This Week in Startups - Market dynamics, RIFs, and AI’s role in law with Becki DeGraw | Wilson Sonsini Startup Legal Basics

Episode Date: July 27, 2023

Today’s show: Wilson Sonsini Partner Becki DeGraw joins Jason on the latest edition of Startup Legal Basics! In this episode, they discuss the contrast between late-stage and seed-stage investing (2:52), repricing stock options (5:48), the adoption of AI in the legal industry (23:29), and much more! * Time stamps: (0:00) Wilson Sonsini Partner Becki DeGraw joins Jason (1:19) The increase in tech layoffs and AI startups (2:52) Late-stage vs. early-stage investing and the seed-stage value chart (5:48) Repricing stock options when underwater (14:05) Disclosing revenue, burn rate, and growth rate (18:08) RIFs and knowing your employees (20:57) The long-term effects of remote work (23:29) The use of AI and chatbots in law * Check out Wilson Sonsini: https://www.wsgr.com * Read LAUNCH Fund 4 Deal Memo: https://www.launch.co/four Apply for Funding: https://www.launch.co/apply Buy ANGEL: https://www.angelthebook.com Great recent interviews: Steve Huffman, Brian Chesky, Aaron Levie, Sophia Amoruso, Reid Hoffman, Frank Slootman, Billy McFarland, PrayingForExits, Jenny Lefcourt Check out Jason’s suite of newsletters: https://substack.com/@calacanis * Follow Jason: Twitter: https://twitter.com/jason Instagram: https://www.instagram.com/jason LinkedIn: https://www.linkedin.com/in/jasoncalacanis * Follow TWiST: Substack: https://twistartups.substack.com Twitter: https://twitter.com/TWiStartups YouTube: https://www.youtube.com/thisweekin * Subscribe to the Founder University Podcast: https://www.founder.university/podcast

All right, with me again, Becky de Groff from Wilson-Sacini. Becky and I have been through many legal adventures. Some of them were a lot of elbows being thrown around. Becky and I, down there on the paint, pick and roll, trying to defend ourselves from craziness. Other times, it's just we're shooting three-pointers. Everything's going in. Sometimes you lose. Sometimes you win.

But you always want to have a great legal coach on your team. And that's Becky for me and my team. Thank you for all the late nights and weekends when we have to get on crazy phone calls, especially the last couple of years. It's been crazy. 2022, balkers, 23, less bonkers. And it's kind of high and low right now. Seeing so many great young startups at reasonable evaluations, taking their time and being thoughtful, having reasonable expectations of valuations and deals getting done. green shoots everywhere for me as an early stage investor.

But oh Lord, my late stage portfolio is, it's literally like I go from tending this beautiful garden, Becky, and then now I'm in like a war zone and bombs are dropping everywhere around me. It's like picked the day. You are not alone. I'm not alone in this. What's life been like for you these last six months when all of a sudden AI startups and everybody can't, you know, Google, Facebook, Twitter, everybody's laying off. And we know what happens when that happens.

Three or four people start sitting around a cafe and say, hey, maybe we should start a company since so painful to work at some of these big companies and they're not hiring anyway. And now we have all these great new startups. The process has renewed itself. That's right. And we're right. The cycle begins again, right? But yeah, I think that's exactly right.

And we're seeing a lot of activity in that seed and age stage where you've got really experienced talent that would typically be at perhaps one of the big tech companies. And they're not. And they're deciding to do their own thing now. And that's always been the case. But I think it's been a little bit more of a foreseen function of getting kicked out of the nest maybe a little earlier than what they thought they were going to to do that. And, you know, I mean, it's, it's there's a lot of doom and gloom out there. like if you read, you know, any of the blogs and look at the stats of, oh, it's down, it's down, it's down. It is absolutely down, as you said, in your later stage portfolio, don't get me wrong.

The deals aren't really happening. The valuations are down. Lots of doom and gloom on that side of the equation. But on the seed side, it's actually still really, really hot, especially, yeah, I mean, that's kind of its own bucket. Little bubble. We'll put it by itself. We'll put it by itself. A little mini bubble.

Frothy, I think that's a good one. Like a cappuccino. Yeah. But on the seed side, you know, like pre-money valuations are actually up. Like if you look at the data, like compare and that's like even compared to what I call the frenzy, right? The funding frenzy that we had like that really began and like the latter part of 2020 and certainly rolled through all the 2021 and a little bit of early 2022. things were crazy. Things, like, if you look at quarter over quarter, year over year numbers and you're looking

at, okay, how does 2023 stack up against 2021? Yes, we're going to be down. We're going to be down like crazy because that was such an outlier in terms of where the numbers were. But some of those late stage correct were almost like IPOs. I mean, so there's a lot of big numbers in there. When you see those charts, you're like, oh, my God, it's down so much. The number of deals is not going to be down.

as much as the dollar amount per deal. So you might not have some $300 million or $600 million investment happening in some late stage company that everybody thinks is going public next year. Yeah, yeah, that's definitely true on the later stage stuff. On the later stage stuff, on the seed and the A, you know, I mean, like, those are, those are pretty consistent in terms of like the dollars being invested in those, those companies. But the valuations are holding, you know, even compared to that, that frenzy, there

they're kind of holding. And when you compare it certainly to kind of pre-francy, we're up in that market. So that market is doing, you know, really, really well still. And there's a lot of activity there. We'll have them pull up a chart here for a second. This is a chart that just shows the seed deal value in billions of dollars.

Angel deal value, you know, sort of stacked on each other. And yes, if you go back. to, you know, we were just to draw a line, Q1 of 2023 is going to look, you know, pretty comparable to where we were in 2018, 2017, right? If you just draw our line straight across, and really the abnormal part started in 2020. 2021 was really weird. 2022, also a little bit weird. And we're just normalizing.

So that slope from the peak, yeah, it's gone down. It might go down again, but we're seeing great companies. And if you were to draw the average line here, it probably would go from 2013 at $1 billion, just straight to, you know, like the $2.5.3 billion level, so per quarter. Yeah. And we also, we published what we call our entrepreneurs report. You can grab it off from our website. But we go through and we kind of look at the quarterly and the annual stuff and do a bunch of comparisons, have some charts in there. And we try to summarize like the high level financing trends. If anybody is interested in that, take a look. Yeah. And so when in these later stages, you know, when you're starting a company, you got a nice clean slate, everything, fresh documents, there's no stack of liquidation preferences.

There's no preference stack of, you know, somebody who invested in 2018, 19, 20, 2021. No, that's conflicting. So that's super easy. But one of the things you do have to deal with with these later stage, and even, even some of the mid-stage ones is if they're going to do a down-round, you know, just figuring out how to reprice options because people might be underwater. And so people got their stock options. They were given a strike price, a price at which they could buy a share of the company. As an employee, I'm the CFO. I'm the head of growth. I got a million dollars in shares.

I got a half million dollars in shares. I was to pay a dollar for them. But now the company's worth less than a dollar, so now everything's underwater. How does one deal with that mechanically legally, tax implications, everything. Yeah. And I will say we are seeing a lot of these right now. And it's just that, right? That scenario that you mentioned of companies raised at a really, really high valuation. And even if they haven't done another financing that was a downround, like certainly

if you did a down, if you did a down round, your valuation, your 401A valuation that's used to price your options is going to come down as well. But even some companies that haven't actually gone out and done the raise are being impacted. They have to get these foreign and A evaluation reports every 12 months. And just given the general macroeconomic factors that are out there, some of the valuations are dropping. And dropping fairly... Percipitously. Exactly.

Dropping fairly significantly. Yeah. And so we are seeing this a lot right now. I will say if you're in the bucket in that category of, I might need to do this, it's a good time. You're not going to get a lot of PR about it because everybody is doing it. So you have the old air cover. I guess Stripe went through this. I don't know if they're a customer year,

so I have to be careful here. But we saw Stripe and some other companies say, hey, we were worth $100 billion, now $50 billion. I think it's the mature thing to do because it's good for employees. If the employee strike price is too high and they're underwater, it's not, it's hard to keep them insented because the savvy employees, the top people and the company have been through this before.

Maybe they worked at Google and before that they worked at Microsoft or Amazon. So they understand. a 409A, the value of these shares, they understand the market's changed. So who drives this at a company? I'm always interested in which party drives this. Is this HR, the board, the CEO, or maybe the management team saying, hey, this doesn't quite seem fair. The people who came here at 2018 are in at one penny. We're in a dollar. We know the 409 says 50 cents. Like, I need to get my options repriced if I'm going to stick around here. Yep, exactly. It's usually the management team.

that drives it. And, you know, a lot of times they're, they're interested in driving it because they also have, you know, grants that are at the higher price. So, you know, the first thing would be to get a, you know, get a fresh 401A evaluation report so that you have something from an independent valuation firm that you can say, yes, this is the value of the company and say, okay, we have options that are out there priced at a dollar per share. This says it's 50 cents per share. What are we going to do about that. What you want to think about in that scenario is like what are the goals that you're trying to accomplish with with a repricing? And then from there, you can back into all the various decision points that you'd have to make. Like, who gets to participate? Is it just current

service providers? Are you going to offer it to former service providers that may still have options that are outstanding? Is it all employees and consultants or just employees? What if you have directors and officers that have, you know, underprice or underwater options. Do they get to participate? So kind of depending again on what is the goal coming out of, out of this? So the goal, ostensibly, would be to keep talented people at the company and not to sound like a marauder, but if you're no longer at the company, most people would say, that's not our issue. They're no longer here. They're on their own. So if you left the company on your own accord or We laid you off and you're out a dollar.

Should we take the time to do this for you? And the only reason to do it would be PR or to be a mensch, I guess. I'm trying to figure that out. And so most boards would have some sort of conversation like, oh, we really care about everybody's there. But we don't have to do this. So we're not going to do it. I mean, that's what I would, that's what I've experienced. Yeah, absolutely.

And it almost always is current service providers, you know, whether you pick up the consultants, too is a question as to who is included there. Really, the only time that boards really stop and pause and say, should we offer those to former folks, and that's usually in the RIF scenario, right? Where we just let go a lot of people and it was kind of sudden and should we give them a little something extra to maybe help them exercise their option grants before they expire and they lose the opportunity to exercise them. And this is where fairness comes in.

because it's a special circumstance. So these aren't people who were fired or left. They weren't fired for cause. They didn't leave for a better opportunity. This is in between those two. We did a riff because we were trying to save money as we talked about in a previous episode.

That one sounds to me like a logical thing to do. Okay, they were priced at a dollar. Maybe we put them, we give them some relief here. And then they just get a letter to them that says, by the way, your options are now repriced or something signed this piece of paper

to be repriced? If only it were that easy. And this is where I get more complex. Okay. Tell me. So one of the big decision points after you figure out who is do the participants have to give anything back in return? So are we just going to say your options were a dollar? We're going to just reprice them.

And magically, they're now 50 cents per share and that's it. No changes. Anything else? Or sometimes it's coupled with, okay, I'm going to give you that. but in exchange, maybe you take a haircut on some of the shares that are subject to the option. Maybe we extend the vesting on some of... Oh, we get to keep you around a little longer.

So we'll put these down to 50% but you're going to need to vest them over instead of two more years, we're going to put it back up before. So life's in negotiation, we're going to reprice this and everybody's best interest, but we want a little more commitment. That makes sense.

Yep. So a little, you know, quit pro quo there is I'll give you this. You got to give a little something too. if you have that that type of structure in place, then you will need to get the participants to opt in, right? You can't unilaterally say, I'm going to do this to you. I'm giving you a good term, but I'm also taking something.

Ah, they have to opt in. So that they would have to opt in in in that scenario of like if we are going to say, we're going to extend your vesting or we're going to ask you to give back, you know, some number of shares. So they could keep the original deal or take the new one. Yep, that's kind of the idea. behind it. Then there's somebody at some cap table software company or a lawyer with a spreadsheet who has to then maintain a list of who's on the new deal and who's on the last deal. This is

mechanically a bit of work for the CFO and or law firm. And the other piece that goes into this is you probably have more than five or ten people that are impacted by this. If you're talking about these later stage companies, right? Maybe there's 50, 100 folks that, you know, may fall into this category, when you are making that offer to them, that basically is covered by what we call tender offer rules. And anytime you're in tender offer land, it just means we have more disclosures that we have to do to those stockholders. And we have to keep the offer open to those optionease, in this case, not stockholders, but optione is for a period of at least 20 business days. So there's more process around it. There's like an actual whole formal process that has to be followed with this

disclosure and this opt-in. They have like an election. They have to sign. So they have to be informed to make a rational decision, which means you have to tell them your revenue, maybe how much you're burning, the growth rate. Is that right? Some amount of data. And that's where it gets into the little bit of the gray area. Like certainly if you're a public company, it's really clear what you have to do on the private company side. It's less clear as to what you have to provide. And that's where, you know, really understanding the very specifics of where you're at with the business, what you're asking them to do may also determine how much, you know, disclosure is comfortable or not. So definitely a little bit of a gray area, but that's a whole topic

of conversation and something that lawyers will need to prepare and go through that tender offer process. I will say, all that said, not very many right now in this environment are asking for something in return. Most are just saying, you know what, we need to keep you. This is a huge step down. We're just going to give you the 50 cents in our example. Makes sense. Life is hard right now. People are fried. Post-COVID, post-market correction. You know, it's been a lot of seesong. I think everybody could use some normalcy and getting a nice little thank you.

You know, somebody's sending you, you know, a little ice cream, you know, in that little frozen container. Somebody sent me a celebrity, sent me some ice cream. And I was like, Hassan, Minaj, sent me ice cream after I went to see a show. And he sent me this beautiful box of Jenny's ice cream. And I'm like, you gave me tickets to your shop. But I just always thought like, what a classy guy, right? And this is a classy thing for a board and for the founders to do for their management. It's classy.

It's unexpected. It says a little ice cream. It's a nice thank you. Send in somebody a box of chocolates and just do the right thing in this. And so for management teams that want to broach this with their, the way to do this is not go to the board, but to go to your founders. The CEO and CFO and say, hey, you know, as a group, we're underwater. we listen to Becky and J-Cal discuss this on this weekend startups. Here's the video.

Any way we could maybe be thoughtful about this process, you want to be gentle there because you don't want to come across as being like union leaders or, you know, being aggressive or agro. You want to have it feel constructive, yeah? Yeah, for sure. And there is no good D-goes unpunished. That goes along with this too. If the company just gives it.

away with no consideration received, there is a potential corporate waste claim that could be made. So there's fiduciary duty considerations that need to happen and have the board talk through what are the justifications and why should we be doing this. Even if we do that where like, I'm not asking for anything from you, if folks hold an ISO, an incentive stock option that only employees would hold. If they hold that, basically, this is, every pricing of that would be considered a re-grant. It's considered a modification. So what that means is we basically have to reset the holding, the, the, the, the holding period for time, from time of grant to receive the beneficial tax treatment. So there is a little give there, because depending on how long these ISOs have

been outstanding. Long-term tax treatment versus short-term. And just whether they qualify for that better ISO treatment upon exit. So there's a lot of, there really is. It's why I was like, oh, if it's only that easy, we just send you a note. Yeah, I mean, so now the board's got to decide, hey, as we've talked about in previous episodes, hey, we got a certain amount of runway, we got to do a down-round. Where do we even prioritize this, right?

and we've got to keep this company up and running, and we've got competitors, and we've got this AI threat. And this is, you know, what makes our lives so interesting and it's great to just have awesome counsel with you along the rides

with these riffs, just as we wrap up here, has there been, just broadly in the industry, not talking about your specific customers and clients, this is always general, just, you know, me and Becky,

just, you know, chewing the fat, discussing the broader topics we're not talking about any specific companies. Have the rifts caused blowback? And what have we learned anything about, like, how to do them as a best practice? Because I don't think I've ever seen at-scale rifts like this at big companies. Obviously, these small companies go out of business, but this has been a lot of riffing, I must say.

There have fun. And I think, like, that air cover is a good analogy here, too, you know, like when a company does a riff and they're kind of the only ones doing it. They catch a lot of heat from it. Like, oh my God, what's going on over there? We're seeing very widespread. We're seeing multiple rounds of riffs at very respectable companies. So that is happening. I mean, it's a difficult area right now. I would say one of the most difficult things is because of COVID, we have had our workforces remotely distributed employment law, and that's the including riffs, is governed by the state where the employee is located.

Oh, my Lord. So I would just, I would say, if you're doing a massive RIF, get an employment lawyer involved. You can call me and I will get an employment lawyer involved. That's not my area of expertise, but I know enough to know, like, you really need somebody to hold your hand. One of the things I learned from this process was that some startups and mid-sized companies didn't know where their employees were. So employees, you know, they didn't tell employees they could move, but then they found out, hey, you know, this employee's tired all the time. It's like, yeah, they're on a different time zone. They're six hours ahead. Four hours behind. They were no, literally, people went to Hawaii. People went to, you know, London or Italy. And you're like, yeah, you know, you got a background that's blurred or whatever. It's one thing. But, you know, you start to see Florence behind. You're like, what time is it over there? 11 o'clock at night? You're working? And this then leads to employees. tax,

jurisdiction issues and how much you have to give in severance and the process. And then also some employees, I think, were not very thoughtful about this either. And they're living in a different country. They're not considering their visas,

their taxes, et cetera. So people kind of freelance this a little bit. It got a little loosey goosey. It was a technical term in the business. Yes. I would say that that definitely took place around the employment situation

over the last couple of years and still has having impact now. with most recent topics of RIFs. And then this long-term work from home, I mean, we all have feelings on it just personally. Like, I do like to be at home with my kids sometimes. I do like to be able to go to Tahoe and do a little skiing. A little extra skiing is always nice.

But I also, I'm going back to an office because I want to be with people a little bit more. Putting aside our personal preferences, as terms of best practices and then legal processes, what's changed for startup founders? is it really about having like a great personal employer organization, PEOs or a great provider to help you with that on the technical science? Or how are law firms dealing with this?

Is this becoming like a practice internally where you've got to start up with 20 people? And you're like, my lord, employment agreements have to change because we have people in Japan, Florence, you know, and Hawaii and, you know, wherever. Yeah. So your offer letters, your employment agreements, your IP assignment agreements, they're all governed by the state where the individual is located. So the California form is different than New York, right? Like New York can have a non-compete in it. California cannot. Otherwise, it's invalidated. Certain states require certain things to be included or not included. So that was a pain point for a lot of clients, particularly startups, of like, I have somebody in Montana and now I have to pay. my law firm to put together a custom form for one person in Montana. Well, but we did. We are always trying to kind of push the envelope a little bit on the innovation side of things. We have a platform. It's called Neuron where we're trying to automate a lot of things. And one of the first things that came out on that was in corporations. We do like board consents for, you know, option grants and some other kind

routine things, but what we launched earlier this year was actually a 50 state employee consultant onboarding process where if you're a client, you can go into the neuron platform. You can say, I want to hire an employee in Montana and here's the information. You can walk through online. It'll tell you, ask you the right fields. We have all of the templates now. And then basically, it's not a, basically think of it as a automation with a white glove service. Like, But there's a real person that will get that input and say, oh, there's a red flag here. I don't know if this is all great. Put it in the form and let's go.

So we specifically work to create that to deliver what folks need to just get people hired and have them on the right forms to not cause problems later. As we wrap here, how do you, the firm, look at AI? A lot of people are, well, let's take the first. out of it. Let's speak, just generally speaking, are attorneys using chat GPT and other AIs to, you know, are they playing with them right now? Is anybody using them in practice? And when you've, you know, played around with them, are you impressed? Are you in awe? Are you concerned? What's the, what's the general vibes, as the kids say these days? What's the vibes in the legal community about AI, not replacing lawyers, but augmenting lawyers?

Yeah, all of the above. Concerned, awe, ooh, scary. I'm impressed all that. So no, we are, and I will say, like, a lot of companies, including law firms, including us, like, have put out a AI policy. You cannot give legal advice based off from chat GPT. Oh, wow.

You have to remind everybody in your company. Just a reminder. That's not what we're... We're paying you, not open AI. That's not what we're allowed to do. We still has ethics and illegal practice of law matters if you do that. But that aside, right? It is kind of, it's fun.

Like, we definitely are playing with it. So I recently moved into the role of a co-chair of our emerging companies practice. And one of the things that we are focused on is like I was saying, like this whole innovation, automation, and we're looking at all sorts of stuff. And we are certainly looking at AI in terms of supplementing things that we can do. do as well. When I play with it myself and we have our chief innovation officer go through and play with it and kind of come back to the co-chairs and we have looked at it quite a bit. It's, it gets you, it gets you a much better answer than Google does, right? There's always going to be the little nuances, you know, like the high level stuff, it's doing pretty good at. And it's,

it's pretty scary. Like when I compare that to maybe like if I asked my one of my first year associates a question. Yeah. Chat. GPT is probably probably got a leg up. That makes sense. And ultimately, what my thesis is, we're going to see a lot more startups that are able to have more efficiency.

So they'll do more with less. A 10-person company will do the work of a 20-person company, a 20-person company, a 20-person company will do the work of a 40-person company. So I think we're just going to see a lot more startups because there's so many problems to solve. What happens in legal is it a lawyer can service more clients and charge less money for things that are de minimis to do, that are boring for lawyers. I mean, you guys are, you know, you're the top lawyer, so you're always going to have the top clients.

There's always going to be a lot of nuance for major customers and innovative customers. But, you know, I guess this impacts like maybe the lower end law firms, the more affordable ones. How does it shake out for the industry, do you think? I mean, I think it'll be a good thing, you know, overall, right? Like, there's a lot of stuff that for particularly for startup clients that is very routine. But man, it's got to be done right. Like option grants. Like you mess that up.

You have bad tax consequences. It's not like, oh, we'll just go back and ratify it now. Like, it's real dollars when you mess that type of stuff up. So we can, but it's very simple. Like once you, like if you follow these steps every single time, if you get it right, we can automate a lot of that. And we can kind of put in triggers to make sure the bad thing. the red flags are getting, you know, flagged and processed the right way. So I think, I think it's a good thing. I think,

I think the way that you said it is right is like there's a lot of things that you don't, you don't need to pay my hourly rate for. Like, my hourly rate is to provide hopefully valuable strategic advice about complex transactions. It's not a cheap hourly rate. I've seen those bills. Becky. But, but you want to make sure that the simple stuff, but you want to make sure the simple stuff is done right to. sure, which means, yes, we pass it down to the lowest level that we can, but why not automate some of it? And that's really where we're focused on saving some time. Because at the end of the day, like, we only have so much time. And we'd rather be doing the cool, more complex stuff, too, rather than, okay, you have 20 safes. Let me go in and type in each one of them and send them out. I mean, sometimes the work being done by lawyers is clerical data entry, double checking. And I don't know what percent. of a young lawyer's time that is, but it's got to be 20% or 30% wrote, something like that, I'm guessing.

Yeah. And we're basically trying to squeeze that to where you got to learn how to do it, but once you learn how to do it, let the computers do it. They're a little bit better with mistake. I mean, I don't know if you, I think you caught the tail end of this like I did. There was a typing pool. There was a messenger pool in the building. Did you catch the end of that where people were typing stuff up and there was a document, a photocopy pool and a document delivery service in the building or no?

I mean, we still have a document processing center that helps with various things, whether it's deliveries or couriers or whatnot, but it's in far less use than it ever used to be. I just remember coming in and installing the computers at like, I don't know if it was Cahill Gordon or Sherman Sterling,

somewhere in the 90s when I was storing local area networks and document management systems. And they were like, see this room where they photocopy everything and see this room where they type everything? Like, document management's going to get rid of all this. And I was like, huh, what are you going to do with all these people? They used to be like the mail rooms that some of these places were huge. And there was a person who would walk around before email with inter-office mail. There was a thing called inter-office mail. Did you catch the inter-office mail? you missed it. Yeah, I've always been on email, so.

Inter-office mail. I'm a little bit older than you, Becky. There was, you had envelopes, and you would write the number of a person's office and put the document in, and then somebody would walk around and pick up inter-office mail, and you put it outside your office in a little folder,

and a person would bring it to another floor and drop it off for somebody. And then you would cross out the person's name, and then you'd write, J-Cal, you know, room 512, and then you cross it out, Becky, room 617. That was email before you, All right, listen. That sounds like a nice, slower pace of life.

It was different. Yeah, you would be like, oh, let me run those documents up to you. Walk up, you get a cup of coffee, you drop the documents off, have a little chit-chat. Everything was, yeah, it was super slow and charming. Now everything is the speed of life. All right, everybody, go to this week and startups.com slash basics. Very simple to remember. This week in startups.com slash basics to see all the basics I do with Becky over the years.

So many of them we've done together just to help founders. We'd love to help founders. Becky and I both are aligned in that. And if you want a great partner, WSGR, Wilson, Cincinnati, great firm, my lawyers. Thanks, Becky.