A COVID-19 rescue package for start-ups?

If so, what would that look like?

A recent report in the Financial Times said investors warned that many at the earliest stages of development were at risk of collapse.

These businesses, which are often lossmaking or lack assets to provide security, aren’t eligible for a new government-backed loan scheme for small companies.

Underlining the challenge, entrepreneur network, Tech Nation, said of 116 UK-based tech companies that answered questions on COVID-19 related business challenges, 77% reported they expected cashflow to be impacted; 80% said they expected securing new customers to become a challenge; while 40% said they planned to lay off staff.

One of the options mooted in the media is a convertible loan, which could either be repaid by businesses after the crisis, or turned into state-owned equity stakes with venture capital backers (VCs) matching government investment.

Questions raised

Of course, at this stage, there’s much we don’t know and plenty to speculate on.

Namely, what would proposed repayment time be? Specifically, will the re-payment window, before the loan converts to equity stakes, be far enough in future to provide time for economy to recover?

What, if any, percentage interest would be charged against the loan balance?

What will equity stake look like, if the loan isn’t re-paid timeously, and will co-investors — both venture capital and government — require a special class of shares with certain rights attached that are more favourable than the rights attached to founder shares, for example I’m thinking here of preferential dividend, controls and vetoes.

Qualifying criteria

And what businesses would qualify?

There’s some suggestion co-investment from VCs will be necessary. Firstly this would be to show start-ups are well supported and also, the FT article suggests, as a work-around European state aid regulations.

Let’s take the first point.

It’s highly probable VCs will be very selective about which businesses they invest in.

If their usual investment criteria are applied, potential recipients would be expected to be further along the timeline from the start-up point, as otherwise (if technology isn’t proven and there’s no or little trading history) it may be impossible for VCs to justify to their committees that money should be invested.

This might preclude a lot of start-ups from benefiting.

After all, the nature of start-ups is that many will fail. VCs understandably prefer that risk to be at the minimum end of the scale and tend to invest accordingly.

Then, even if a start-up qualifies, if normal criteria are applied, the government and VCs may want to test the viability of the start-up before committing funding.

Normally, VCs would carry out due diligence.

This can be a lengthy process, which can only be made slower in a lockdown scenario where access to necessary documents and paperwork will be more difficult. If the goal is to inject money into start-up businesses quickly, this may be a potential stumbling block.

Post investment and conversion of loan to equity

And what happens after, if, the loan converts to an equity stake?

Will the existing membership be able to compel either the government or VCs to ultimately sell shares? And what will return on investment look like? Will the shares these investors receive have preference over normal shares? Will they be sold on at a fixed price or will they track market value of the company?

Plus, what corporate governance controls will the government and VCs expect to be in place to protect the investment?

Common examples in standard investment include the company having to seek consent before carrying out certain actions, such as

• Engaging new employees

• Appointing new directors

• Committing to capital expenditure

And even further down the road — will there be tension between a VC and government co-venturers in terms of an exit strategy? VCs typically look at a three to five-year window for selling on their interest, many start-ups may not have reached the point where they are ready to be sold in that period.

In that situation, would shareholders, or more likely the company, be expected to fund an exit for co-investors?

What next?

It’s clear, at the moment, there are far more questions than answers.

Even if this does come to pass and we have more clarity, as ever, it would be sensible to have legal advisors look over any documents before entering into them, in order to fully understand what obligations the company (and potentially individual members) are subject to.