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.
[2] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11841&Mode=0
[3] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11839&Mode=0
[4] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11867&Mode=0
[5] http://sidbivcf.in/files/article/articlefiles/COVID19_Scheme_Details.pdf
Archana has worked in private equity, capital markets and general corporate teams and has primarily worked on investments by private equity investors in unlisted companies and offerings of equities and securities by listed and unlisted companies.