The authors here explain the steps that startups may take in the aftermath of the pandemic to face economic losses.
AS we brace for exit from the second phase of the lockdown, it is imperative that a start-up entity (“Start-Up(s)”) considers the implementation of certain preventive measures from a legal perspective in order to reduce/ mitigate the losses faced by it during the lockdown. These measures may be taken either ‘during the lockdown’ or ‘post lockdown’.
Whether these measures are taken ‘during the lockdown’ or ‘post lockdown’, will depend entirely upon the nature of business of the Start-Up and its financial condition. It might be impossible to suggest any straightjacket measures to be taken by the Start-Up in order to recover or minimize its losses and position in the market which was prevailing prior to the advent of this mayhem. Surely, the only sure-shot means to recover will depend upon the sheer “will power” and determination of the founders to recover from here. No doubt, it is going to be a difficult task. However, if certain measures from a legal perspective are kept in mind, this journey might become less strenuous.
Some of the suggestive legal measures in this regard are as follows:
Re-negotiation of Investment Agreement with the Investors
Impact on Valuation for the Next Round Funding
Irrespective of any last round of series of funding done by the Start-Up (i.e. whether Series A or Series B etc.), the founders would have committed to the existing investors that, the next round of funding would be done at a higher valuation and if any of the existing investors have been issued convertible instruments without freezing the price, then, some kind of discount would have been offered on the next round valuation.
Now, it may be unrealistic to achieve higher valuation in the next round of funding on account of the impact on business operations and additional costs. Thus, it is advisable that, as far as possible, the founders should open the door to negotiation with their existing investors for revisiting such ‘future valuation clauses’ and try to amend the same in accordance with the current market situation. In order to provide some comfort to the existing investors, such existing investors may be offered a right to invest in the future round at the present valuation (i.e. the valuation at which they invested) up-to certain limited amount of investment. They may also be offered certain additional information rights or even a board seat till the next round of financing. The founders should be flexible to give any kind of comfort to their existing investors if the existing investors are willing to have a re-look at such future funding clauses. Needless to state, this is applicable only in cases where the founders are clear that it will be impossible to raise any future funding at a higher valuation.
Anti-Dilution Provisions
Some of the investment agreement for Start-Ups would contain “Anti-Dilution” provisions, i.e. if any future funds are raised at a valuation lower than the current valuation at which the existing investors have invested, then, the existing investors would be compensated to such future reduced valuation by way of grant of extra shares. Such adjustment may be either based on a “full ratchet” or some kind of “weighted average”, i.e. less than a full ratchet. This means that the founders would have to part with their shares (and suffer dilution) either free of cost (if it is full ratchet) or at some low price (if its weighted average) in order to compensate the existing investors for such future reduced valuation than the current valuation at which they have invested.
Irrespective of any provision, it is advisable that such provision is re-looked at and as far as possible some kind of liberty be obtained from the existing investors. Such liberty could be either in terms of reduction of the gap of ratchet adjustments so that founders suffer as little dilution as possible or some kind of thresholds on time or amount of money raised within which such anti-dilution provision will not kick in. This may be relevant if the founders are looking to raise the next round of funding immediately.
Multiple investors in the same round of funding (i.e. Same series)
Very often, a Start-Up is not able to raise the required and necessary funds as part of pre-series A or Round I (or by whatever name called) from just one investor and thus, it tends to raise the necessary funds from multiple investors at the same valuation. Now, such kind of funding activities takes anywhere between 4-8 months to close the entire series and the companies start accepting the investment amount from the investors and execute the investment agreement as to when they are able to close the terms. All these investment agreements are executed with multiple investors at a different point in time but on the same terms and conditions. For example, a Start-up is intending to raise an amount of Rs. 3 (three) crores as part of one particular round/series, it may raise it from 10 (ten) different investors with different investment amounts but on the same terms and same valuation. Further, it is not necessary that the said investors execute the investment agreement and provide funds on the same date. Generally, as and when the first investor is agreeable, the company tends to accept the funds and execute the agreement and then look out for other investors. If this is the case and if any of the Start-Up is stuck between this lockdown period with some investors and not able to raise its complete amount, then, it might pose serious complications. This is because, in all likelihood, the founders undertake to raise ‘up to’ a particular amount within a certain time period on the same valuation.
It may not be possible to raise future amount after the lockdown on the same valuation if the business has taken a hit during the lockdown. In such situations, although it may sound quite gruesome to the founders, but they may want to offer a discounted valuation to their current existing investors and offer them free or low-priced shares so that they allow the round to be completed on the reduced valuation.
Exit Rights
It is not very common to provide for any kind of guaranteed exit rights to the investors by a Start-Up in its initial round of funding. Many economists are predicting long term effects on the economy on account of not only lockdown but also after-effects of Covid-19.
However, if any such exit rights have been provided to the investors in the form of IPO, third party sale etc. within a certain time period, then, it is advisable to re-negotiate with the investors and extend such time period/threshold by at least one (1) year.
Investors would be keeping their fingers crossed and would take all possible steps to save its investment. The company may lose all its value if it does not get further funding, and in that event, the investors may also be open to any of the above suggestion or any other suggestion even though it may be bit risky. This is a time when everyone has to take a hit and the entire burden cannot be shifted either only upon the founders or upon the investors.
In addition to above, there may be more remedial measures which may be taken based upon the provisions of the investment agreement.
Employment Agreements
Many of the founders may be forced to take a hard unwilling call to either reduce the workforce or reduce the salaries of the workforce. The decision will purely depend upon the financial condition of the Start-Up and its future business prospects. However, any decision taken should be taken in terms of the employment agreement with the employees. All the employment agreements with the employees which are not covered under the Industrial Dispute Act, 1947 are governed by the Indian Contract Act, 1872, i.e. by the terms of their respective contracts. Thus, it may not be possible to reduce the compensation outrightly in some cases, if the terms do not provide for the same. If the workforce is reduced, then, the same should be as per (a) any notifications/ directions issued by the central or state government in this regard and (b) the prevailing notice periods provided in the employment agreement.
In the event, the company intends to re-negotiate the employment terms by offering some future perks, then, they should be clear on what can be offered in terms of the law as future perks. If ESOP is offered, then, the current limit of ESOP`s should be checked. If Phantom Stocks are offered, then, although there is no specific law on phantom stocks, the mechanism of the same should be understood quite clearly. Whilst exercising any of the options with respect to future perks, appropriate tax advice should also be sought.
Lease Deed
If the lease deed does not contain any kind of “force majeure” provision or the “force majeure” provision does not cover the current lockdown situation, then, it may not be possible for corporates to claim “force majeure” and seek a waiver of rent. Thus, if the lessee has stopped paying rent unilaterally without obtaining consent from the landlord, then, it may have serious implications. Perhaps none of the lease deeds was drafted keeping such a situation in mind as no one could have contemplated a situation that, access to the property would be unavailable for more than a month beyond the control of either the lessor or the lessee.
Thus, it is advisable that before taking any steps to withhold payment of the rent, please read the lease deed carefully and either send a force majeure notice if permitted under the lease deed or try to negotiate with the landlord.
MCA Relaxation
Ministry of Corporate Affairs, Government of India has provided certain relaxation in terms of corporate compliances and filings. Corporates need to make sure that they are aware of the same and take advantage of these deadlines so that your time and attention is utilized to more important steps to be taken.
Pending Obligation under any Commercial Contract/Client Contract
Those who have any pending obligation towards any of their clients or any third party which requires movement of any goods or personnel or any other obligation which has become impossible to perform because of the lockdown, then, it is advisable that they should immediately send out a force majeure notice in terms of the contract if they have a clear case of “force majeure”. Usually, most of the business contracts/commercial contracts contain “force majeure” clauses and if there is no “force majeure” clause, then, one may send out a notice invoking the “doctrine of frustration”, i.e. informing the other party that, the performance of the current obligation either needs to be cancelled or postponed since it’s beyond your control and is on account of “Act of God” clubbed with Government directions and thus, such non-performance should not amount to a breach of the contract.
The concepts of “force majeure” and “doctrine of frustration” are complicated concepts. However, the same may be used in order to prevent the other party from calling it a breach of your obligations provided the persons giving notice has served a written notice in this regard. During such times, it is advisable to avoid any kind of complicated litigation by invoking force majeure without proper application of mind and instead, an attempt should be made to negotiate the terms with the counter-party.
These are some of the measures which a Start-up may take in order to reduce its losses and also to gain some momentum in its onward journey post lockdown.
Usually, in business, it is said that one party `s loss is the other party`s gain. However, it seems that this is one situation wherein every party is at loss and thus, it is necessary that, a joint and combined effort is made by all the stakeholders wherein each one takes some hit without putting the entire burden on any one party.
(The Authors are part of Boutique Corporate Law Office providing corporate legal advisory services to Start-Up Entities and Mid-Sized Corporates)
Note: This article does not claim to give legal advice to anyone, those seeking to advise may consult a lawyer, the publication takes no responsibility for the consequences of action the reader may take based on these suggestions and this article is no substitute for an expert opinion
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