As of the date of this post, the Small Business Administration (“SBA”) is no longer in a position to accept applications to the Paycheck Protection Program (“PPP”) due to a lack of available funding. While Congress is currently considering a possible funding increase, the delay caused by the lack of funding and the SBA’s affiliation standards, which preclude many venture-backed companies from participating, many start-ups and emerging companies are looking beyond the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act relief programs for other sources of funding to weather the current crisis. Traditional methods of raising capital, including both equity and debt financings, may have become more difficult to obtain but are still viable options. Startups should be aware of their current options and trends with respect to raising capital in a post-COVID-19 economy.
Venture Capital Investment
In early April, the Wall Street Journal reported that capital from seed-stage funding has declined by about 22% globally since January. About 42% of investors responding to a survey by 500 Startups indicated that they would allocate less investment to startups as a result of COVID-19, and over 84% of respondents indicated that COVID-19 would have a negative impact on early-stage investing activity. It seems apparent, that COVID-19 will likely stall venture capital fundraising deals in the near term.
Nevertheless, venture financing deals have and will continue to occur during the crisis, and we have been involved in a number of venture financings that are still ongoing. This bodes well for seed and early-stage companies who have historically done better during periods of economic downturn. However, it may result in a significant slowdown of Series B and later financings as venture capital investors decide whether to allocate investment to follow-on investments or early-stage companies.
Even for the on-going financings, we expect that COVID-19 will have significant effects. Start-up valuations will likely be depressed in the short term. Additionally, many prior valuations may no longer be current given material adverse effects on operations as a result of COVID-19. Start-ups will need to carefully balance their capital needs and the potential dilutive effect on current stockholders of a depressed valuation. Furthermore, we expect to see a rise in more investor favorable terms in financings deals, including those below:
- Liquidation Preferences. Investors may request higher multiples on their liquidation preferences.
- Protective Provisions. Investors may request more extensive protective provisions. While start-ups applying for the PPP and other SBA economic relief under the CARES act may resist protective provisions that may result in negative control for an investor and thus affiliation under the SBA affiliation standards.
- Consideration and Closings. Investors may request more flexible closings, or push for post-closing adjustments to conversion price and liquidation price if certain performance metrics are not met.
- Pay-To-Play Provisions. Investors in later stage Companies undergoing a down-round follow on financings may request the inclusion of pay-to-play provisions to incentivize the other investors' follow-on or lose their preferential rights.
Given the current economic uncertainty, securing debt financings from traditional lenders will likely be more difficult even as interest rates reach historic lows. However, venture debt may become a more popular option.
Start-ups eligible for venture debt typically have completed one or more equity financings, but have not attained the necessary cash flow for traditional bank loans. Venture debt is traditionally provided by technology banks and dedicated venture debt funds, and has multiple advantages in the current climate, including less equity dilution for current stockholders that it does not require a current valuation. Thus, in a time period of depressed valuations, it is readily apparent why venture debt may be an attractive option.
Reduce Burn Rate
While not a source of funding, reducing a start-up’s burn rate can significantly increase a company’s runway to potentially delay a capital raise until a more favorable time. As such, it is critical that start-ups review their spending and goals, and consider areas where the start-up can potentially cut back, including revising hiring plans and holding off on hiring decisions until they are truly required. Similarly, start-ups may want to review existing agreements with vendors and advisors to determine whether there is any possibility of reducing or deferring spending.
The significant impacts of COVID-19 are just beginning to be felt by start-ups and emerging companies. There is some investor sentiment that the early-stage investing community may continue to experience the impact of COVID-19 for 1-2 years. It is likely now more important than ever for companies impacted by COVID-10 to consult with their trusted advisors and attorneys to review opportunities to cut expenditures and raise additional capital.
For further information or if you have specific questions, please reach out to the Hopkins & Carley attorneys in our Emerging Growth Companies Practice. To stay up-to-date with the latest legal issues regarding COVID-19 please visit the Hopkins & Carley COVID-19 Resources page.