In brief 7 min read
Public markets in Australia have fallen by almost 25% from the highs reached in late February 2020 as a result of the financial downturn caused by the COVID-19 pandemic. As Linklaters has also discussed, this fall in public markets and the associated flight to liquidity is starting to be reflected in adjustments to private markets. Startups seeking to raise capital are likely to face a more protracted and drawn-out process, with exit events becoming more challenging.
In addition, the lockdown and physical distancing measures, government stimulus packages and changes in the regulatory landscape have created profound uncertainty for members of the startup ecosystem in Australia.
Our team explores some of the immediate impacts and issues, and the opportunities these create, for startups and investors amidst the current crisis.
- The pandemic is impacting overall investment levels and we may see further declines in the coming months.
- Startups and investors alike will need to be aware of the major changes to Australia's foreign investment approval (FIRB) regime and how this may affect opportunities for offshore investment.
- Downward pressure on valuations from current market conditions mean companies seeking investment should be careful to avoid excessive founder dilution when negotiating investor protection mechanics. There is also a heightened risk that existing investor protection clauses that were negotiated in previous funding rounds will now be triggered.
- Australian investment firms that have recently raised funds will need to decide whether and how to deploy available dry powder. For startups, these opportunities may present some vexing issues about how to use their own capital – eg limit expenditure to cover essential operational costs, or spend money on R&D to capitalise on opportunities.
There is some evidence to suggest that, at least in the early stages of the crisis, venture capital investment levels remained robust. In late March, Xinja announced it had secured a $433m equity capital injection from Emirates' World Investments. SafetyCulture announced in early April it had raised $60.5m from new and follow-on investors, securing 'unicorn' status in the process.
However, recent newsworthy examples such as these are likely to reflect transactions that were committed before the current situation had reached its zenith at the end of last month. Figures for March 2020 indicate a substantial decrease in deal volumes compared to the same period last year. In previous downturns, evidence suggests it took a full year for investment to hit its low point– so it is entirely possible we may see a further decline in the coming months.
In recent times, Australian startups in search of capital have been able to look overseas in order to tap larger pools of foreign capital and expertise. With a weak Australian dollar, the Australian market may present an attractive investment opportunity for foreign investors.
Against this backdrop, both startups and investors alike will need to be aware of the major (albeit temporary) changes to the FIRB regime, announced on 29 March to address risks arising from the COVID-19 pandemic.
Prior to these changes coming into effect, it was unlikely for smaller-cap players to have to consider the application of FIRB approval processes in an investment context. However, with key monetary screening thresholds being reduced to $0, all foreign investment involving a minimum 20% interest (less if a foreign-government investor or associate is involved) will be subject to the FIRB regime.
Startups and investors should be aware that an investor will be deemed as 'foreign' if a foreign holder holds a ‘substantial interest’ in the investor (ie 20% or more), which is traced up through the chain of ownership. This means that if any one or more members of a trust or limited partnership are foreign, and together those members hold 20% or more of the interests in the trust or limited partnership, the trustee or general partner is itself considered foreign for the purposes of the FIRB regime.
It is worth highlighting, there is an exception to the application of FIRB review where an offer is made to all existing shareholders on a pro rata basis. In that situation an existing foreign investor could take up their pro rata entitlement but would not be able to participate in any shortfall without first seeking FIRB approval.
This temporary tightening of foreign investment regulation may temper opportunities for offshore investment, creating a need for businesses to seek capital from existing or local investors to mitigate the impact of liquidity pressure in the short- to mid-term.
If startups are limited to local capital due to stricter foreign investment rules, local VCs and other investors are likely to drive a harder bargain on valuation. This potential arises not only from the revenue impacts caused by the current crisis, but also as a result of an increase in leverage following a tightening of capital supply.
Significant downward pressure on valuations means companies seeking investment should be careful to avoid excessive founder dilution when negotiating down-round anti-dilution protection mechanics.
For companies seeking to raise capital now, this is also likely to bring into sharp focus existing investor protection clauses that were negotiated in previous funding rounds, with a heightened risk that these will now be triggered. The extent of any dilutive impact to founders and ordinary shareholders alike will turn on the anti-dilution mechanic adopted at the time.
The venture debt market may become an attractive option for businesses that are keen to preserve founder equity and control, particularly if equity markets prove difficult to navigate.
For those Australian investment firms that have recently raised funds, decisions will need to be made about whether and how to deploy their stores of dry powder. VCs will be aware of the short term impacts to, and capital requirements of, existing portfolio companies, but will also have an eye to longer-term growth opportunities.
One of the benefits of private capital is that it is mobile and can be deployed quickly to take advantage of potential growth areas. This means that opportunities remain for members of the startup ecosystem to stay agile and capitalise on new opportunities that have been created by the current crisis. Early-stage investors will be interested in progress made by businesses that are well placed to offer products and services that have found higher demand in this climate (eg those businesses in the med-tech/healthcare, logistics and supply chain and remote work and productivity solutions sectors).
For startups, these opportunities may well present some vexing issues about how to use their own capital – should businesses batten down the hatches and limit expenditure to cover essential operational expenses, or should they continue to spend money on R&D to capitalise on opportunities or pivot in a new direction? The answer to this question is likely to differ depending on the stage of development of the relevant business. Companies that are pre-revenue/pre-launch and, therefore, more insulated from a general market downturn, might find this an easier choice than a company with an established product in market that might choose to focus existing resources on executing existing contracts and retaining staff. Either way, startups should be very aware of unnecessary cash burn and carefully consider their cash runways.
Businesses should seek, where possible, to take advantage of government-assisted recovery packages and stimulus measures in order to maintain operational stability.
The JobKeeper subsidy scheme will provide some relief for those that are able to access it. However, for many early-stage companies that are pre-revenue or have recently seen significant revenue growth, there will be challenges in establishing a 30% fall in turnover compared with the previous year, which is a requirement to access the scheme. There is the tendency for early-stage companies to hire in anticipation of continued revenue growth. So, whilst startups may struggle to trigger the 30% threshold requirement, there may still be a need to lay off staff.
Some sectors of the startup community are agitating for further assistance to be provided by the Government, given the difficulties faced by startups in accessing this job retention scheme. In particular, there has been a strong push for an acceleration of payments under the R&D Tax Incentive, to assist cash-strapped startups and to provide a potentially crucial lifeline. In light of this, members of the startup ecosystem should keep a watching brief for further announcements from the Government.
For more immediate short-term liquidity needs, startups could also consider availing themselves of any relevant commercial bank COVID-19 support offerings; just be sure to read the fine print.