How the coronavirus crisis has changed term sheets

The coronavirus pandemic has thrown the global economy into a downward spiral, marking its biggest decline since the 2008 financial crisis. With nationwide lockdowns and plunging stock prices, these are perilous times for business organisations of every size and in every industry.

The coronavirus pandemic-triggered economic downturn, however, has threatened the very existence of small businesses and startups. From operational inefficiencies caused by supply chain disruptions to a significant decline in revenues, the startup community has been confronted with a multitude of challenges.

As a result, a majority of startups are facing an acute cash flow crunch, and their woes have further worsened by dampened investor sentiment. Funding activities have gone down drastically, the average deal size has decreased, and the investor community has adopted a more cautious approach towards their spending.

This shift has also been reflected in the term sheets, with many investors re-negotiating to ask for lower valuations, tranched investments, identifying revenue centric milestones, valuation protection mechanisms, and visibility on operational costs.

ALSO READ

The anatomy of a term sheet and why startup founders shouldn’t lawyer up excessively for one

Reasonable valuations

While the government has eased the lockdown restrictions, the startup sector is still reeling under financial distress. Despite taking measures such as scaling down operations, cutting salaries and laying off employees, companies have experienced a slump in revenues and sales figures as consumption patterns have changed radically in the last couple of months.

Against this backdrop of weak demand and dwindling consumer spending, a large number of start-ups have witnessed a decrease in their value. Investors are now, if not completely backing out of term sheets or shelving deals till things get better for the consumer markets, offering valuations lower than what they would have before the pandemic.

Startup founders have also adjusted their expectations concerning valuations, giving precedence to survival over aggressive growth to at least be able to leverage a runway for their companies during these trying times.

Investment in tranches

Under normal circumstances, most investors prefer disbursing the entire investment amount at once, unless of course, the relevant company is to meet certain milestones in line with its business plan, be it in terms of revenue generation, customer acquisition or geographical expansion, in which case tranched investments are common.

However, taking into account the economic uncertainty fuelled by the pandemic, the investors are now turning to tranche investments, wherein the total funding is spaced out over a stipulated period, often over the four quarters of a year even without any specific milestones, simply to minimise their instantaneous loss, if incurred, which could have a potentially bigger impact if the entire amount is disbursed at the very onset as opposed to being disbursed in instalments.

This investment strategy also enables investors to closely monitor the financial progress of the company and recognise the viability of its business model early on.

As investors are likely to remain apprehensive for the unforeseeable future, tranched investments are regaining traction and reappearing in term sheets more often than not.

Revenue Based Milestones

It is becoming clearer that investors are now concerned about the revenue generation of businesses in real numbers rather than the projected value of the securities of businesses. Term Sheets are now seeing a lot of milestones to be achieved by companies directly linked to disbursement under tranched investments, utilisation of funds, and preparation of annual budgets, all of which are being made subject to investor consent.

Milestones are now becoming a function of actual revenues rather than projections and fictitious numbers. These milestones are directly entrenched in the term sheets and definitive agreements based on business plans and budgets prepared by companies as investors are now only interested in generating value to their investment in real-time rather than far-fetched projected generations.

We are seeing milestones such as the achievement of a certain number of orders, subscription by a particular number of viewers/users/consumers, etc. rather than acquiring/building resources and utilising funds for research and development. For example, the achievement of occupancy in co-working spaces, rather than square foot coverage, etc.

Anti-dilution protection

The anti-dilution protection can be of two kinds – 1) broad-based weighted average and 2) full ratchet. The broad-based weighted average anti-dilution is the most preferred and fair manner in which this provision can be applied. Under this method, the value of the original investors’ shares is brought closer to the new investor’s price by using a set formula, which turns out to be an average between the two prices, weighted towards the new price.

Under the full ratchet method, however, the price of the original investor is simply brought down to the new lower price, rather than an average between the two.

While broad-based weighted-average has become a standard practice in recent years, investors are now opting for the full-ratchet provision as it provides them additional financial security amidst the crisis. The existence of a full ratchet provision can make it difficult for the company to attract new rounds of investment, but companies are now agreeing to this somewhat unfair methodology to attract and retain external funds.

ALSO READ

[YS Learn] 5 must-read books before you raise funding

Close tab on expenditures

The onset of COVID-19 and subsequent measures to prevent the contagion have made a direct impact on the financial stability, revenues, and resources of companies. Startups that were once enjoying a robust growth trajectory are now faced with unprecedented losses.

Given the tumultuous business environment and the uncertainty around the economy’s revival, investors are pushing startup leaders to keep a close tab on business expenditures and find out ways to optimise their resources and extend their runway up to 12-18 months, or until the crisis subsides.

In the term sheets, there has been a marked shift from leniency to stringent budget guidelines for hiring, management expenses, and operational costs. Investors have also been more involved recently in the financial proceedings of their investee entities to ensure these guidelines are being followed.