Despite the economic downturn in light of the COVID-19 pandemic, investment rounds are still underway as businesses need funding to stay afloat and investors are keen to capitalise on companies that project a high growth trajectory.
For instance, several companies have raised funding from both domestic and foreign investors since January 2020. These include food delivery firms Zomato and Swiggy, ed-tech unicorn Byju’s and agri-tech platform Clover.
Moreover, Reliance Industries Ltd has been making the headlines after drawing investments from Facebook and a bunch of private equity firms for its digital unit Jio Platforms Ltd.
Needless to say, COVID-19 has been a shock to many businesses in terms of strategy and modus operandi, and is likely to alter the landscape of doing business. Those operating without a virtual presence are struggling with business continuity, while others are rethinking business models to save themselves from a potential collapse.
Certain sectors such as pharmaceuticals and specialty chemicals, FMCG, e-commerce and delivery services, telecommunications, internet companies and fintech services (lending and payments) are likely to gain traction after the pandemic, making them attractive investment avenues. It is likely that after COVID-19, there may be a shift in dealmaking and manner of doing deals.
Due diligence considerations
Typically, while conducting business due diligence, investors tend to give lesser importance to the viability and strength of a target’s business continuity plan (BCPs). While there is no legal requirement, the need for voluntarily establishing robust BCPs are crucial for operational sustenance. Its importance has been reinforced by the pandemic.
Among other factors, BCPs may take into account aspects such as employee requirement, workforce management, talent staffing and replacement solutions to ensure uninterrupted service delivery in times of crises.
Additionally, assessing the target’s remote working arrangements, its ability to address production and supply chain disruptions, fulfil obligations under material contracts and the ability of its customers to make regular payments become critical considerations to withstand any business interruption risk.
Going forward, it is likely that investors would be more mindful of these aspects that were previously ‘less priority’ matters.
At the same time, investors are likely to focus on assessing costs associated with supply chain alternatives, termination risks under material contracts, adequacy of insurance coverage and presence of special adjustments for or reserves of working capital to compensate for slower collection of dues from customers, to name a few.
This would require investors to closely examine the company’s financial statements not just in terms of top-line growth but also assess the company’s efforts towards constructive reduction in bottom-line costs during such troubled times, including strategies.
On the transactional front, parties may have to rethink certain commercial factors in light of the changed circumstances. Both in the present as well as in the post-COVID-19 scenario, companies are likely to require sufficient cash flow to ensure uninterrupted business operation.
However, fresh equity issuance or debt conversion is likely to, in most cases, trigger anti-dilution provisions. Factoring in such events has always been crucial while negotiating valuation, but it is even more so in these times, when valuation discussions are likely to prolong the deal process.
Further, it may also be worthwhile to factor in the sensitivities of such contingencies and avoid insisting on fixed pricing or locked-box strategies.
Alternatively, investors can offer more flexible funding options such as deferred or tranched consideration. This could at least provide companies some respite by augmenting or supplementing their essential cash flow.
Additionally, most deals are likely to have a post-closing purchase consideration adjustment to align the amount payable with the reality of the situation, thereby benefiting the company, while being fair to the investor.
At the same time, companies would need to ensure that they have a regular and secure source of cash flow while avoiding dilution of existing ownership.
In such situations, companies often structure follow-on investment obligations in the form of ‘pull-up’ or ‘pull-through’ provisions. These provisions incentivise existing investors to participate in future funding rounds by swapping their existing shares for preferred ones – shares that are convertible at a favourable rate and carry additional entitlements such as full-ratchet anti-dilution protection and seniority in liquidation, among others.
However, while investors are keen to invest in profitable and sustainable ventures, they are unlikely to commit upfront to 100% of the investment amount, and there is a likelihood that milestone-based funding will be the preferred investment mode.
While this may be a tempting offer for early-stage companies that foresee significant growth in the near future, it is necessary to factor the likelihood of not achieving these targets on the resurfacing of a future COVID-19-like situation that may hamper progress and profitability.
This can be resolved by negotiating a moratorium on the time limit for achieving such pre-decided milestone events, if the contingency is capable of impacting the attainment of the milestone event.
Investors, on the other hand, may consider negotiating for the company to provide full ratchet anti-dilution protection in the event the company seeks additional external funding to meet its operational targets.
On the debt side, availing long-term financing on favourable terms can be difficult in present times. Investors, on the other hand, are looking to back businesses that can prove profitable despite such testing times.
As a via media, providing convertible bridge loans with a pre-agreed conversion rate can meet short-term working capital needs while making the investors eligible for a conversion into equity (at a discount) in a future funding round. Such conversion would not entail exchange control compliance for domestic investors.
However, depending on the risk appetite and investment strategy of the foreign investor, those seeking to optionally convert bridge loans will be permitted to do so, subject to conditions prescribed in the RBI’s regulations governing external commercial borrowings. Those seeking to compulsorily convert bridge loans would be subject to the same compliance requirements as applicable to equity instruments.
Exchange control regulations also permit the issuance of convertible notes, which may be of relevance to foreign investors seeking to explore convertible options in start-up companies.
Towards the end of the investment term, while investors are looking to exit their portfolio companies at such times, exit negotiations can be difficult, particularly when the company is unable to offer the pre-decided exit.
An initial public offering is a near-impossible option for the time being, and one must factor navigating exits in such troubled times in the future.
Given that adjusted valuation is not a favourable solution from an investor’s perspective, parties may consider agreeing to impose a moratorium to forego (or defer) their right to exercise a call or put option for certain identified events.
As predicted by Sequoia Capital in its article ‘Coronavirus: The Black Swan of 2020’, recovery from the pandemic is going to take a considerable amount of time, possibly extending to several quarters.
However, commercial activities will continue, and both investors and companies are going to look for opportunities to make their ventures more profitable. Keeping in mind such considerations can help reduce the impact of such troubled times on financial investments.
Vineet Shingal is a partner, Tanushree Bhuwalka is a principal associate and Akash Srinivasan is an associate at law firm Khaitan & Co. Views are personal.