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22 Apr 2021

Early stage investments: the impact of Covid on term sheets & availability of equity funding

From looking at the headlines, there is a case for saying that the UK's start up ecosystem was one of the few beneficiaries of the Covid pandemic.

Over 400,000 new companies were incorporated in 2020, with recent figures from TechNation suggesting that the UK start-up and scale up ecosystem increased in value by 23% last year. Overall, after a short freeze following the initial outbreak of the pandemic, investment demand has held up surprisingly well. Some start-ups have even been reportedly given so much cash as to risk becoming ‘VC foie gras’.

As many of us will have seen in practice, these headline figures mask huge variations in the sector. While some tech start-ups have boomed, other early stage companies have been hit with the same uncertainties and difficulties that impacted the wider economy. This is especially the case for businesses who need some ‘bricks and mortar’ presence.

We have seen this dynamic play out in the terms that investors have been willing to offer early stage companies. In particular, businesses benefitting from Covid have remained able to extract founder friendly terms. Given the laws of supply and demand, and the levels of investment capital available this may not be surprising.

On the other hand, some investors into businesses affected by Covid have insisted on more downside protections. These protections take a number of different forms, aside from simply investing at a lower valuation.

One of the most common has been for investors to insist on their investment being made in tranches, rather than in one hit at completion. For example, some investors have increased the link between their investment and the company hitting revenue milestones. Given the level of uncertainty in the economy, it has been easier than normal for investors to insist on structuring their funding in this way.

Another term where there has been some change is the use of participating liquidation preferences. These provisions mean that on the sale or winding up of the company, the investor gets a preferred return before the ordinary shareholders plus a pro rata slice of any remaining proceeds together with the other shareholders. The use of such provisions has, however, been limited to larger funding rounds (given that they are incompatible with EIS/SEIS).

Of course, Covid has also impacted how early stage companies have been able to go about getting equity funding. Given the amount of weight that investors in such companies put on their own assessment of the founders, it has been interesting to see how investors have adapted to lockdown and the resulting curtailment of in person meetings and pitches.

This has played out in different ways between investor types. VCs and similar institutional investors have shifted online reasonably successfully (and in some cases are finding it more efficient to have Zoom calls rather than face to face meetings).

Those trying to raise funds from non-institutional sources (e.g. private angel investors), however, have had more of a challenge. Some of this appears to be technological, but also arguably reflects the more cautious approach of such investors in light of the current economic climate. This is supported by research by the British Business Bank, which found that increased economic uncertainty was ranked as the number one barrier to investment by 45% of angels.

The challenge has been particularly tough for those raising funding for the first time. Such founders cannot call on the relationships built up in person before the pandemic and have found it less easy to build up a rapport with potential investors. This has resulted in what I view as good start-ups either failing to get the seed investment they were after, or the process simply taking a lot longer.

Overall, the effect of the pandemic has not made raising equity funding as difficult as most of us had first feared. However, the impact has not been evenly felt by early stage companies. Behind the headlines, the experience of early stage companies has been far from uniform.

This article was first published in The Wealth Net on 22nd April 2021.