COVID-19 and How Should Start-Ups Navigate These Troubled Waters

Introduction

Outbreak of COVID-19 throughout the world, coupled with the precipitous fall in oil prices owing to dispute between Saudi Arabia and Russia on oil production and overall weakening of global demand, seems to be having a domino effect across multiple industries.

Large-scale quarantines and social-distancing measures have been implemented by governments and private businesses, globally, to tackle this pandemic. However, these measures have also resulted in a sharp fall in consumer and business spending along with an overall drop-in business activity.

With the unprecedented lockdown in China, there has also been an adverse disruption in global supply chain leading to many industries. Companies have stopped allowing ‘non-essential’ travel and some have banned international travel altogether. As consumers are staying home, businesses are rapidly losing revenue and are being forced to lay-off workers resulting in unemployment levels rising sharply.

As regards start-ups, given today’s inter-connected business environment, they are facing clear challenges which would require them to re-evaluate a bulk of their prevailing assumptions. This blog tries to address some of these concerns and what should be at the top of the start-ups’ minds in these trying times.

Key Considerations for Start-ups from a Business Perspective

1. Cash Runway and Expenses

Start-ups should consider ways of reducing their cash burn rate, as this is a key factor in any start-up’s sustainability. Founders should question assumptions about necessary business expenses and trim all expenses which would not fundamentally hurt the business and reduce the cash burn. This is especially important as fund raising may become more difficult, and there may be a larger delta between the founders’ and investors’ expectations on valuation. With a potentially large part of the workforce under lock down, founders should assess the potential possibility of reduction in wages and compensation to adjust for decrease in productivity. This should be examined in consonance with the relevant employment contracts of the company.

2. Reviewing the Business Plan

Founders should revisit their business plans and important underlying premises, such as those relating to customer acquisition costs, sales cycles, supply chains and borrowing costs since given the evolving situation these assumptions may no longer be true. Founders should also prepare contingency plans for this situation and re-assess their team growth plans along with evaluating if they can do more with less while growing their business.

3. Communication is the Key

Customers and investors will appreciate a proactive approach where the business is expecting any disruptions or delays in service/products and it may also help build long-term loyalty and bolster faith in the founders. Teams should communicate about the manner in which the business shall be seamlessly managed while being cautious about health and safety in handling the current situation. Likewise founders and their companies should update their investors outside of their reporting requirements to help investors understand and prepare in advance for the business impact in their investments.

4. Revisit Timelines

Finalising and closing an investment deal often require numerous face-to-face meetings which will not be feasible due to the imposition of travel bans, and general social distancing measures. VCs have also been advising founders to expect longer timelines in terms of diligence, signing and closing of deals.

Key Considerations for Start-ups from a Contractual Perspective

A. Evaluating impact on existing Agreements

Start-ups would have to evaluate the impact of this situation on all their key agreements, such as their agreements with partners and vendors as well as any investment agreements. Some of the specific clauses in such agreements which may be reviewed in light of this pandemic are:

1. Material Adverse Effect: Depending on the stage of the investment deal, if it is at pre or post-closing stage, the happening of a material adverse effect on the business or financial condition of the company can often result in either termination of the agreement by the investors (prior to closing) or could trigger investor’s exit rights before expiry of the exit period (if the material adverse effect happens after closing of the deal). Thus, such provisions and consequences of their breach should be reviewed by the founders and discussions may be initiated with the investors accordingly.
2. Representations and Warranties: Transaction documents for investment deals are usually structured to take representations and warranties both on the execution date of the transaction as well as on closing of the deal, thus founders should ensure that their representations and warranties continue to remain true on such dates. For instance, representation and warranties relating to a company’s financial statement or operation viability of a certain project may possibly be rendered inaccurate.
3. Standstill Covenants: In investment as well as acquisition transactions, during the standstill period between execution of agreement and closing of deal, the founders and the company or target are usually only permitted to do actions or take business related decisions in the ordinary course of business. Further the consent of acquirer or investor may also be required for taking certain business decisions during the standstill period. Founders should assess the standstill restrictions, and only take actions outside ordinary course of business with the approval of investor/acquirer.
4. Business Plans: Founders should review their business plans shared with investors, especially if the ability of meeting set targets is linked with the valuation of the company or subsequent tranches of investments or in case the non-achievement of certain milestones may trigger adverse consequences. Founders in the process of negotiating investment term sheets and those who have raised capital should note that the business plan deviations are typically investor approval matters and may have built in thresholds of deviations below which approval may not be required.
5. Conditions Subsequent: With the shutdown of government offices due to large-scale quarantines, there might be a delay in the fulfilment of conditions subsequent relating to government approvals or licenses, which should be adequately conveyed to the investors and their consent/waiver recorded.
6. Information Rights: Adhering to the normal timelines for submission of MIS reports, financial statements, annual budgets and draft business plans set out in the agreement may not be feasible for the business and there may be delays.

If there has been a substantial change in situation, possibility of a breach of certain covenants or agreements or delays due to the effects of COVID-19 as discussed above, then founders should take it upon themselves to adequately communicate the situation to their investors or business partners (vendors or joint venture partners) in advance on a good faith basis and get appropriate waivers or extensions.

B. Issues to be analysed while negotiating agreements

1. With deal making expected to take longer than usual, start-ups may wish to go through the following clauses in investment agreements with a fine-tooth comb while negotiating with the investors: Material Adverse Effect: With regards to provisions such as material adverse effect clause, which can be triggered if there is a material change to the business of the company, founders should consider drafting the definition tightly, adding necessary carveouts and providing adequate cure periods to ensure short term impact of COVID-19 on the business and operations of the company don’t trigger these provisions.
2. Representations and Warranties: When negotiating investment deals or agreements with investors, business partners, such as joint venture partners, founders should consider limiting representations where possible and adding disclosures where there is a possibility of inadvertent inaccuracy.
3. Conditions Precedent: As timelines for closing deals would also be affected, founders should negotiate to turn non-essential conditions precedent actions and actions required to be completed prior to closing, into post-closing actions. This would require an assessment of the urgency and materiality of all the condition precedent actions by the start-up and its investors.
4. Commercial Targets: While it is not possible to determine for how long the effects of this pandemic are likely to be felt, businesses should take a conservative approach while finalizing their business plans, revenues milestones and business targets, especially if breach of these targets could lead to adverse consequences under the agreement. Founders should also be cognisant of any performance obligations in the investment documents and proactively, inform the investors on the impact on the metrics measuring the performance obligations.

Conclusion

This pandemic has had, and would continue to have, unprecedented impact on the business and financial prospects of most start-ups. The need of the hour is for start-ups to tighten their belts from a financial perspective to ride out the storm. At the same time, they should revisit their obligations under their existing/future agreements based on some of the suggestions made above and successfully navigate their ships home.

This material and the information contained herein prepared by Algo Legal is intended to provide general information on a subject or subjects and is not an exhaustive treatment of such subject(s). Algo Legal is not, by means of this material, rendering professional advice or services. The information is not intended to be relied upon as the sole basis for any decision. Algo Legal shall not be responsible for any loss whatsoever sustained by any person who relies on this material.