In startup world, coronavirus puts spotlight—and strain—on investor ethics

A few weeks ago, lingerie retailer Zivame was in talks to close a round of funding, after months of looking for capital, from a well-known Indian private equity (PE) fund. With its business taking a beating due to the coronavirus outbreak, the money would have seen the company through the crisis. But as negotiations were being wrapped up, the PE fund pulled out.

Moneycontrol has learnt of seven cases where investors-- PEs, Venture Capital (VC) funds or billionaire family offices--pulled out signed term sheets, leaving startups scrambling for money. A term sheet is a non-binding document that broad strokes the conditions under which an investor puts money in a business.

The coronavirus that has taken a huge toll on lives and business and wrecked economies around the world has also shone the spotlight on investor ethics, a highly divisive issue that has gained more prominence as startups try to survive the pandemic.

“We are well-capitalised and supported by our current investor base. The team is committed towards the business and we do not see any concern at this point,” a Zivame spokesperson said. 

But that isn’t the case with other consumer companies that have been forced into layoffs and salary cuts even though they have enough funds.

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As all term sheets are non-binding, and explicitly say so, it absolves investors from legal consequences. 

Moreover, companies across the world are enforcing force majeure clause, with the viral outbreak being an unforeseeable event preventing parties from fulfilling contracts.

However, startups expect investors to honour term sheets, with precious exceptions. 

“If you have a signed term sheet, and although it is non-binding, there is an unwritten convention, in India at least, you pull out a term sheet only if there is a diligence issue and someone discovers information they did not know before or something that was not conveyed to you,” said Ritesh Banglani, managing partner at early-stage VC firm Stellaris Venture Partners.

Most of the term sheets pulled out by investors in the last few weeks was because revenues were negligible as the lockdown shuttered malls and until recently didn’t allow online sale of non- essentials. Some of these restrictions have now been eased in areas that have a low count of infections. 

“Just because the economic conditions changed if you pull out the term sheet or renegotiate, it could be seen as unethical. I think it is a reputation issue. Word spreads around very quickly, so VCs do stand to lose reputation. Entrepreneurs expect you to follow through,” Banglani added. 

VC funds generally take a seven-year view on businesses, the period in which they expect an exit. 

Analysts believe many online businesses such as retail, vertical ecommerce and fashion, will be stronger in the long run, with pent-up demand waiting to be met along with the safety of ordering from home.

“Yes, VCs take a five-seven year view. But if you’re not sure if the business will even survive for a year, what long-term view will you take? This is a unique time in history when the whole world is suffering. So if your existing businesses are dying, then how can you think of committing to a new business,” said a partner at an early-stage fund, requesting anonymity.

A founder was close to finalising a Series A fundraise of $5-10 million, when days before finalising the shareholder agreement, the final step towards a deal, the lead investor came back asking for a valuation discount of 35 percent.

When economic conditions change drastically, a change the terms can be asked for. Investors can ask for a lower valuation, greater ownership and more rights to protect their interests. 

However, in two separate cases over the last two weeks, including the case above, founders preferred to walk away than accept a lower valuation, sources have told Moneycontrol.

‘Asking for dowry’

Some investors think it is unethical to renegotiate a signed term-sheet. 

An investor even compared it to asking for dowry. “On the day of the wedding, if the groom comes and asks for a car, how will it be? Maybe I can afford it but do I want to be in a relationship like that?” he added.

“It is a very grey area. The founder can say it is unethical but the VC has to look at his interests too,” said Mohit Gulati, managing general partner, ITI Growth Opportunities Venture Fund. 

Venture capital funds are accountable to their investors or limited partners, generally endowment funds, pension funds, insurance companies and high-net-worth individuals.  

The mismatch in expectations of honouring a term sheet also stems from the difference between the venture capital world, of smaller and risky deals, and private equity, of large and more scrutinised deals.

"Private equity investors tell you upfront that a term sheet does not guarantee an investment. VCs generally see if a company’s figures are directionally correct,” said a partner at one of India’s top funds on condition of anonymity.  "PE funds need to believe every cell of your excel sheet. The trust equation is different. So, a PE fund pulling out a term sheet may still be unethical but is much more common and a bit of a cultural shock to some founders and even investors

Some investors insist on an exclusivity clause in the term sheet that forbids a company from engaging with others when negotiations are on. 

“Most growth equity investors do the bulk of their commercial due diligence post-term sheet. So we advise founders to take adequate precautions by not giving exclusivity in such situations,” said Shivakumar Ramaswami, founder, IndigoEdge, a startup-focused investment banking firm. 

Founders and investors broadly agree that ethical implications of pulling out of a signed deal vary from case to case-- whether the company needed the money immediately or was raising it for later; whether the business is from among the worst-hit sectors or can bounce back quickly, etc.

“I may hate the investors who pulled out of a deal in my portfolio but I will defend their right to do it,” said the early-stage investor cited above.