This Week in Startups - Common First-Time Founder Mistakes Part 2! with Becki DeGraw | Wilson Sonsini Startup Legal Basics

Episode Date: April 2, 2021

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Welcome back to startup basics. Visit the website. Thisweekinstarups.com slash basics. Or you can go to the This Weekend Startups channel on the YouTube or you can look for This Week in Startups on your podcast player of choice. Becky, we've been going through these mistakes, we're trying to just help founders avoid mistakes. Now, not having anyone sign anything because we're all friends

is something you and I hear all the time. Don't worry. This person's my friend. I've got a great relationship with them. Now, if there was a legal parallel to a startup, some might pick a marriage as being one of those. And I have had, you know, just in my peripheral vision, I've seen that maybe sometimes a divorce in a marriage can get cantankerous. I don't know if you've ever had this. But it seems like it could get cantankerous.

I hear about this often. Yeah. And they might fight over things or everything, depending on how Katanga is. Does that happen in startups too? It does. It really does. And I mean, you're right. I get it all the time.

Oh, we've been friends since, fill in the blank. We've worked together for X number of years. There's no problems here. And I will always tell them to say, I get that. Everything is great until it's not. And there is a point where it becomes it's not in a number of, of these instances, right? I mean, like, you're starting a brand new company. You're getting into brand new roles that neither of you have even gone down the path for. You have ideas as to,

okay, I'm going to be this position. You're going to be this position. I'm going to spend all my waking hours on it. I expect you to do the same thing. We're going in full speed ahead. Well, that may not work out. I, you know, you may decide, I am. I'm going to work nights and weekends. And we're just going to pound this out. And I may be like, you know what, until I start getting paid, I'm just going to do a little bit here and there. And now I'm not pulling my way. And you're upset. And things get, things get heated.

Yeah, exactly. If you don't have anything in writing, what happens? Like, one, who knows what the equity split is supposed to be? I could be coming to you saying, I thought I owned 50% of the company. And you're like, what do you mean? Exactly. I have a free to 10. Exactly.

And, you know, you start looking at emails and text messages and they are never clear. Discovery, here we go. Exactly. And at the end of the day, like, as a startup, if in our example, I walk away because I'm mad, I'm not getting enough. I come back, I see you and say, I'm entitled to 50% of the company. As a startup, you don't want to mess with that. You don't want to pay legal fees to fight some battle about what this person's entitled to or not. and I will be perfectly honest.

And a lot of these instances, our suggestion is find a way to settle, even if you don't think that it is fair. Like, this is not the time to go to bat and, you know, exhaust every little last dollar that the company has, which is not the right result in a lot of places, right? You may feel like, oh, I gave this person more than what they deserved. Don't put yourself in that position is the really easy answer. just get things signed when when you all agree. The thing that is so crazy about this is I could see people saying like, oh, you know, we got married, we had nothing, we didn't do a pre-nup, we built this world together. You know, one person was the power attorney at Wilson, the other person was an entrepreneur, one person made money for 10 years, you had the lost money, and then it flipped. Who cares?

All right, chop it up at the end. But here in startups, you don't have love, family, marriage, and all these other complications and a giant ceremony you had. It's just a company. So it's very easy to have these conversations. How much effort are you going to put in? How much effort am I going to put in? Do you see yourself doing this for 10 years or two? Let's pick a vesting schedule that works and just nail everything and have it tight because there's not enough runway and resources to have a 10 year battle over this. It just can't happen. And then once you have a battle between the founders, correct me if I'm wrong, the chances of funding happening down the road is close to zero. sinks. It really does. Right. Because because what you're, well, with the exception of, you settle it with that former co-founder and you have a nice settlement agreement that is wrapped up with a pretty bow to where investors know that there's a full release. They've signed. They agree that this is what they're entitled to and that's it and you're done. That would be the instance where you can get past it. But to get to that settlement agreement can be difficult. And what I found a lot of times,

in these startups is it's a lot of emotion that goes into it, much like marriage or personal relationship, right, as I was the co-founder, I sunk my heart and soul into this. I'm entitled to. My ideas. My ideas in that product. And it's hard to get away from like just thinking reasonably and rationally as to what somebody might be entitled to. And other industries, you know, for something like movies, they have the Writers Guild. And when there is a dispute between people or the producers guild, I believe they can go to this like third party and say, hey, I wrote 18 pages, this person ran 90, here's the first script, here's the second script, here's the Delta's of everything that changed.

And they kind of negotiated for you. There's like almost like a negotiation that happens, okay, you'll be a co-writer or you can take your name off the script. But there's a process. They're here in startups. We don't really have like some startup board or founder guild where we say, oh, go to the founder guild and they'll come up. they'll help you mediate this.

And in the cases where it does get settled and there's a lot on the line, sometimes the new investors become the reason for this to settle, right? Like, hey, they're going to invest if we can settle this. Here's what, you know, we can do. Or if not, this company's going to get sold and it's going to get shut down. Yeah. I mean, that's typically. Although that's a hard, hard place too.

It's like if you're the founder that's at the company and you're going to, you know, a former co-founder, it's hard to say, hey, I really need to settle this. because we have an investor on the line. In some regards, that works because this co-founder presumably is walking away with some equity. And it's like, hey, do you want your equity to be worth anything or nothing? And if you want it to be worth something, we need to come to the table and settle. But you're also revealing a card in your hand that you need them. And they recognize the leverage.

I tell my founders, because we do a cap table review before people join our accelerator. Now, that seems over the top. but this comes from a lot of scar tissue where we will see somebody gave half the company to a dev shop or a third of the company to their uncle or whatever and we say hey we're giving you a hundred thousand dollars to come to the accelerator we're fine with you using up to half of that to settle this if you want to use 10k or 50k or anything in between feel free but coming to the accelerator is contingent on the cap table being cleaned and this class is starting on you know April 1st and this one starting on May 15th pick which one you want to go to

go talk to your co-founders or whatever and settle it. And if you don't, you don't. And I just use that as like, I just don't want to be associated with a company or put even just a hundred K, which is a tiny amount of capital for us and our $44 million fund. I don't want to waste all of my team's time and the founders time putting the 100K in to only have one of my seed investor friends give a term sheet and then they discover the problem and they pull the term sheet. And now we just spent 16 weeks helping introduce the founder to a thousand people, all for not because of these issues. Just do it right. Tight is right.

Absolutely. And on this one, like if you, if you just are absolutely like I can't, I'm not going to a lawyer for whatever reason, at least do your best to put something in writing and have you both sign it. Okay? Like, it doesn't have to be perfect legal, but at least if you have something in writing and you both have signed it, it can be chicken scratch. It doesn't matter.

Literally a piece of paper that says, Becky gets 80%, Jason gets 20%, vested monthly for four years, and you both sign it. It's like, at least you can pull that out and say, here's something that's not an email, that was signed,

and that had some details on it. Here's at least some parameters that we can work within so that you don't have some crazy terms coming out. It's not ideal. Don't take this the wrong way. I don't suggest doing that, but... No, it is a backstop.

I mean, early in my career, I would write a bullet point letter it when I hired somebody and I would write bullet points when we agreed to a deal with a vendor or whatever and I'd say, hey, can you just sign this letter agreement? And I came up with my own standard. I called it the letter agreement. I don't know if that's, I don't think that's a legal standard. Is it? Sure. Sure. I mean, anything you sign. I came up with it because I was broke and I had no ability to pay attorneys and I just thought I could figure everything out myself. It got myself in a lot trouble. Put that aside. I had to do the flipping of the LLC thing and I had to flip the

accounting from accrual or cash to accrual. I mean, it was, when I say a year in hell, it was a year in hell. And it at least cost me between $50,000 and $100,000 just in the accounting and legal bills to do that flippinging. And the flippinging was one of the most brutal experiences of my life. That's why it's scar tissue now. But I would just write these letter agreements. And then even to this day, I will put in a contract the bullet points in plain English, like we get a board seat, you know, we have information rights or whatever. And I'll just ask them to initial those bullet points. So that, when they initial it, they read it. As opposed to now, where everybody just reads a docu sign and just signs it, I've had people say,

I didn't know we gave you a board seat. I'm like, it's in the document. And they're like, yeah, so now I just make it super clear. Put it in an email, put it in the, I asked them to put it in a little initial thing and then I'm on my attorney. Why do you have to put the initial thing? It's not necessary. I'm like, because I want to in three years or two years when they say, oh, what about the board seat or what about the information rights? I'm like, because you look on page seven.

See where we both initialed it? That's in there for a reason and it's initialed for a reason. What do you think of my technique, my weird techniques? I mean, I think it's good to call out to founders because a lot of founders are super smart in what they do, right? And you could talk to them about their product or their engineering or whatever it is that they're doing. And a lot of that, to be honest, who's like, who's right over my head. And when it comes to legal or something in that realm, they just don't, don't get it. So calling it out, I think it's a good thing. It's being very blunt and plain English about it and making sure that

they realize what they're signing. But from a legal standpoint, if it's in the document and they sign it once, you don't have to have them do the initial. But I think, you know, I mean, like calling it out is always a good thing, however you may want to do that. Yeah, you could do it on a phone call. You could do it an email. You know, it could happen in a text. I mean, just ways of, this is for me a practical way of making sure people understand. I literally had somebody today say, oh, I didn't know you had a board seat and then this new deal we got done. They want you to give up your board seat. I'm like, yeah, no, we can't do that? And they're like, okay, but can you give up your pro rata and your information rights? I'm like, we can't do that either. We own 11%

another company, like we need to have proper governance. And I sold my LPs in my fund that I, one of our strengths is that we have a seat at the table. And when these companies decide to raise more money, we might be able to put more money in. As opposed to when I did the Uber or Robin, who are a com deals, I don't have a board seat. Might have some information rights, but I don't have a seat at the table with those companies, nor should I. Maybe in Com's case, I was at 6%. It's kind of on the bubble. But in those other cases had basis points. I don't have a seat at the table. I get whatever information I can glean from the founders just as much as they trust me to have that information, right? So when I went to raise my funds, I said, listen, we are not just angel

investors blindly investing in companies and hoping for the best. We have a system here. We're trying to get to 15% ownership. Here's how we're going to do it. And so now I just go back to my founders and tell them that. But I'm constantly having to remind them because founders have a zone of excellence and they don't consider illegal their zone of excellence. So they ignore it. You know, yes. They kind of like put it out there and it's like come on man that's like ignoring eating your vegetables just eat the damn vegetables i know like you may not like carrots or green beans but and i'm not calling your whole professional vegetables i think let me just be clear i see i see where we stand he's like oh god we have to do this in a way you have to do it you have to eat your vegetables

okay this one oh so painful no vesting on the shares oh yeah yoi explain the worst case scenario Yeah, so worst case narrow, you've got kind of a similar example that we just talked about. You got a couple of friends who started a company. It's like, you know what, this vesting stuff, we don't want to have it. We don't want to have it on our shares. Let's just all be fully vested in our shares. And we're going to have so much leverage by the time. Like we get funding because we're going to be the next hottest company.

When we talk to investors, we're going to convince them at that time and deal with it. Okay, that's a strategy. let's say that before you go, you're at this for a year and before you actually go and get the funding from investors, something happens between you and your co-founder. Again, everything's great until it's not. Your co-founder says, you know what? I'm just really not that into this anymore. I just got married.

We're going to have a kid. I'm going to spend more time on that. But, you know, good luck. Good luck with the venture. And you're like, wait a minute. You can't walk away with half the company then. Oh, but I can. I bought half the shares.

Yeah, here's a piece of paper. But I'm rooting for you. Good luck. I'm rooting for you. Right. So that's a really good example of why you want to have vesting on your shares. Even if you think like it's to do with the investors, it's not just the investors. It's between you and your co-founders to make sure that people are pulling their weight.

That, again, whatever roles you've established for, yourselves they're actually falling through on and that they stay with the company. Please, please, vest your shares. Please. Just so you, because here's the reality. You're going to get into a game of chicken where you're both racing at each other and you as the founder who wants to stay, you have to be able to say, look the other founder in the eye and say, I would rather see this company go to zero than for me to work on

in five years and for you to get a free ride. So I am shutting the company down. We can sell it for assets. I too am walking away, but you can be sure tomorrow I'm starting another company that in no way uses this company's IP, but I am out of here. This is not equitable. And now you have to actually believe that and you have to be able to follow through on it. I'm going to stop working on this tomorrow. And most founders are emotionally caught up in their company and they have a million dollars in revenue and like, I don't want to start over. You have to then become like a berserker.

Like I've had to do this in my career, but it's kind of who I am anyway. So I kind of enjoyed, I kind of enjoy that berserker moment a little bit too much. But I'm a little bit crazy. that. I'm just like, okay, fine. Chuck the whole thing down. I don't care. I'll start over. I can do anything. I literally did it in my career one time. I won. I was. They start my way. But for the record, that's probably not the best way to go. It's probably the worst way to go because I didn't have to burn that relationship and create months of drama. But I literally did that one time. And it could have been a cointos. I could have maybe had to like, it's literally like, what's the,

What's the fable of the baby where they're like, okay, yeah, just cut the baby in half, give each mom half the baby. And one mother's like, no, no, no, no, give her the baby. Okay, now we know who the real mother is. What's that tell? I don't know, but I know. You know what I'm talking about. I do.

Not to be graphic, but it's kind of like cutting a baby in half. You don't want to be put in that position. Okay. Yeah. No IP protection. So this is again kind of in that whole theme of like we didn't sign anything, right? So even, you know, a lot of misconception is, okay, we formed the company. we've been working on this together.

So the company must own everything. I mean, we've been signing documents in the name of the company when we enter into with third parties. Like, okay, but what did you sign? What did the founders sign with the company other than just buying your stock? Oh, yeah, we haven't signed anything yet. Well, then the people who owns any IP that you personally, your co-founder, have developed is you personally are your co-founder. That's the default rule.

until you sign an agreement that says, hey, anything I develop, anything I create, the company owns, that's not the case by default. It's like, oh, I didn't know, as a founder, I didn't know I had to sign that agreement too. I'm making sure everybody else signs it. You got a sign it too. Great, great that you got everybody else to sign it.

Good. Halfway there. Exactly. But probably the most important is that the founders actually assign their IP. Who comes up with the ideas at this company? Who approves which. ideas actually become reality. Ah, you do. Okay, good. Just so we're clear, sign your IP. It really is so hard to go back and ask people to do this. My rule is you can't come to work. You're not, and in the virtual

world, you're not getting your email turned on. You're not in the Slack until IP is, you know, assignments are all signed. We're doing it buttoned up because, you know, now I'm a target. It used to be, and this is what you quickly learn. In the case you are successful, now all of a sudden, the amount of legal issues you'll need to deal with and the number of people who are looking at you going, hmm, there's a good target goes up, correct? Like these legal issues tend to come out after the series B or C. And people are like, oh, I saw a news clipping that you raised 30 million. Here's my lawsuit. And it's like, here's the menu of extortion. What would you like to pick? How would you like to extort me today? Shares, money? What would you like? It's so brutal.

And you know, why? Being successful. It is. It literally, it's just like, it is one of the brutal things I found, you know, having spent 30 years not being successful in the last 20 being, you know, some degree of successful. It's a very successful. Every time your success goes up, the number of legal letters just goes up in direct correlation. Is this directionally correct my experience? I think so, right? I mean, like, who wants to sue a startup that has no money? Yeah, more money, more problems. I mean, at the end of the day, like, lawsuits are always going to go after the big pockets, right? Right. You see this. Like, when there's some lawsuit, they're like, okay, who was running this carnival? And it was like, Country Joe was running the carnivals. It's like, uh, country Joe got no money. Who made the wheel at Ferris wheel? Oh, that's the German company that makes Ferris wheels.

Oh, they have a lot. Oh, they're publicly listed? Great. Let's sue the German company that made the Ferris wheel. Not country Joe who ran the carnival. All right. There's a lot of weird stuff going on with founder shares and dual class. systems. I find the whole thing wacky. I had one founder who came to me with a startup that was not growing for two or three years and she reassigned herself. She redid the class

structure. Then she did have some success and she went out to raise money and somebody called me. He's like, do you know about this founder's share stuff? And I'm like, I'm sorry, what? This is 10 years ago, maybe, seven years ago when this stuff was all starting to bubble up and they're like they gave themselves a thousand to one voting shares or something crazy. I'm like,

so I said to her, I said, why did you do that? And she said, oh, somebody told me, like, Larry and Sergey have that. I'm like, you're Larry and Sergey and Google? I think they got that at the end of the line when the VCs gave them a high five for making them billionaires, and then they gave them those shares. Am I correct? And explain the different structures here that we typically see people do, you know, funky stuff with. Yeah.

A legal term, funky. Funky, yes, that's definitely a straight out of the book legal term right there. Absolutely. It got funky. So I get this question a lot from founders of like, okay, you know, we want, we want the super voting shares. We want dual class common. We want founders preferred. At the end of the day, the advice is the same across all of those.

And that is, and you're right, they will refer to the Googles, the Facebooks of the world of like, well, well, look, Mark, he still owns, you know, control of the company because of the super voting shares. And I say to them quite simply, like, if you are Google or Facebook, you can pick these terms. If you are not, these terms aren't going to fly. It's going to cost you more money to put these structures in place at the beginning. They're not, you know, just pull off the shelf standard terms. They require a lot more maneuvering on the formation side of things. You're definitely not going to be able to do this in a legal Zoom clerkie online. you're going to have to go to a real lawyer who puts this together.

And that's going to cost you more money to put these in. There's tax issues usually with these unless you do them at the very beginning and you do them right. And then come your first round of sophisticated investor shows up at the door and says, okay, you've got to get rid of all this. Yeah, rip it all out. So then you're going to pay the legal fees to literally go through and take it all out. So it's just, it's a lot of time and energy and money. Yeah, exactly what happened in this case. They spent all this time of money to add it,

then rip it out. And it was like, okay, you literally just built a bathroom without getting it approved. And then the inspector came and told you like, ah, this is not an ADA bathroom. And now you're going to rip it all out and put it back. Like, just do it right from the beginning. Like, how many stories do you hear about that? Just do it right from the beginning. All right, This has been amazing. Thank you so much for doing startup basics with me again.

This has been amazing. If you want to see the entire, I don't know, we did four or five episodes here, all great. Go ahead and visit this week in startups.com slash basics.

Very simple. And Becky, how do people connect with you? If they wanted to. Email, phone. You can find me at WSGR.com. Email is R.D.Graw at WSGR. There it is.

Okay, everybody. We'll see you next time. Bye bye.