-raising to manage liquidity and the current cash flow. As monetisation of assets through exit activities will see a consequential hold before their prices recover and economic activity returns to normal, investors will want to protect their assets through insertion of restrictive covenants. Owing to the pandemic, venture capitalists are seeking stronger deal terms as the leverage has shifted back to investors.

For the purpose of hedging the risk that presents itself during this time, it is important that both the investors and the start-ups cooperate to maximise efficiency and solve the liquidity crisis that has hit the market currently. The contractual clauses so drafted depend upon the factual matrix of each start-up, made up of the bargaining power of either side. Often, it is a tussle between either side to include clauses that are more favourable either to the start-up or the investor. Such bargaining power resides in the potential of the assets that the start-up creates. There is an inverse relation between the strength of the company and the bargaining power of the investors to introduce such clauses that hedge the risk faced by the lender at the cost of the company. For those companies that are doing well amid the Coronavirus pandemic, these investor-friendly terms come up less. The strongest companies don’t see those tough provisions.

Such methods that hedge the risk by cannibalising the control of the start-up and inserting provisions that dilute the risk for the investor are detrimental to the relations between the two parties. Mostly, the survival of the firm shall be determined by various factors. Among them is the low burn rate through liquidity, adaptability and the basic strength of the start-up and its baseline health before the pandemic hit the world.

However, unique times require unique solutions and the same is reciprocated by legal measures so sought to reflect the mood of the start-ups and the venture capitalists. Conservative measures are on the rise across various industries to either protect the existing values/assets or to drive the economic activity up once the lockdown ends. Therefore, the conservative protective clauses that were prevalent during the dotcom phenomenon are rising again.

Full ratchet anti-dilution protection: This prevents the dilution of the shareholding of the investor in different scenarios. It is a form of protection against the dilutive events that the companies might face, as it completely protects the value for the investors by new stock issues at a price that is lower than the investor’s original investment. It changes and updates the price of conversion in order to maintain the investor at the same level of ownership stake in terms of the percentage owned.

Liquidation preferences: This gives one class of shareholders the right to be paid back first in the event of an exit. Though investors exiting during this time period will be exceptionally harmful but the fact remains that many firms will not survive this pandemic. Then in the case of exit by the investors such a provision would be an area of conflict, especially in this scenario.

Pay-to-play provisions: This enables a firm to penalise investors that don’t invest in later rounds. It is done to assure an investor that his/her firm isn’t the only investor in future rounds.

Pull-up provisions, discounts on bridge loans: Similar to the pay-to-play provisions, these are designed to provide a strong incentive for existing investors to participate in future financing.  Heightened rewards are only affirmative of the unequal bargaining power of the investor against the start-up.

Blocking rights on exits: This gives investors more control of a company so that they can block an acquisition of a firm. This can be used if an investor thinks his/her firm isn’t making enough money in an exit.

At this stage of the Coronavirus pandemic and its resultant impact on the economy of the country, it is imperative for the investors and the firms to amicably cooperate in order to effectively guide the firm out of troubled waters. The devastating effect that the pandemic has had on the bottomlines of firms, especially start-ups is not something that can be wished away overnight.

It will take a concerted effort, on the side of the investors, the start-ups and all stakeholders to steer companies out of the current storm. More measures aimed at reinforcing the moral fabric of the company by providing the right treatment to the employees should be adopted and the firm should not be seen as a lamb being fattened up only to be slaughtered at the apt time.

(Writer: Sonam Chandwani; Courtesy: The Pioneer)

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