COVID-19 - Legal steps for start-ups to ensure long-term stability

If you ask any successful entrepreneur what it takes to succeed in the start-up environment, they'd likely put resilience, proactivity and adaptability at the top of the list. Many early-stage companies are well-accustomed to operating with a minimal workforce, on a tight budget and in a flexible manner. You might therefore think the same group of UK-based founders and CEOs who attracted a record £5.5 billion of investment in the first half of 2019[1], would be well-equipped to deal with the COVID-19 pandemic as well as the related social and economic fallout.

Nonetheless, despite the £1 billion support package pledged by the government in April 2020 (including a new £250 million Future Fund to be administered by the British Business Bank), as the country begins to emerge from lock down, early-stage companies are likely to be cash-strapped and faced with increased competition when it comes to attracting investors, with many also having to reconsider their short and long term growth strategy. Below are some key considerations for UK start-ups on how to withstand the inevitable increase in investor scrutiny, cash-flow scarcity and emerge from the crisis stronger than their competitors.

Revival of the cautious investment approach

On the Future Fund's first day, the British Business Bank received applications from 533 tech start-ups, seeking a total of £515 million of funding[2]. This implied that either the Future Fund was offering generous terms to applicants (which we discuss in our articles on the topic) or the UK's start-up ecosystem was in need of help. However, according to a report published by the Government's Digital Economy Council, early-stage UK-based tech companies received an impressive £4.1 billion from investors in the first five months of 2020[3]. Investor appetite is evidently high, with the stats suggesting that Britain continues to be one of Europe's most attractive destinations for tech investors. Even higher, however, are the demands being placed on founders and CEOs having to operate on even more of a 'hand to mouth' basis than ever before.

It seems inevitable that many early-stage companies will be in need of vital capital injections in the coming months. Some will turn to their existing investors (especially given the Future Fund requirement for matched private sector funding and an investor-led application process). Meanwhile, those looking to attract new investors may encounter a more traditional, cautious approach, with investors paying keen attention to:

  • Financials (rather than just market share)

  • Investor-friendly investment terms (potentially making the raising of capital more expensive along the lines of the Future Fund convertible loan note)

  • Long-term potential: this is not a new approach, but you can expect investors to be taking a 7-10 year perspective on potential investments

  • Valuation justification: investors will likely look to challenge existing valuations; increased scrutiny may herald the end of the unicorn valuation trend

  • Tech stability: now more than ever, the importance of tech being at the heart of many start-ups has been brought home. Those companies whose day-to-day operations have been able to withstand the shift to remote working, will come out looking the strongest.

The importance of effective and sustainable cost management

Start-ups will need to be looking to take every measure possible to ensure effective and sustainable cost-management. Such measures might include:

  • Establishment and/or expansion of EMI share option schemes to help counter any salary cuts or freezes and continue to attract the best talent

  • Review of existing commercial contracts with a focus on:

    - Any onerous terms that counterparties might look to rely on to lock the company in at future times of crisis

    - Any force majeure clause that might allow the company to terminate in the event that its future obligations cannot be performed in light of COVID-19

  • Review of existing investor rights, to ensure that any emergency funding measures (e.g. down rounds) don't breach terms and upset existing investors

  • Consideration of alternative investment structures, such as advance subscription agreements, which can be used to navigate disagreements as to company valuation and attract investors looking to rely on the EIS/SEIS tax schemes

  • Cost-saving on space. How effectively has the business operated with employees working from home? Could a longer-term flexible working scheme benefit both the company's cashflow and employee welfare?

Over the coming months, investor scrutiny and the demands placed on start-ups will continue to increase. But, instead of feeling overly pessimistic about the future, founders and CEOs should look at the now thriving businesses founded in the post-financial crisis era including the likes of Whatsapp, Instagram, Uber and Pinterest, to name but a few. Crises of this scale highlight fundamental weaknesses in existing systems and gaps in the market. For example, look at the unprecedented growth of Zoom in recent months.

The ability to innovate and create solutions is key to any start-up's success, crisis or no crisis. Yes, demand may be down and cash may be more strapped than ever, but many of the challenges faced in the post-COVID-19 era can be tempered if start-ups continue to rely on some of the measures that will no doubt have proven vital to their early growth. Turning to old tactics, rather than implementing drastic measures, is a practical way to ensure sustainable, long-term growth and investor interest.