This Week in Startups - Legal must-haves before raising capital with Becki DeGraw | Wilson Sonsini Startup Legal Basics

Starting point is 00:00:00 All right, it's time for Startup basics. Go to this week in Startups.com slash basics. We're doing our legal basics with Becky DeGraw. We've done a dozen of these over the year. She's with Wilson Sincini, WSGR. They are premier legal advisors to tech, life science, all the great companies, funds, myself, a bunch of folks, just a great firm.

Starting point is 00:00:26 And Becky's a straight shooter. She does this work every day. It's done it for a little bit. And I wanted to talk today about kind of growing up as a startup. You do your notes, you do your safes, you're raising money. You don't have a cap table yet, but you got all of these loans and or promises for future equity. And now it's time. The moment has occurred.

Starting point is 00:00:47 You hit a million in an ARR, 2 million in revenue. And I don't know, Fred Wilson or rule off at Sequoia. Some David Sachs, Bill Gurley comes and says, we're doing a price round. We want to join the board. and it's time to grow up and convert all those notes. What do you need to do? This is like an elite moment for startups that most startups don't get to, yeah? Yeah, absolutely.

Starting point is 00:01:09 And thanks for having me in all the kind words, as always. And I will, I promise I'm not going to say this thing first to, you know, try to plug lawyers, but I will say get legal counsel involved, get them lined up and get them up to speed. That's one of the first things to do. oftentimes we'll get brought in. I'll be like, I have a signed term sheet. We are already behind the eight ball then, right? Like you really need to get your counsel, whether it's us or someone else, get them involved early.

Starting point is 00:01:40 Part of that process is just getting the company ready, right? Oftentimes, I work with startups day in and day out. I know that you don't have a legal budget to do everything perfectly from a legal perspective. That's fine. but at the preferred stock round, that's often the time of reckoning. That's often the time when it's like, okay, time to grow up, all the stuff that we might have done that wasn't quite up to par, you're likely to get asked to get it cleaned up now. So if you wait to get counsel until you have that term sheet in hand, you might have heard

Starting point is 00:02:16 us on other episodes talk about. It takes four to six weeks to close one of these things. If you have cleanup, just add. add time. And that could be weeks. It could be months to do whatever you need to do. So, you know, trying to get the council involved so that they can do kind of a pre-look. And we can do lawyers, not just us, but we can do these prelicks quickly. You know, we can kind of look at, hey, here's a diligence request list. Gather all of your documents. You come back with three things. I'm going to be like, okay, we're definitely missing some stuff here. Try again. Go look for this stuff.

Starting point is 00:02:53 And if the answer is we don't have it, okay, then we should start talking about how to put that in place. IP assignments, cap tables, vesting schedules, lots of little tickey, tacky, blocking and tackling items that you may have just missed. Now, we as an accelerator and as a, you know, early stage year zero fund, we try to educate people on this. But, you know, we see founders, they're strong-willed individuals, they might just sign a safe without counsel. They'll just print it out. I mean, you're seeing this more and more, I assume. And maybe they don't know what's in it.

Starting point is 00:03:30 Or maybe they change it. Or maybe the investor changes it. And they say it's a standard safe. But then they read the fine print and maybe the investor or the founder might have changed something. So I've had angels come to me and say, you know, I signed the safe. And then they find out that I had this one instance

Starting point is 00:03:47 where I won't say the name of the company. Obviously, the founder, pretty cutthroat founder, put in the documents, edited the safe to say, when we convert, we have the right to pay you back with this interest or something. And they just wrote it like in plain English,

Starting point is 00:04:03 we have the right to pay it back and that at our option, as opposed to where we'd normally be at the investor's option to take stock or to take their money back with interest. And they did an upround. They paid everybody their 1.7 or 1.12%. and they were like, wait a second,

Starting point is 00:04:21 I waited my whole angel career to hit a big winner. This was my big winner, and I got cash back. The opposite of what you want. And they came to me, Chicago, what's going on? And I said,

Starting point is 00:04:32 did you have a lawyer? Did you redline this? And they were like, what's a red line? Oh, my Lord, here we go. Like, this is 101 folks. And that's on the investor side where people put 50K or 100K into it

Starting point is 00:04:42 and didn't spend $500 or $1,000 on a lawyer to review the DAC. So what are the most common mistakes? or things in diligence people screw up that need to be cleaned up that are not, let's just say, so tickey, you could do it in an hour. Things that take more than an hour of lawyer time and founder time to get cleaned up, top three. Yep, easy. So cap table, IP assignment stuff, and employment agreements. Those are the ones because, so I represent companies about half the time and investors half the time. So I'm constantly flipping back and forth. And particularly,

Starting point is 00:05:18 particularly on your first financing. Almost every single investor out there is going to look at those three things. Okay, you don't have the perfect contract. You didn't get your privacy policy. You haven't filed for trademark. Your terms of service, you copied from somewhere else and even has their other name in there. Those are all things that will work itself out. Nobody's walking away from the deal from those. Nobody's saying, I'm not funding until those things are taken care of. There may be a whole, hey, let's figure out good governance and how we're going to do things on a going forward basis conversation.

Starting point is 00:05:54 But those aren't things that hold up closing. Cap table, IP assignment, employment agreements, they will hold up closing. So, like, on, let's start with like the cap table stuff. You know this as well as any investor. You want to know exactly what percentage you're getting. Not about 10%. I want 10.76%.

Starting point is 00:06:14 That's what I'm expecting to come out of this. Two decimals, please. right? Like, we know it. Like, the cat table has to be perfect. It has to be pristine. And you want to know who, they want to know who each item is. Like, so when they see, we do this ourselves at, you know, the incubator level, because we do our little mini diligence and we give them like, here's the grown-up diligence. Here's our mini diligence of what we need. Just so you know, and we'll find somebody in the cap table with 17% ownership. Who's that? And oh, that was the company that built the 1.0 of the app we made that we pivoted away from because we started

Starting point is 00:06:48 as a dating album. I'm like, I didn't know you started a dating out. Oh yeah, we started a dating app. We got sued. And then we pivoted. I'm like, whoa, whoa, whoa, whoa. Where's the lawsuit? Who built it? Who's the third founder I never met? Like, this is the kind of stuff that could kill a deal. There's a third founder out there. There's a legal letter hanging. You pivoted and there's an IP assignment for, you know, missing. Okay. You're a venture firm. you're going to join the board, you're going to own 20%. You don't want to catch a knife. You want all the knives put away neatly in the draws,

Starting point is 00:07:22 not falling from, you know, five feet onto my foot. I can't tell you how many times we have seen a very similar situation to what you just explained. And then when we start digging into it, you know, we'll say, okay, so where's the documentation behind this? They'll say, okay, here's my cap table. I'll say, okay, can you pass along the board consents and the stock purchase agreements?

Starting point is 00:07:43 and then they'll send like an action by incorporator. I'm like, no, no, like the actual like stock purchase agreements and where did the board approve this? Oh, we don't have any of that. I'm like, okay. Well, then we don't have a cap table. That's what we don't have. That's hard because sometimes you may say like, oh, I downloaded this from Google and the document's really bad and it's got blanks and stuff. At least you have a document and we have something to go from. When it comes to stock, if we have nothing, that's even harder because there is no valid issuance,

Starting point is 00:08:17 which means you might have thought that you bought your shares a year ago when the company is worth nothing, but because we didn't actually have the board of proof it and we don't have a valid issuance, that means we have to issue you your shares today. And now you have a term sheet in hand that says the company's worth $20 million. Uh-oh. Tax people getting involved now.

Starting point is 00:08:40 Uh-oh. Exactly. So then it's like, okay, we got to figure out what the valuation is today. We got to get tax involved. There's going to be a bigger payment. The cleanup that goes along with that just gets messy, particularly because taxes are real dollars in that situation. Turns out the IRS, they're not like a loosey-gous creative organization.

Starting point is 00:09:07 They're kind of. buy the books and kind of by the books individuals and if you owe them something they're going to find you and so this is where like being educated especially as the two or three founders on vesting schedules and issuance of shares

Starting point is 00:09:25 and maybe even buying your shares and setting the clock on capital gains it's this stuff can be mind-numbing you may have to have it explained to you three or four times but you know what you'll get it either on the second third fourth or fifth time you'll get it There's lots of articles online. And so you can do your own research.

Starting point is 00:09:41 And then when you get to, you have counsel, you know, you may start with some friend of yours counsel who does it for $300 an hour. But eventually you might have to clean stuff up. And it's kind of the job of founders to learn this, I'll call it 20% of the job of starting a company. And you know what? It's kind of like if you were in a restaurant, or you watch this TV show The Bear, Becky, ever? Uh-uh. Watch this TV show The Bear.

Starting point is 00:10:05 It's just a wonderful television show. But, you know, if you work in a... in a kitchen, you know, you need to know how, you know, some of the basic sauces work and how the front of the house works, how the stove works, how the temperature works, just even if it's not your station or whatever it is, it's just good to be well-rounded and to understand the basics. And that's why we do this series. It's just so you understand those basics and just take a little joy in learning it. It's like, it makes you good at your job to understand how to clean the oven properly and

Starting point is 00:10:34 how to set the temperature in the walking box and what certain sauces are and what. why they're considered the quintessential base sauces. Like, just learn the basics, understand it. Even if it takes an extra hour or two of your time, it's well worth it. Yeah. Oh, yeah, absolutely. And I think just what you're talking about with the lingo, too, right? Like, when you get in that investor meeting, they start throwing around, what's you fully diluted, and, oh, are we talking pre- or post valuation? Like, if you haven't heard these terms or have some familiarity with them, you know, you're going to be at a little bit of a disadvantage in that initial negotiation. Now, we can come back and we can help and, you know, get you up to speed and all of that. But doing a little bit of the

Starting point is 00:11:13 pre-planning in that regard of how are these, how is this process going to work? What are some of the terms that are going to come up? What is a liquidation preference? What are people talking about with that? Like, just having that basic understanding when you go in is at the end of the day, there's a whole lot of other things you're going to be talking about and negotiating. Just having, like, I can understand the things that the investor are saying, I think is really helpful for founders. I just love founders taking out an Excel or a Google sheet and actually building their cap table from scratch, ground up and understanding how to do a couple of formulas and just understanding how dilution works. One example comes up all the time, oh, you don't have a stock

Starting point is 00:11:53 plan for employees. You don't have your e-stop, employee stock option plan, ESOP. Okay, I remember them explaining to me. Okay, when does, when do we create the ESOP? I'm like, well, what does that matter? We're creating a 10% thing. Well, who's, if Sequoia just bought 30% of the company and then you do a 15% ESOP, they're going to get diluted 15% once that gets distributed. Okay, so they want you to do the ESOP before they invest. So it only affects the 100% the founder's own. So the founders are taking their shares and they're carving out the ESOP.

Starting point is 00:12:29 That one decision could be extremely meaningful to everybody. It might be one of the most meaningful moments of dilution you have outside of financing grants, correct? Yeah. And to that point, one of the things that I also encourage companies to do in that pre-planning stage is to put together what we call a pro forma cap table. It just means it's your cap table today, but we're going to project out what it's going to look like after a financing comes in. So we can play with some numbers, you know, and it can be toggles of like, here's the percentage of whatever your option pool is going to be. are going to ask you to have one. So we know that's, that's a given. That work is not going to be not used, but this will help founders really start to understand, particularly if you have, you mentioned earlier. What happens to those safes and those convertible notes that you have? It's hard

Starting point is 00:13:18 to visualize, if you haven't gone through this before, you know, as a startup of like, okay, I've got these convertible notes or I've got three different rounds of safes. I've got one from friends and family, one from an accelerator, incubator, one from angels. They're on different. terms, what do they convert into? Oh, I got this new pool. And then I have the actual financing, the preferred stock financing that's going to come in. Okay, quiz, what percentage do you own now? I don't know, right? I mean, like, that's a lot of variables to just map out in your head if you haven't done this before. So putting together that performer. You might not be able to do it in your head. And that's why having the ability to do this yourself, there are plenty of online

Starting point is 00:13:59 tools to do it. You know, every YC or Techstar's class, some ambitious person, learns this and makes a calculator. So you type in cap table calculator and then every single service provider out there who has cap table management will have all kinds of pro forma. But what I like to do is ask the attorney is, okay, we're talking about a sale. You know, I'm on the board of this company. Great. What's the sell price? What are the terms? Great. Let's see a pro forma and show me what everybody gets paid. And man, the founders don't ask for this. I think in some cases they're scared to see what happens and how little they get if they've raised 30 million and they sell for 50 and they have liquidation preferences and all of a sudden it's like,

Starting point is 00:14:37 huh, you did participating preferred, you raise 30, okay, and now all of a sudden, wait, is there any money left? Oh, wait, there's no money left. Oh, wait, there's no money left. Okay, what do we do here? And then bank debt and transaction fees and all of that, like has got to come out of there. Yeah, and you got closing costs or whatever. Oh, and there's some cash left in the account.

Starting point is 00:14:58 How much cash is left in the account? What happens to that? So running M&A scenario, also like a really nice thing to do sometime with your management team. So everybody sees what your actual goals are because I was on a board one time. One of the investors lost faith. They want to sell their shares. They just want their money back.

Starting point is 00:15:20 They all of a sudden made that decision. And the founders want to keep going. So much money had been raised. The market was so bad that it would have meant the management team got nothing. And so I said, hey, if you're agreeing with them to sell the company at this number, you do realize your five years of work is nothing, and then the acquiring company is going to want you to sign up for a two or four year thing.

Starting point is 00:15:43 So it's going to be seven years of your life to get seven years of salary and maybe a little bonus from the new company, but they'll probably fire you anyway. So in that case, you might want a carve-out. So do you want to negotiate a carve-out with me now as a board member? They're like, what's a carve-out? And I said, you know, like, listen, I'm doing this for my own reputation management. And because I love these founders, you should ask for a 30% carve out.

Starting point is 00:16:09 Whatever the company gets sold for, you get, if it's a $50 million sale, the management team gets $15 million, no matter what. Carved out for the management team based on performance and their equity plan. And that will at least keep some hygiene here for you to stay. Because I'm worried you're going to quit. And then nobody gets an exit. Now, of course, this is where the dynamic of your board composure comes into play, yeah, Becky.

Starting point is 00:16:34 Of course, yeah. And also, like, what is that, depending on when you're negotiating that carve-out, are you negotiating in connection with a down-round? And what's the next step? Are you using this down-round? Are you using this bridge financing to get to a sale? Are you using it to get to the next step? You know, like, if you're using it to get to a sale,

Starting point is 00:16:58 which we do see often, right, some sort of bridge to a sale. It's like, okay, what don't we really expect that sale to look like? And putting together that waterfall to know common, are you going to get anything from a sale in that range? You may have hired bankers and they're telling you this is the range that we could expect to see. And okay, we're on board with that. But then once you start all those deducks, they're like, oh, what am I getting? Yeah, 5% of the bankers with a minimum of 2 million. you know, then you have legal fees, accounting fees, whatever it is.

Starting point is 00:17:30 You know, that's another million bucks. And then all of a sudden there's 30 million an overhang. Oh, some people, there was a note that was done with, you know, a 3x liquidation preference on it. And that was a 2 million notes. And now that's $6 million's got to come off the top. You just start having all this stuff happen. And the waterfall shows the water being money and how it flows down everybody's agreements. And, you know, just make sure you understand that.

Starting point is 00:17:55 And that's where alignment comes in. And it is one of the strange things. If you make it to an IPO and everybody converts nicely into common, that's why that exists, right? Am I right in the history of that? That's just, hey, we all get to the finish line. Everybody's shares are the same. We all get to sell our shares or hold them.

Starting point is 00:18:14 If we want to keep being Spotify shareholders, we keep being Spotify shareholders, we want to clear whatever your personal preferences. But in any other scenario, this waterfall really is meaningful. It really is. And oftentimes, you know, again, depending on what the board dynamics are and who's represented, have the founders been through this before, do they even know to ask for these types of things? It is. It's understanding what's the goal of where we're going to go.

Starting point is 00:18:44 And if we end up there, what does that look like? And what should I be asking for today? And those are really important. And as a founder, you're feeling like you're not getting the right education in that moment. Talk to somebody else. Talk to. You know, if you don't feel like your board members are the ones that are there, like, reach out. There's a whole network of folks to get educated on. What should I be thinking about? This is where your counsel matters, you know. And we say this all the time. Your counsel is going to matter in these kind of situations. Because I will tell you, there is somebody at that late stage venture from private equity fund that dips down. or whoever. And they got four wonky, you know, MBAs doing all these scenarios, explaining it.

Starting point is 00:19:30 They're spending an hour talking about it before they get into the meeting. They're spending a half hour on text, knowing exactly how much. And then the founder is at a disadvantage because they don't have that team. And they haven't done 12 transactions in the last year and had these discussions. Now, a venture firm has to do that. They have LPs. They have to protect their interests. So, yeah, they're going to look at the totality of their portfolio for Fun Fod.

Starting point is 00:19:53 and say, you know what, let's just get our money back on this one and return it to our LPs because we're already in the money and we get 20% carry on everything going forward. So even though this is only going to be 10 million back, we're getting 2 million of that because we're already over our hurdle for our venture firm. Now, an entrepreneur has no insight into that, zero insight into that. That they, by just getting their money back, they're making $2 million or something, you know. Really important for you as a founder to run these scenarios, have great counsel. and to get educated. Just look at this as like your chores. And you know what?

Starting point is 00:20:28 If you got kids, you want to teach them to do chores, these are the chores. You know, you got to do your chores. Somebody got to empty the dishwasher. Somebody got to load the dishwasher. Somebody got to clear the table.

Starting point is 00:20:38 Just call it what it is. These are chores. They're arduous. They're painful. You know what? You get good counsel. You got a good accountant. It's going to be a lot easier.

Starting point is 00:20:45 So do the work. Becky, you're amazing. Thank you for countless, countless weekend, late night calls to clean this stuff on behalf of of the launch funds founders and all the other founders out there. You're awesome.

Starting point is 00:20:58 Everybody go to this week in startups.com slash basics. Thanks, J-Cal. Really appreciate it. Always good to chat with you about these things and hopefully founders can take something away from it and avoid some pain that we have seen with others. Absolutely.

Starting point is 00:21:13 You don't have to make the same mistakes as everybody else. We'll see you next time, everybody.

This Week in Startups - Legal must-haves before raising capital with Becki DeGraw | Wilson Sonsini Startup Legal Basics

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