Funding Landscape for Start-ups during COVID-19
The prevailing COVID-19 pandemic has had a butterfly
effect across various sectors, particularly at a time when the Indian economy
was under stress and various sectors were looking for incentives and support
from the government. The pandemic and the ensuing lock-down having caused a significant
disruption in business, trade and movement of cash, paving the way to a
worldwide recession. As start-ups find their business plans floundering, it
seems to follow that there is an urgent need for low-cost funding options
encouraging new businesses. This article explores the avenues of funding available
to start-ups and related nuances.
Typically, an early-stage start-up would look for
funding from venture capital funds, angel investors or even a “friends and
family” round. Such rounds would in most cases, be through the issuance of convertible
equity instruments and investors would agree on the valuation, business plan
and terms of conversion / dilution. However, the current economic circumstances
can make it a challenge to take the first steps towards such a fund raise –
creating a business deck and projections and agreeing on the valuation with the
investors. Equity investments, therefore, may prove to be difficult for both
promoters and investors. Investors may very well see the circumstances as an
opportunity to invest in companies at beneficial valuations. However, the
market uncertainties may force investors to rethink such investments, since it
is not clear how the impact of the pandemic will be felt in various sectors in
the short, medium or long terms.
Organizations, particularly start-ups need to urgently
put together strategies for survival (and indeed, growth), forcing these
businesses to adopt measures such as consolidation mergers, selling off to cash
rich businesses or considering scaling down or winding-up.
In cases where dilutive or equity transactions are not
preferred, certain modes of non-dilutive funding which could gather steam are
considered below:
Crowdfunding
In general terms, crowdfunding most forms of which are
known as peer to peer lending, is when a business generates small sums of
funding[1]
from a large number of people. Peer to peer (P2P) lending is regulated
by RBI under the Non-Banking Financial Company – Peer to Peer Lending Platform
(Reserve Bank) Directions, 2017 (NBFC P2P Regulations). P2P funding
garnered interest at the height of the cryptocurrency bubble, where investors
would receive electronic tokens, which could be traded in a decentralized
digital market, in return for the sums of money invested. There are other forms
of crowdfunding where the contributors/investors are given certain perks such
as the ability to buy future products at a discounted price. In real estate,
this could take the form of projects in which ownership of units is shared by
people directly, or through a corporate entity.
Convertible Note
A convertible note is a funding instrument which is initially
structured as debt financing. The Companies (Acceptance of Deposits) Rules,
2014 allows duly recognized startups to issue convertible notes. This
instrument can be converted into: i) a specific number of shares in the company
upon the occurrence of certain events; or ii) into cash of equal value within a
period of five years of the issue of the note. This method of raising finance
is particularly useful to a nascent startup, though it has not been as
prevalent as it was expected to be when first introduced. The convertible note
has a benefit that it is not considered as a debenture and deposits although it
gives a fixed return with voting rights. Unlike a commercial paper, the issuer
of convertible notes are not required to meet minimum networth requirements.
Debt
Borrowing a sum of money by offering a conventional form
of collateral such as immovable property is the oldest form of funding. Startup
businesses normally stay away from this form of funding due the relatively high
capital costs and the difficulties in providing acceptable collateral. However,
going forward this may prove to be a reliable means of short-term funding
particularly as banks and lenders focus on providing loans structured to help
entities tide over the current circumstances. The RBI in order to infuse
liquidity in the system has reduced the cash reserve ratio of all banks[2],
reduced the Bank rate[3],
reduction in the repo rate and the reverse repo rate[4].
SIDBI has set up a Covid-19 Startup Assistance Scheme[5] to
provide short term credit assistance to innovative startups that have
demonstrated ability to adapt to economic impact from Covid-19 and ensured its
employees safety and financial stability. The credit facility is in the form of
a term loan of about 36 months and ticket size of not more than INR 2 crores.
There are net-worth and minimum revenue requirements that have to be met by the
start-up.
SAFE or SIDBI Assistance to Facilitate Emergency
response against Corona Virus scheme provides credit facilities to MSEs engaged
in the manufacture of masks, gloves, headgear, bodysuits, shoe-covers,
ventilators, goggles, testing labs etc. These are loans of up to 50 lakhs at a
fixed interest rate of 5% per annum with a 5 year term.
SIDBI has several other credit schemes to provide
financial assistance to start-ups such as:·
- SMILE or SIDBI Make in India Soft Loan Fund for Micro Small and Medium Enterprises available to 25 identified sectors. The loans have a minimum size of 25 lakhs and a term of up to 10 years.
- SMILE Equipment Finance (SEF)
- Loan under partnership with OEM
- SIDBI Trader Finance Scheme
- SIDBI – Loan for Purchase of Equipment for Enterprise’s Development
Old wine in new wineskin An option which may see increasing favor, is the
strategic mergers or acquisitions of start-ups by other companies, competitor
or entities in the same or related sectors. However, strategic investments take
a great deal of time and finesse to put together, and the structuring requires
detailed consideration of the strengths and weaknesses of all of the entities
concerned. In some cases, an acqui-hire transaction may make the most sense,
whereas asset or business purchases may seem more appropriate for other
entities. Such deals, depending on exchange control compliances, may be
structured as all-stock deals requiring no cash payments to be made. In fact,
all-stock deals were popular even before the pandemic and its impact on the
economy were felt.
Deal making trends. While one may argue that the scales of leverages in
deal negotiations are heavily tipped in the favour of investors as cash becomes
scarce and expensive, investors will be required to make capital calls of their
existing portfolio companies, make investments with longer sunset periods as expectation
of returns are stretched. Investment negotiations will see greater focus given
on drag along clauses. Another trend that we believe would emerge is the
requirement of companies to set aside emergency reserve funds. The requirement
to create emergency reserve funds will affect valuations and exit returns on
account of the pressure to generate revenues and profits with a smaller cash
pool. Shares with differential voting rights are also likely to come into pronounced
usage as the instrument essentially allows the promoters to garner capital into
the company while protecting promoter management rights.
Overall, given the ebbing confidence in the market,
the overarching sentiment remains that industries and companies are looking to
the governments (Central and state) for lifelines and support.
[1] A lender’s maximum exposure to all borrowers across
all P2P platforms is INR 50,00,000 under the NBFC P2P Regulations.