How COVID-19 Has Transformed the Term Sheets

The global crisis has upended livelihoods, created a significant impact over the start-up and investment community, and impacted the terms being offered in term sheets.

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The onset of the pandemic has resulted in an entirely unprecedented turn of events worldwide. It has caused almost every business to experience an interruption of their routine business operations, laying a bumpy road for the businesses across all verticals, especially the start-up ecosystem. For the start-up and investor community, there have been changes in points of consideration from a funding perspective, with deals declining significantly for sectors which are not active or have seen a drastic reduction in revenue during this lockdown phase.  With such change in the mindset of investors, we are noticing some transformation with respect to various terms of negotiation in an investment transaction, resulting in alterations of certain terms in term sheets being offered in this duration.

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Tranched investments

Prior to the pandemic, many investors would consider investing in a single tranche as business viability was not questionable. With the current global economic environment, investors have been taking a conservative approach and are viewing term sheets from a different perspective with regard to deployment of capital. Tranched investments allow investors to hedge risk by deploying the investments in tranches and therefore de-risking the investment in part. Investors are now choosing to fund the businesses over a stipulated period of time instead of giving them the entire investment amount all at once. Usually, a business getting a tranche investment will get pre-negotiated capital commitment as long as it achieves milestones (time based, revenue based or performance based) decided by investors and allow the investors to monitor the progress of the company, validate the business model and thesis of investment without risking the entire capital. To ensure that companies deliver on their promises, tranche based investment is gaining significant scale and reappearing as a common condition in term sheets.

Valuation Expectation

With the lockdown declared in India, many businesses have seen a slump in revenue and sales figures. We are nearing three months of closure/restriction in business activities which has resulted in low demand of products/services other than the essential services/commodity sector which has led to change in business projections and plans impacting the valuation of the business in its entirety. We are noticing that the valuation being offered in term sheets are far conservative than they would have been prior to the pandemic. We are also observing that founders’ expectations with regard to valuations have become more reasonable and the need for survival and to sail through to normalcy of business operations, they are conceding to the valuations being offered. Many marquee funds have warned startup founders to be prepared to not see their valuation jump in the coming rounds and have a 12-18 month runway with what they raise.

Anti-dilution treatment

An anti-dilution provision protects investors from the dilution in a down round. There are two prevalent ways of granting anti-dilution protection to investors, one is full ratchet, where investors’ dilution is completely adjusted in a down round by giving the investor the benefit of the same share price as offered to the new investor in a down round. The second one is broad-based weighted average wherein the investor dilution is not adjusted completely giving the investor the entire benefit but is adjusted basis a new weighted average price using the broad-based weighted average calculation. In the recent years, broad-based weighted average has become a standard market practice globally and is also considered to be a founder friendly approach. However, we are noticing many investors asking for full ratchet anti-dilution treatment in the current economic scenario primarily because of lack of certainty of future potential growth of the company and fundraising capabilities.

Closer watch on expenditure

The unprecedented rise of COVID-19 and subsequent government measures are triggering immediate P&L impacts on businesses across the world. Public social distancing obligations and guidelines are translating into various effects on business depending on the segment—demand-driven revenue losses, fulfilment-driven revenue losses, portfolio imbalances and reduced workforce utilization. Keeping the above in mind in addition to uncertainty around future funding, many investors are urging founders to keep a closer watch on expenses and look at extending the runway of their current capital to ensure they get past the prevailing uncertainty in the investment space. We have seen this shift from leniency or no cap on expenses (till it is being utilized for working capital requirements) to clear restrictions on hiring, management expenses and operational expenses. Investors are reassessing business plans and have been working with their portfolio companies to create more checks and balances to ensure compliance to a stringent budget.