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It may be the fear of a pending pandemic, lockdowns and calls for social distancing due to Covid-19 or even a looming recession that is keeping young entrepreneurs from approaching Venture Capital firms; but now is not the time for fear, it’s a time to take action.
Young entrepreneurs are encouraged to approach Venture Capital firms
As South Africans continue to be locked down due to the Covid-19 pandemic, companies already in discussions with Venture Capital firms are urgently trying to wrap up negotiations and secure their anticipated influx of capital; but what does that mean for the company still looking for an investor in the time of a pandemic?
The opportunity we believe is still there, just not in the packaging you initially thought it would be in.
Alternative funding avenues
In the average life cycle of a start-up, the funding pool usually starts with some seed funding or funding from an angel investor, like a friend, family member or successful entrepreneur. This usually allows for the basic reel and tackle and for the founder to start operations.
After a bout of success, a company may then look at approaching institutional investors, meaning that they are ready to grow and scale the business, as well as possibly bring on managerial and technical expertise which only a particular investor could offer. Enter the Venture Capital firms.
Negotiations will usually kick off with the type of funding that the investor is looking to invest, with the accepted norm being equity financing. This form of funding presupposes a trade-off of equity, being a percentage of ownership in the company, in return for capital.
This may be riskier for the investor because the investor receives a claim on company earnings based on their ownership stake rather than the full repayment of the investment and as a result of this risk taken, their rights and benefits usually exceed those of ordinary shareholders, which the founder team usually forms part of.
This form of investment could bring more to the crew than merely capital though, as the investor often seeks a seat at the directors’ table and can bring with them knowledge, experience and a network of contacts.
It is important to note, however, that equity investors are often more interested in the exit or initial public offering of the company due to the risk taken and would therefore be more interested in the liquidity of the company, so make sure that this lines up with the vision that you have for your company.
It is possible that Venture Capital firms will be hesitant to take on the risk of acquiring equity in times of a pandemic, however, there are different options available, which either a Venture Capital firm will recommend, or will be impressed by if tabled by a team of founders, two alternatives being debt funding or convertible loan funding.
Debt funding can take the form of a conventional loan facility or be by means of the issuance of debt instruments by the company. In effect, the company is acquiring capital with an obligation of repayment, usually tied to an interest obligation and within a pre-determined period of time.
Further to this, the investor is satisfied that his investment is secured. If the company fails to make repayment, the investor could potentially apply for the company’s liquidation and become a creditor against the company, resulting in repayment of its investment taking preference over any shareholders claim.
If the company does not have sufficient assets, it may be necessary for the founders to provide security or suretyships and guarantees in their personal capacity to secure the loan.
The benefit for the company, yes there is one, is that they do not have to give up a percentage of ownership to secure the investment and can remain captain for a little longer, provided they meet their repayment obligations.
If a company has little runway left and requires an urgent injection of capital without all the checks and balances, a possible avenue could be convertible loan funding, a form of bridge funding.
As it’s a more aggressive form of funding, an investor would usually advance capital to a company, without undertaking extensive due diligence investigations, or security and on a more urgent basis.
The catch is that they are usually willing to do it as a loan, which will convert to equity in the company if the loan is not paid back in time and in full, as well as on the basis of a return in the twenty to thirty percent range.
Although it may sound simple, there are nuances to convertible loan funding in the form of set valuation caps and discount rates. A valuation cap is a predetermined company value at which the investor’s investment will convert to in the future, meaning that if a new investor comes along, the original convertible loan investor can convert at his pre-set valuation cap rather than the new investment cap set by that new investor.
What this basically means is that the original investor secures his shareholding at this next round of funding at a lower price than the new investor, allowing the original investor a bigger bite at the shareholding pie.
The right legal approach would be to focus on what the founders are getting out of the deal. Usually, it is much more than just an injection of cash and your company could benefit from seasoned investors and advisors for your board, as well as a vast network for your venture.
However, in times of uncertainty such as those created by the Covid-19 pandemic (and this goes for any other rogue crisis, down market or recession), founders may need to think more strategically and possibly approach riskier investment opportunities to ensure its survival.
If the route of debt funding is traversed, investors can be motivated to come onboard with a secured investment and guaranteed interest return, but no equity, whereas bridge funding can provide immediate relief to the founder team, but at a cost of higher interest rates and a conversion mechanism aimed at greatly benefiting the investor for the risk taken.
If you, however, end up choosing the route of equity funding, it may be best to negotiate an adjustment mechanism that uses a discounted cash flow valuation now and determines the actual value of the company in the future.
If expectations are exceeded the valuation is adjusted upwards, and downwards if expectations are not met. If you are a founder, you obviously only suggest this if you believe that the valuation currently applied is below the value of the company in normal circumstances.
This has the effect that, if the founder team is successful in steering the company through the uncertain times ahead and outperforms the forecast revenue figures (or the valuation at which funding is raised in the future), there is an adjustment in the valuation applied in the current funding round.
This mitigates the investor’s downside risk, but also rewards the founder team with less severe dilution if the risk ends up not materialising. It is, however, quite obviously a double-edged sword, as the investor will be able to get even more shares if the company performs worse than expected.
For this reason, there can be a floor (minimum valuation) and ceiling (maximum valuation) that limits the effect of the adjustment. You are effectively kicking the valuation can down the road, but if structured realistically and accurately, this mechanism can bring about quite a balanced position.
It is therefore important that founders raising capital in an unstable economic climate realise that the macro risk of the economic situation will likely be ‘priced in’ when the funding terms are determined. What that means practically, is that founders are more likely to secure investments on more investor-friendly terms in times like these.
It can be reasonable in the circumstances, as the investment world always aims to award risk with reward and investors who are investing in uncertain times do indeed take risk that needs to be rewarded.
But be careful not to commit to unfavourable funding terms based on a temporary ‘Black Swan event’ and then having to live with terms that frustrate your ability to derive value from your development efforts.
This means that if your company does not require funding right now to, for example, pivot your business to pursue time sensitive opportunities, it may be best to wait for the current storm to pass before pushing your boat out into fundraising waters.
Jacques Stemmet, Associate at Dommisse Attorneys is the author of this article with contribution from Director SG Laubscher
Featured image: Cytonn Photography via Unsplash