Disputes-Proofing and Compliance Readiness: Not Optional for Start-ups in 2021 – By Burgeon Law

The Indian startup ecosystem has grown significantly over the last 5 years. As the Startup Ecosystem Report 2020 suggests, as opposed to 29000 startups in 2015, presently there are more than 55,000 startups to date out of which more than 3,200 startups have raised $63 Billion in funding in the last five years alone. While the ecosystem may seem to have come a long way, but the aforesaid numbers also raise some eyebrows since the funded companies constitute less than 6% of the total startup sector and most of the growth that was seen was during the bloom period between 2015 to 2017. 

No doubt that 2020 witnessed unprecedented and uncertain times because of which capital infusion has been on a decline as compared to last years, but there are other financial and psychological factors as well which deserve specific attention. The investor community overall seems to have adopted a more reasoned and cautious approach towards their spending. This change in the investor perspective has been visible in the latest investment cycle and transactions where we have witnessed investors focus greatly on the compliance and regulatory side of business, keep a close tab on expenditure and outflows, give greater weightage to sustainable/ more realistic goals like EBITDA/achievement of economies of scale as opposed to projections on gross revenues and size of target user audience etc. It is upon the new age promoters to realise that given the huge money in play in this ecosystem there is a lot to lose for the investors and hence they must respond to the critical challenges faced by the investor and adopt measures to strengthen investor confidence, more so given the change in investment trends that have been witnessed post the outbreak of COVID. 

Previously in early and growth stage startup, some of the main criteria for investment were the promoter profile, technological reach and addressable market size. However, whilst passionate promoters who are focussed on building unique solutions are key to a successful startup, investors are now placing greater weightage on legal and compliance aspects of business prior to taking the call on investing. 

Frankly, given the fact that most startup’s financial statements are in negative given the heavy cash burn, there isn’t much to evaluate for an investor in that regard. Further, most startups in India are technology based and are operating in very challenging or uncertain regulatory environments or in sectors where there is no law or the laws have not caught up with the advent of technology such as med-tech, fin-tech, quizzing/gaming, fantasy sports, e-pharmacies etc. Therefore, the legal validation of the business model, inter se arrangement between the founders, measures adopted to protect intellectual property, ESOP and non-compete arrangements, license from authorities etc. are some of the key factors which are pre-examined and relied upon by the investors these days in order to determine the seriousness/credibility of the promoters and also ensure security of their investment from business continuity perspective in the uncertain regulatory environment.   

Ever since the boom in the innovation based startup sector, one often wondered how the valuation of these companies with such high cash burn, negative financials and weak P&Ls obtained such mammoth valuations. The reason for the same is that the methodology for valuing mature companies i.e. asset approach, income approach & market approach are not of much relevance for valuing startups since they, by their nature and stage, are future driven and hence, the methodology used is often the adjusted cash flow method which was based on future projections and potential market capture and monetisation potential. Because of the COVID and lockdowns, the startups (barring a few sectors) experienced a slump in revenues and sales figures as consumption patterns had changed radically and there was low demand for products/services, which has led to change in business projections and plans impacting the valuation of the business. Not only that, given the financial stress in the market and the decreased liquidity, there is also an increased realisation amongst the investor community that startup valuations need to be looked at more conservatively based on firm business plans and budgets which are achievable in the near future with a focus on monetisation. 

Another related shift in the startup investment ecosystem has been to opt for milestone based tranched investment rather than single one shot capital deployment which allows investors to hedge risk by deploying the investments in tranches and therefore de-risking the investment in part. As opposed to purely time based milestones, we have witnessed that investor are setting operations and busines expansion based milestones be it in terms of actual revenue generation, active subscriber based customer acquisition or geographical expansion with utilisation numbers. This investment strategy enables investors to closely monitor the financial progress of the company by keeping a tab on expenses and giving them shorter runway to achieve business growth in real terms and recognize the viability of business model early on without putting the entire capital at risk upfront. Even in the investment documents, one can notice protective covenants around periodic furnishing of information, right to conduct financial audit, stringent budget guidelines, stricter enforcement and damages in case of breach of promoter representations and valuation adjustments in the event the milestones are not achieved within the stipulated time period. 

The messaging from the investor community as to the path ahead to be adopted by the entrepreneurs going forward in order to have access to capital seems loud and clear, i.e. “avoiding compliances and legal checks until the day I get funding” will not work because for securing investor’s money, the company needs to be safe and protected from the regulatory changes and challenges and in respect of its risk exposure in contractual arrangement. Thus, in order to be “investment ready”, the entrepreneurs must engage with lawyers at a profound level to validate their business model from a legal perspective which can withstand the ever-disruptive and dynamic regulatory environment and to stitch together the contractual arrangement with the various stakeholders that the companies interact with to de-risk itself and limit the liability exposure. Further, the promoters need to be true to their promises and make only true and achievable representations while singing investment documents and be frugal towards making only reasonable and necessary expenditures to optimise business operations, else the investors will utilise the contractual provisions to withhold capital deployment and make valuation adjustments to increase their stake at a later date and take over operations if the promoters repeatedly deflect from achieving time based targeted growth.     

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Burgeon Law is a new-age boutique law firm that provides a one-stop legal solution to emerging companies, incubators, accelerators, angel investors, family offices and venture capital/ private equity funds. 

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This article has been published in partnership with Forbes India and first appeared forbesindia.com:

https://www.forbesindia.com/article/legalpowerlist2020/disputesproofing-and-compliance-readiness-not-optional-for-startups-in-2021-burgeon-law/66367/1

Disclaimer: The views or opinions expressed are solely of the author.