The valuations and deals offered to startups seeking investment in this time will change significantly, and founders may need to consider accessing alternative funding sources, such as the £500 million Future Fund (which Taylor Wessing played a leading role in advising the UK government on) - most likely for the first time.

This article describes the 'state of the nation' for startups looking at their fundraising options in the next 6–12 months.

We work with both startups and investors, and see hundreds of term sheets for investment rounds of all stages, from seed through to Series A to growth and so-called 'megarounds' ($100m+). We hope our panoramic view of the market and insight into investor strategies will help you create your own investment plans with the highest chance of success, both for now and the new future.

2019 vs 2020

2019 was a record year for UK startup investment. Over $13 billion was invested in total, up 40% from the previous year. UK startups received $1 of every $3 invested across Europe and attracted more funding than those in Germany and France combined - countries with thriving startup ecosystems of their own. Megarounds and unicorns were becoming relatively commonplace, with eight new UK unicorns created in 2019 alone.

The UK's Fintech sector benefited from a disproportionate percentage of this investment, particularly the neo-banks such as Monzo, Starling Bank and OakNorth. Other sectors which saw significant investor attention include AI and deep tech, med tech and life sciences, as well as energy and cleantech.

2020 started where 2019 finished, with a number of megarounds being announced in the first quarter, including Revolut's $500 million round and Cazoo's £100 million round, and with every expectation of continued buoyancy in the startup world. 

Of course, the COVID-19 pandemic has since turned the world upside down. The supranational lockdowns have created serious revenue and operational pressures for the majority of businesses, forcing them to put discretionary spend on hold.

The VC response

This will inevitably have an impact on VC funding over the next 6 – 12 months. VCs will first and foremost seek to shore-up the existing stars within their portfolios by working with founders to review cash burn, and ensure adequate cash runways for the next 12 – 18 months.  

Much of this financing into portfolio companies is likely to be through convertible loan notes, which are typically quicker and cheaper to implement. Convertible loan notes also have the advantage for the investor of being debt until the time of conversion into equity. This debt sits above equity in the event that the worst happens to the company.

Conversion is typically triggered only at the next round of funding, so by definition the portfolio company will have survived and prospered to the extent it has been able to attract that next round. Another benefit of a convertible loan note is that it avoids the immediate need for a valuation discussion, with the loan notes typically converted at a discount to the price paid by investors on that next round of funding.

Valuations

The expectation is that valuations, which arguably have been due a correction in any event, are likely to come down over the next few quarters. However, valuation is not the only economic lever that is available to investors, and which will be set out in the term sheet.

Remember that the term sheet, albeit non-legally binding, creates a handshake agreement for the investment round. Principles agreed in the term sheet are hard to re-negotiate in the legally-binding long form documents. Founders should therefore ensure they take advice before signing the term sheet, so they fully understand the deal they are agreeing.

In addition to the discussion around valuation, we examine below some of the other levers that may change for term sheets being proposed in a more challenging economic climate.

Term sheets

For a number of years, VCs invested into 'non-participating preference shares', where the investors' return on exit is either their money back or a pro-rata share of the overall proceeds, whichever is greater.

We may see a return to 'participating preference shares', which provide the classic "double-dip" bonus of money back PLUS a pro-rata share of the overall proceeds. 

As well as enhancing returns, participating preference shares may allow the investor to offer a superficially higher valuation, which looks favourable when compared to another investor's offer involving non-participating preference shares. A standard liquidation preference is one-times the money invested, but a further related lever that could make a re-appearance in VC deal terms is the multiple liquidation preference. With a multiple liquidation preference the investor receives a multiple of the money invested. Again, the use of multiple liquidation preferences may allow investors to offer higher valuations as the return to investors is enhanced and protected before other shareholders receive any return.

It might also operate to avoid another lever, likely to be already included within a company's articles of association (if it has previously obtained venture investment) – the anti-dilution ratchet.

Anti-dilution ratchets provide protection for an investor who has invested at too high a valuation, and operates with the benefit of hindsight. If any future round is priced lower than the post-money valuation of the investor who has anti-dilution protection, that investor will receive additional shares for free as compensation for having over-paid. 

Anti-dilution ratchets come in a range of flavours, from a broad-based weighted average protection (which provides a weighted adjustment taking into account the amount of money raised and the valuation at which it's raised) through to a full ratchet (which brings the average price paid by the original investor down to the price per share paid in the down-round).

Other levers that may be introduced to deal terms include an accruing dividend that gets added to the liquidation preference, and is paid out to investors on exit: a typical coupon might be 8% as this mirrors a typical hurdle in a VC's own fund formation documents.

We might also see an increased use of tranching (splitting up) of investments, so that the company receives only some of the investment at closing and must satisfy certain milestones (such as regulatory authorisations or commercial targets) to unlock further investment amounts.  Ratchets could also appear so that either the investor's return increases if performance targets are not achieved or, conversely, the return to ordinary shareholders is enhanced if the exit valuation exceeds particular thresholds.

Pitching

Even before the market entered its current state of uncertainty, it would be common for founders to speak to a large number of VCs (and on multiple occasions) before getting a term sheet.

Although most VCs will see hundreds, if not thousands, of business plans each year and meet with many companies, a typical VC will perhaps make only 5 – 10 new investments a year. 

During a time of economic uncertainty, founders should expect that business plans and models are likely be scrutinised in greater depth than previously, and so should be more prepared than ever before going into those meetings.

This includes detailed research into the VCs that they approach, and approaching the right VCs for the stage and sector in which the company operates.  As ever, warm introductions to investors from respected contacts are more likely to result in face-time than cold calls and shotgun applications to any investor found on the web.

There will no doubt be winners and new attractive business models coming out of the current crisis and these companies will succeed in being offered investment term sheets.

The Future Fund

The Future Fund, due to launch in May, will offer innovative companies convertible loans between £125,000 and £5 million funded by the government, provided that the company can obtain matched the investment from private investors.  

This convertible loan investment will convert into equity (in a future funding round), at a discounted price per share to that paid by the investors in that future financing. This discount is largely seen as an incentive for investors for taking a chance on risky companies, where their future is uncertain. The loan may also be converted on certain other events, such as a sale or IPO, as well the 3 year maturity date.  If the loan does not convert, then it will be repayable by the company at a 100% premium to the amount loaned.

As mentioned above, the convertible loan being offered by the Future Fund is a well-worn instrument in the VC toolbox and it is good to see direct government support for the startup community in this difficult environment.

The 'New Normal'

While it's still too early to be completely sure how the market will play out over the months ahead, it seems pretty likely that we are heading into a more challenging climate for startups seeking to raise money. Terms on which investment money is offered will be constantly changing as the market adjusts to the new normal. 

Founders who are in the privileged position of being offered a term sheet in the coming months should run it past a trusted advisor (for example, a lawyer!) with insight into the latest dynamics and trends of what will be a rapidly changing market.