This Week in Startups - Fundraising hurdles and M&A slowdown with Becki DeGraw | Wilson Sonsini Startup Legal Basics

Episode Date: September 5, 2024

Todays show: Wilson Sonsini Partner Becki DeGraw joins Jason on the latest edition of Startup Legal Basics! In this episode, they break down fundraising trends (1:33), the challenges of M&A (7:39), and the evolving regulations for tech companies (13:29). * Timestamps: (00:00) Wilson Sonsini partner Becki DeGraw joins Jason (1:33) Fundraising trends and investor expectations (3:57) Breakeven points and penny warrants (7:39) M&A slowdown and regulatory challenges (13:29) Proposals for M&A regulation reform (16:08) Compliance costs and cybersecurity for startups (19:58) Legal strategies for startups and data policies * Check Out Wilson Sonsini: ⁠⁠https://www.wsgr.com⁠ * Subscribe to the TWiST500 newsletter: https://ticker.thisweekinstartups.com Check out the TWIST500: https://www.twist500.com⁠ * Subscribe to This Week in Startups on Apple: https://rb.gy/v19fcp * Follow Becki: LinkedIn: https://www.linkedin.com/in/rebecca-degraw-639bbb62 * Follow Jason: X: https://twitter.com/Jason LinkedIn: https://www.linkedin.com/in/jasoncalacanis * Great TWIST interviews: Will Guidara, Eoghan McCabe, Steve Huffman, Brian Chesky, Bob Moesta, Aaron Levie, Sophia Amoruso, Reid Hoffman, Frank Slootman, Billy McFarland * Check out Jason’s suite of newsletters: https://substack.com/@calacanis * Follow TWiST: Twitter: https://twitter.com/TWiStartups YouTube: https://www.youtube.com/thisweekin Instagram: https://www.instagram.com/thisweekinstartups TikTok: https://www.tiktok.com/@thisweekinstartups Substack: https://twistartups.substack.com * Subscribe to the Founder University Podcast: https://www.youtube.com/@founderuniversity1916

All right, everybody, welcome back to this week in startups. It's time for our startup basic segment. We do this every year or so. Becky de Graen and I get together. She's with Wilson Sincini. I'm with this week in startups and launch. We both are involved in the startup ecosystem for decades. And we both care deeply about founders and the ecosystem.

So we get together and we talk about the challenges, the legal issues. And you can get all of our startup basics that we've done in history over the years at this week in startups.com slash basics. All the basic stuff is important, but things are getting a little complicated of late, huh, Becky? Yeah, it's not all up into the right, unfortunately. So I asked you to tell me

what are the most painful things that you've seen in the market? Now, of course, you're not talking about any specific companies here, but the trends, because you get to see the trends at a great firm like Wilson. So I'm seeing my attorneys. So what do you see?

seeing what's happening with startups in 2024 last year. I mean, it seems like it was a decade ago, but we had Silicon Valley bank, go under. And, you know, it's coming back now and it's, you know, in different parts, but that was like a seismic, crazy thing that occurred in our industry. We had the downmark, we have peak syrup. Okay, here we are.

2024 halfway through the year. Things seem to be getting better, but man, there's a lot of problems that people are still working their way What are the top couple of things you're seeing? Yeah, I would say, you know, I think you hit it right on the head, right? So many things have caused a more challenging fundraising market for companies and more so than what we've seen in prior years. And not just compared to, you know, 2021, the outlier year where everybody's hair was on fire and felt like everybody was getting financed. But just more challenging in general, you know, good companies are still getting finance, but they're having

to jump through more hoops. And the later that the company gets, the harder it is from a fundraising perspective. And one of the things that's been very interesting, right, is like, what have investors been telling companies for the last two and a half years? Cut cost, reduce your burn, extend your run rate, right? All of these things, because the market hasn't been great. We need to wait, you know, we need to wait this storm out and hopefully it gets better. Well, when you do that, right, that that pressure to cut cost, I'm probably not going to see the super hockey stick of up to the right. Like, it's kind of you're expected to do more with less.

And now when these companies are forced to come back to the market, they don't have like the, ooh, flashy metrics that investors love to see because they have been. They've been more conservative, or at least most companies have. So that's the paradox. We had everybody say batten down the hatches. Founders in some cases complied. In some cases, they just went yolo.

They said, forget it. You know, I'm going to run my company how I want. But let's say in good faith, a large number of them did that. And all of a sudden, this idea of doubling revenue became flat revenue or negative 10% or plus 10% revenue growth. But we hit break even, right? And it's like, okay, well, that could be a shallow victory. because you hit break-even, but now nobody wants to invest in a company that's kind of growing 10% a year. That's not a high-growth company.

And the companies that we want to invest in as a community are high-growth companies and high growth in private companies. Let's face it, 50%, 100%, 200%, 300-per-growth year-over-year depending on the stage. So where does this leave all these companies who took the advice of batten down the hatches and got to break-even? maybe they're at break-even. They have some money in the bank. They've got, you know, 24, 48 months of runway, but they don't have high growth. What happens to these companies?

Well, now when they are starting to run out of money and have to come back to the market, they're not getting an upround, right? Like, we're seeing fewer and fewer upgrounds. Like we were just looking at our data coming out of Q2, the aggregated data, and we down rounds have increased flat rounds have increased. And I'll say flat rounds in quotes, because some of the flat rounds have

creative things that go along with it like penny warrants that when you calculate them, it really ends up looking more like a down round. But from an optic standpoint, you can kind of say flat. But I think that's what you're seeing and why we're seeing more of those than we are these up rounds. Let's talk about those penny warrants for a second, because everybody hears that and goes, hey, what's that? That's interesting. what is the penny warrant and why do people ask for those? Yeah, so right now I feel like what we're really trying to solve for in a lot of cases is investors have a lot of dry powder.

They want to invest, but their valuation is down here. Founders, you know, they raised, let's say, in 2021, and their valuation was really high. And maybe due to what we were just talking about, they're kind of flat on revenue. when investors are saying, this isn't really what I thought it was going to be. I think that your valuation should be lower. So we've got this delta of what the company thinks it should be, and investors think it should be.

One of the things that we're doing from a creative, quotes, creative way to solve that gap is to add these penny wards. So you would say, okay, you know what, I'm going to give you a flat round. I'm going to buy new preferred stock at the same price as what your last round was, but you're also going to give me a warrant to purchase a share of stock for a penny per share.

So now, from an investor perspective, when I combine those two, I get a different economic, I get a blended rate that brings me down to the valuation I wanted, while the company kind of gets to save face and say, oh, I had a flat round, you know, in terms of what they sold from the preferred stock. So to put some math on this,

company was worth $100 million. They had raised $10 million. And let's say they had $100 million shares just to make the math super easy. Every share is worth a dollar. They come back to market. They tell the existing investors, hey, we need to top off with $5 million to get this thing back on track. They say, okay, we'll give you the $5 million. We'll give you those for a dollar a share at $100 million valuation.

But we also want this little side deal over here that says we can buy another $5 million. shares for a penny each. So for but $50,000, we can buy another 5% of the company. So you put those two numbers together, $5,000 for essentially 10% of the company, but it's a warrant so they can execute that at any time in the next, say, 10 years, typically I think when they do this warrant coverage. And so the cap table looks good right now. Nobody, everybody's looking at the cap table you know, in a in a spreadsheet going, okay, it looks good. But then when the sale happens right before the sale,

that investor says, here's your $50,000, we'll take another $5 million shares. And that, of course, comes off the top and everybody gets diluted to 5%. Did I describe it correctly? What is happening here? That's exactly what's happening.

And today founders get to say, face and say, oh, I had a flat round. And, you know, you can, you can adjust that ratio so that it gets to, you know, whether you get one for one or whatever it might be on the warrant side to get to that right valuation that the investor was looking for. Yeah, let's say the valuation was like they wanted to get to $25 million, right? So now they need, instead of one extra share for every share they put in, they need more, right? They need another two or three.

So, man, it can get a little bit hairy. Tell me what's going on with M&A. You know, we have a very chilled market with M&A. I have been all caps. Everybody knows when I go all caps on social media, something's going on here. So I was all caps with SVB. Hey,

we got to save SVB, at least a deposit. If the company got wiped down and people's equity got wiped out, that's one thing. But you can't take a school or a startup's money out of their bank account. Like, that's not cool.

So, okay, we got through that. All caps, J-Cal saved the day there and some smart people in Washington. Yes, of course. The fact that people even, like the New York Times is writing about my old cat's rants, like it has any impact on anything is ridiculous. But anyway, I went all caps the other day. And I said, listen, and this is me saying this, not you, not Wilson's the evening,

but for me, J-Cal, gosh, you know, it's really frustrating the chill that Lena Khan and this administration has put, and it's political, but they have put a chill in our industry and M&A. Nobody wants to buy anything because they saw what happened with Adobe and Figma. They see what's happening in the market where, you know, Google wants to buy an A company, Microsoft wants to buy an A company. They do this weird synthetic acquisition, I'll call it. I'm going to call it a synthetic acquisition where they buy the team, they give a licensing fee, and then the company still exists, and I don't know what happens.

Have you seen any of this synthetic M&A, I'll call it, or just the chill in general on M&A? and what's your outlook for this changing, if at all? Yeah, I would say the M&A market is chill is a very good description on what's going on there. And it's, I was chatting with a number of our M&A partners recently on this. And they're like, I don't know how, I don't know that I've seen a market quite like this. We always have ups and downs and different things with the market, but not like this. Like, we're seeing just weird stuff happen on the M&A. and the M&A side.

When you get an LOI, that's the term sheet, that's the first step that the buyer passes over to say, I want to, I'm interested, I want to buy, and here's the terms under which I'll do so. If you sign that, between then and the time that you get, say, the first draft and the buyer prepares that of the definitive agreement, I would say, like, we will sometimes see deals die in that period, right? They start doing a little bit more diligence. Maybe they decide, yeah, not the one for me.

But what we have seen over the last year and a half, I'll call it, is the deals get really far along. I mean, like, we're on the finish line. We're a week away. Like, we put in two months, like, you know, each side has half a million, a million dollars in legal fees. And then they come back to the table and there's like a renegotiation or there's just a, we're out. And it's like, what do you mean? It's not happening once, but we're seeing it. happen more. And I wouldn't say like, oh, it's happening 20% of the time. But the fact that it's

happening and even single digit percentages is kind of crazy and really causes that chilling effect over the whole whole market. You know, unfortunately, whenever we get an M&A deal, it's like, go, go, go, go as fast as you possibly can because there's so much anxiety about the uncertainty in the market. So definitely, definitely an issue. It feels to me like the ice age here, you know, And it's so frustrating for me because we'll have great companies that get to millions, low tens of millions in revenue. They're not IPL candidates. We know that. Everybody is cool with it not being an IPO candidate.

Great. It's better than failure or the company shutting down. But we have nowhere to put these companies. And now they go sideways for five years, growing 10% a year from 10 million to 11 to 13. And, you know, they would be so great to be part of Google or Microsoft. and maybe they could 10x these companies or 100x them or have a great team. And what you're saying is they get to the altar. And then they give that line.

You know, if anybody has any reason to object here into this naturally speaking now or hold your piece. And somebody on the acquisition team says, you know, I was looking at the churn. And the churn rates have gone up the last three months. So we think you'll have no customers in 24 months if the churn keeps up at 5% a month. So therefore, we want to. to pay less. And my lord, it's just so frustrating. We need a vibrant M&A market. And so I'm hoping that we, Becky, can get through as an industry with a change in Washington. We'll have a new administration. Maybe they'll have a little more fluidity in what I'll call singles and doubles in M&A.

My proposal is pretty simple. Why don't we just let companies under $250 billion have a very open market so that we have some bigger tech companies, you know, join the magnificent seven. and then if you're part of the Magnificent Seven and you're over $500 billion in market cap or a trillion even, you have a different set of MNA rules. That's my suggestion. It's just let the younger companies,

the upstarts, you know, merge and acquire and maybe have a tougher set of rules for the Googles of the worlds and the Microsofts, etc. There's definitely some regulatory hurdles out there that are putting an additional chilling factor on the MNA market. And how much is international regulatory bodies starting to impact American companies. We see the UK, I think, was the ones who actually were leading to charge against the Adobe Figma,

from my understanding that acquisition. But then you have the EU, generally speaking, how much of these international organizations impacting the American companies, you know, and what they do MNA was? Yeah, I mean, depending on where the entities are and where jurisdiction lies, it's entirely possible that you're not just subject to one regime, but you could be subject to multiple regimes and the antitrust laws in each of those jurisdictions. And every time you start getting into that, it's not cheap. And that's where buyers are making calculated decisions of how expensive is it going to be for me to find out if this is going to be okay.

And right at the end of the day, like you kind of, the fees are so are quite high that you start calculating that in terms of your transaction acquisition costs, right? Of how much am I going to offer the company and how much do I have to pay to get that company? Right. So you could have millions of dollars in legal fees. Then there's this new thing that's been introduced and, you know, could be six months, 12 months, 18 months to get a deal through. And this new thing, the breakup fee, maybe you're, you're. You're seeing a little bit more of that because people are anticipating on the cell side, hey, you know, we don't know if this is going to get the regulator. It's going to be a distraction. Maybe we need a $100 million or a billion if this doesn't work out.

And that's paid for by the seller. I'm sorry, the buyer, correct? It's definitely a topic of conversation. You know, I don't know how successful, like that the percentage has gone up a lot. But the conversations have certainly gone up a lot because both sides are same. a lot of money into this before you're going to get that answer. So if you go into it thinking, hmm, this is a potential regulatory risk, I think one of the things that like our antitrust folks do is really do a lot of analysis up front to try to come up with their best guess as to

what are, what was the risk here? What's the risk profile look like for this company, this particular acquisition? Okay, Payne Point M&A, Payne Point. fundraising. Any other blocking and tackling pain points that are coming up over and over again as we wrap here? You know, I'll add when we're on the same theme of regulatory hurdles, like, even outside of M&A, we've got a lot of that, right? Like, and it's not just related to life sciences companies that have all the FDA and various clearance and things that they have to go through. We're seeing it. Increased regulation on the tech side, too. So think about all the fintech companies that are out there. There's a number. of regulatory items that they have to go through. Digital health is another one that we're seeing more and more issues pop up there.

Digital health, yeah. Right? Privacy. Oh, privacy is a big one, yeah. So, and those are now multi-jurisdiction. You've got California has a set of rules. The United States has a set of rules. The EU has a set of rules.

And the UK, which left the EU, has a set of world. And that's just off the top of my head for, you know, our portfolio companies. it's four sets of rules to get through just on privacy. So what is the best practice here? People just saying, you know what, storing consumer data is just not worth it. We're going to leave it on your phone. We don't want it on our service. Your data is a liability for us.

I've heard some founders tell me that. Like, we don't even want to store this data anymore because the upside is not worth. The juice ain't worth the squeeze in terms of the regulatory issues. You see that as a trend? I think a lot of the counseling that we're doing in this area is talking about those guardrails. What can you do before you cross the line? What can you do to stay on this side of the line? Because once you cross, yeah, we've got all of these and there's, I don't know,

I don't want to say every couple of months, but at least once a year it feels like or twice a year we're seeing, oh, here's another fill in the blank who's coming out with another set of laws and regulations to comply with. And, you know, I mean, all of that, right, is really costly. You need somebody in-house to hire with the expertise that really understands it and is able to help with setting everything up. You need the external counsel.

We've got folks in London, Brussels specifically to deal with a lot of the EU privacy matters. But when you're bringing those experts in, you've got experts from all over the fees, the legal fees on it, just climb. Right. And it's like for these early stage startups, it's, it's a real barrier. It's hard. Yeah. And those regulations, you know, so if you're some giant tech company with a billion users, it's, you know, chump change for you. You've got a whole legal department. You got outside counsel. But yes, for a startup. And this is why really taking security seriously and only storing and keeping what you need. And, you know, my, my lord, like, the more data you store. just because the data expense has gone down dramatically over time in terms of storage cost and technical costs, the liability has had the opposite. It's gotten more expensive.

So, you know, I think that's one of the things technologists have to take to heart. Yes, it's cheaper and easier to store every little click that everybody does, but then the liability keeps going up. That's why some jurisdictions, you know, I remember in the early days of the Internet, France, that had some great regulations like, you can't store your phone bills,

like the phone numbers and who you called past a year or something because the French were just concerned about privacy, they were like a little bit weird that way, and I just thought, wow, this is something interesting there, like, do I need to store

every direct message, you know, because if it does come out, man, the liability could be very high. And hacking is, I guess, another piece of this. How often are startups coming to you saying, we've been hacked, we need to get a war room together here and think about what fines we're going to get and how's that been going? I would say, yes, we definitely see it. It's kind of part of the regular course. You know, the really big ones are the ones that are scary that impact

everybody, right? I think what was it? Maybe like a month ago there was there was a really big one. I think it was AT&T or something. Yeah. And you started thinking about the fallout. I mean, lawyers understand this because they deal with the discovery process. So understanding that everything you write in electronic communication, if it is stored, will come out in a discovery process.

You know, if you're a senior executive who's been deposed or your attorney, you understand this, but young people don't. And I've had to remind young people at startups because they will email me, you know, the least experienced person decides they have

a take on copyright And you're like, okay, you're 22 years old. You've got to take on copyright based on your experience on Reddit and what conversations you've had there. Great. You just codified it. And when we get subpoenaed, that conversation, the worst, most inarticulate, uninformed conversation becomes the center of the lawsuit. Yeah. And I think people tend to understand the email part.

like oh can you know like is it like sometimes they'll even ask like can you bless this email right like is it's okay to send out but then when i remind them about text messages like oh we don't have anything in writing like okay so you didn't have any text messages with so and so oh that counts because that counts well i think you know one thing that i hear a number of executive saying is we're going to have our data retention policy um and some larger corporations have changed are data retention policy, which is, hey, we're going to keep things for one year, two years, but we're not keeping things for 10 years. And, you know, executives, I always tell executives, the rule should be if a legal letter comes in, if a claim comes in, you know, not a lawsuit,

people send a letter first, or they hint at something in an email, that's when you pick up the phone. They have phones. And they're not recorded, and you could have a conversation with your attorney that is privileged and confidential, that is not transcribed anywhere. And this is something also for Zoom for people to understand because everybody is recording. I was on a board call the other day. Somebody was recording the board call. And I was like, whoa, whoa, whoa, are we recording? And then we've got the AI companion on transcribing. And they're like, yeah, that's my default. I'm like, not for board meetings. You just took our liability and made it 100x. that there's a recording of this board meeting.

So is the best practice? Don't record your meetings. Don't record your board meetings. I would generally not record your board meetings. Have your board minutes reflect what needs to be reflected. Sure. Yeah. That makes sense because in any kind of litigation that were to occur, every single statement, your intent doesn't matter.

It's what the opposing counsel can convince a jury if you did get that far. your intent was. Your interpretation of your intent is, you know, only half the battle. It's what the jury thinks of your intent. And, man, people have said some things, you know, that are wrong. And, I mean, at the end of the day, like, you want your board to have an open conversation and not be worried about, okay, if I say this, I'm thinking about that deposition. I'm thinking about litigation, right?

Like, your board members should be there to help you, to brainstorm, to strategize, and you may not want all of that recorded. All right, there you have it, folks. Tons of blocking and tackling, things you're going to have to consider. You always need to have great counsel. Work with, you know, work with a great law firm. That's what I do.

If I have a problem, I call Becky, and we solve it. We've had some great adventures over the years with chaotic things that occur. and, you know, it's great to take that chaos and turn it into tranquility and equanimity. If you want to hear all of the startup basics we've done this week and startups.com slash basics to see all our legal basics. And thanks to our friends at WSvr.com. That's their domain name Wilson, Sincini, Goodrich, and Rosati. What a great law firm. And we'll see you all next time.

Bye-bye. Thanks, Jason, for having me. And yes, names are always kept anonymous. confidential. Absolutely. There's your eye trunk folks to protect the guilty

in the court of law.