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COVID-19: Challenges and opportunities for Tech Startups

29 April 2020

The Coronavirus pandemic represents one of the greatest challenges to businesses in the UK since the Second World War. This applies particularly to early stage technology businesses who, even in boom times, typically fight an ongoing battle to manage cash flow and survive from month-to-month.  However, history shows that times of crisis can also present opportunities for entrepreneurs.

Here we consider the steps that founders and startups can take to manage liabilities, retain and procure sources of income, and attempt to emerge from the crisis in as robust health as possible.

Financing

The old adage ‘cash is king’ has never been more pertinent for early stage businesses than now. Most startups are dependent on third party funding during their early years and a global pandemic is inevitably going to impact the availability of funding sources.

However, there are opportunities available, including the following:

  • Existing shareholders – existing investors that continue to believe in the business will not want the Coronavirus to prove terminal and may be willing to follow on with bridge financing. Clearly this may not be the time for founders to be arguing for frothy valuations; to avoid this and to save time and costs negotiating documents, investments can be structured as convertible loans or Advance Assurance Agreements (ASAs), the latter capable of qualifying for SEIS/EIS.
  • Venture capital – many funds have deep pockets and/or freshly raised capital waiting to be deployed. In addition to supporting existing portfolio companies, these funds may still be willing to commit to the right new opportunity, particularly in sectors that are likely to be high-growth or disruptive in the reshaped economy.  Presumably start-ups operating in areas such as health and wellness, remote working solutions, online ordering and education (amongst others) could end up benefiting from the crisis. Beware though that investors may end up in the driving seat and founders should be mindful of the impact of lower valuations and draconian terms.  For example, will we see the return of the dreaded ‘participating’ liquidation preference or more aggressive forms of anti-dilution/down-round protection. Further information on the latter can be found here.
  • Future Fund the UK government has announced a £250 million ‘Future Fund’ commitment, whereby qualifying companies may apply for convertible loans from the Government provided that this funding is matched by private investors. Further information can be found here. Whilst this should provide a much needed boost to the early stage ecosystem, at the date of this article, there remain significant questions to be answered, particularly whether the matched funding will need to be made via the same convertible loan instrument, in which case SEIS and EIS reliefs (in their current form) would not be available to the matched investors (which may discourage angels from participating). Also, to qualify, businesses will need to have previously raised £250,000 and this will therefore exclude fresh unfunded startups.
  • Government backed loans early stage businesses can in theory borrow significant sums through the Coronavirus Interruption Loan Scheme (CBILS) from a British Business Bank ‘accredited lender,’ with 80% of the loan guaranteed by the Government. However, the scheme has been criticised for not benefiting startups which do not have the cash flow and profitability to satisfy lenders. In response, the Government has announced small firms can separately apply for 100% Government-backed loans of up to £50,000 under the Bounce Back Loans Scheme (BBLS), which could be made available within days of completing a simple online application process.  BBLS loans require no repayment of capital or interest for 12 months. Further information on the CBILS and BBLS can be found here.
  • R&D – the UK Government has also announced that, through Innovate UK, it will make available £750 million in grants and loans to R&D-focused SMEs. Further information can be found here. It should be noted, however, that at the time of writing it is unclear if Government funds committed under the Future Fund or Government-backed loans will, as a result of State Aid rules, negatively impact on a company’s ability to make future R&D claims (including tax credit claims).

Commercial contracts and trading

Any contractual right to terminate customer or supply contracts will be determined by the specific wording in the agreement and should be considered carefully.

Key provisions to look out for include a ‘force majeure’ clause (or a clause addressing events beyond the parties’ reasonable control), notification or termination obligations in the event of delay, and if any of the obligations that cannot be performed due to the COVID-19 outbreak are ‘material’ and might therefore trigger a right to terminate for material breach. If the contract does not contain a force majeure clause, or if there is no express contractual right to terminate, the English law doctrine of frustration may also apply. For further analysis, please see here.

Directors should also be aware of the risks of trading when insolvent and the recent changes to insolvency law introduced by the Government in response to COVID-19, please see more information here.

Employees/service providers

Early stage tech businesses rely heavily on their employees and other service providers. A fundamental challenge for any early stage business right now is ensuring that the wage bill does not drive the company into insolvency, whilst ensuring that its workforce is ready to spring back into life when business picks up.

Thankfully, the Government’s Job Retention Scheme enables businesses to furlough employees and workers. For further details please see here.

If the downturn continues for an extended period of time, redundancies may also need to be considered. This is a technical area of law and will require businesses to use a fair and documented selection procedure and consult with affected staff and is typically not something that should be undertaken without having obtained legal advice.

Tax

HMRC is helping businesses to manage cash flow through its VAT deferral scheme. At the date of this article, no formal deferment scheme has been set up in respect of Corporation Tax, PAYE or NIC.

However, since 2008, HMRC has allowed taxpayers to defer paying taxes and duties through Time to Pay (TTP) arrangements. For those who are in financial distress due to COVID-19, a well-prepared TTP proposal could offer much needed support. Please see more information here.

Looking to the future

A downturn in the economy also represents an opportunity for founders and management teams to take stock and reflect on the shape of the business.

Aside from considering their staffing requirements and looking at ways to improve their products and services, there may be housekeeping and other matters that can now addressed, including:

  • Establishing share option schemes – EMI (and other) share options schemes are a great way to incentivise employees, particularly at a time when salaries may be frozen or cut. This is likely to be a good time to establish an EMI scheme (which typically requires a company valuation to be agreed with HMRC), as employees should benefit from lower valuations.
  • Updating company documentation – a review of existing documents, such as employment agreements, service agreements and company policies and T&Cs, will ensure that they are up to date, sufficient to protect the business and robust enough to satisfy future investors carrying out due diligence.
  • Understanding investor rights – founders should be aware of any existing investor rights that could be relevant in a downturn, for example any veto rights over the issue of new securities or the impact that anti-dilution rights may have following an emergency ‘down-round.’ Also, as mentioned above, founders should brace themselves for the likelihood of new investments containing more aggressive investor terms.

Clearly, this is a challenging time for businesses, particularly those at an early stage, but also a time of possible opportunity.

Our specialist startup lawyers are on hand to assist with any of the issues raised above, or any other legal matters that you would like to discuss, so please do not hesitate to get in touch with a member of our team here.

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