This Week in Startups - Navigating Challenges in Distressed Companies with Becki DeGraw | Wilson Sonsini Startup Legal Basics

Episode Date: September 19, 2024

Todays show: Wilson Sonsini Partner Becki DeGraw joins Jason on the latest edition of Startup Legal Basics! In this episode, they break down challenges in distressed companies(1:04), pay-to-play scenarios (2:31), the importance of a market check in financing (9:25), and high-profile legal and ethical issues (18:03). * Timestamps: (00:00) Wilson Sonsini partner Becki DeGraw joins Jason (1:04) Distressed companies and VCs leaving the board; Challenges in distressed companies (2:31) Insider-led down rounds and pay-to-play scenarios (7:07) Legal actions and stockholder lawsuits in successful turnarounds (9:25) The importance of a market check in financing; Voting against board decisions (18:03) Character and incentives in the startup ecosystem; High-profile legal and ethical issues * 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 startup basics with my friend Becky DeGraw. She is counsel from Wilson Sincini, Goodrich, and Rosati, WSGR, as we call it. People say Wilson Sincini here in the Valley. Becky, one of the things we're seeing is distressed companies. I'm on the board of some of these, and this crazy moment happens when it's pretty clear that this plane is not going to make it across the Atlantic Oceans. and land safely.

To use a dark metaphor, it's not life or death, but all of a sudden, I look to my left and my right, and two VCs and an independent director just took their parachutes and jumped out the back of the plane, and I'm sitting in the cockpit with the two co-founders, and we've got to do something with this plane. So maybe you could talk about,

why do certain VCs just leave the board? Companies not out of business, but they're clearly struggling, and there's just like perception, hey, we're not going to make it. It's going to be a pretty ruffling. So let's talk about distress companies in that final six months. Yeah.

Now, unfortunately, we're having more of these conversations in this macro environment that we're in. But I think if you find yourself either as a director or officer in one of those companies, heading in that direction, your job becomes much more difficult, right, on a number of fronts. you know, anytime you start taking, taking actions, they're going to be looked at with greater scrutiny, right? Oftentimes, it's insiders that come to the rescue in turn from a financing perspective. And we've got insider led down rounds and recaps and these things because it's like, hey, you're running out of money. There's no other options. The terms get more aggressive, more punitive, more dilutive, higher risk for claims later. The other thing that goes along with that, right? We're, tend to be like more complex, more creative. Whenever you do that from a legal perspective, your legal fees start going up. And it's like, that's the worst time to have bigger and bigger legal fees. But oftentimes, you know, you start having more regular board meetings because you need to. You need to have a good record showing what you're doing, that you're paying

attention, that you're well informed, that you're looking at all of these things. But man, It takes a lot of time, a lot of resources, and starts pushing up. And to your point, some investors say, all right, I've already written this investment off. The whole point of me staying on the board was somewhat of an oversight function for my investment. If I've written it off and me staying on as pure liability, I think that's something to weigh, you know, from a company perspective. And that's when people pull the rip cord. It's like, we've written this down to zero. And it's going to take my time.

It's going to take energy. And these situations are 50 times more distracting. And they have a hundred times the bad feelings. Pay to play keeps happening. Maybe you could explain to the audience what this pay to play scenario is, this last ditch effort in some companies that creates massive bad feelings. And, you know, why people do it? and should they do it?

You know, what's your take here? Yeah, yeah. I mean, we are seeing more pay to plays, particularly in connection with down rounds. It's usually,

you know, the company needs money. Nobody else is coming to the table. The insiders are doing this, pointing to each other, like, are you going to go? Because I'm not going by myself.

I'm not going to carry, carry the full weight of this. You got to come along and help too. And some investors are like, I'm not helping. I'm not putting in, good money after bad money. And at the end of the day, like, the company needs, needs a certain amount of money, too,

to get to whatever that next hopeful step is going to be. So when we put a pay to play in place, we're essentially saying, we want you to participate in this financing, you know, for your pro rata. And if you don't, something bad is going to happen. There's all sorts of what we can fill in the blank with that something bad. But oftentimes it's we're going to convert your preferred stock to come and stop. And it may be not that we're converting on a one-to-one basis, we can start messing with that ratio, too. Say, for every 10 shares of preferred, you're only going to get one share of common.

And then for the folks that participate, they, maybe we pull up, we call it essentially like, turn that common stock back into to preferred stock. Again, it may not be a one-for-one basis, but that's kind of the general concept of the pay-to-play and why it comes in to place. This company needs money, and I'm kind of going to use a stick to force you to help support this company at this time. It's really rough. I've been in a lot of these situations the last two years, and I have never seen a pay-to-play-round result in a win for the company afterwards. It's few and far between. It's very risky as a permanent investor perspective putting money in at that point.

Yeah. And, you know, I think you learn, I'm going into my... second decade as an investor here. And I think what I've learned is if we are at that point, this is not going to work out. And so we really should be talking about a sale or a shutdown. But, you know, hey, founders might have a white knight and they say, hey, we've got, you know, a million in revenue, we've got a broken cap table, and this white knight wants to put a million in, and that million will get us to profitability. I want to keep going. You say, well, there's already $10 million in overhang in the company. And that's

that 10 million represents 40% of the cap table. Well, you know what? Of that 10 million, you know, each person who put in a million, now they're 10% of that new round, right? Or something to that effect. Let's say that if I were to do the math, that 10 million bought, let's say 20% of the company, each point would be 2%, or each million would be 2%. Therefore, you have to take 2% of the new round, which means if you put in 5 million, you've got to put in two times 5, 10, you're going to put in some money. to this next round in order to keep your shares

and if not you go to common and some people just might not be willing to do that. That fund is fully deployed or they just see this as super liability. If they are successful, have you seen people

or amongst your contemporaries other firms, other situations when you're chewing the fat and having a beverage after libation to drown the sorrow of some of these days that can go pretty long

you have double McAllen or whatever you're jam is, do you see legal action afterwards? Hey, you guys did this pay to play around. It worked out. It's one of the one in 50 or 100 that do work out. Hey, you know what? Maybe we'll send a couple legal letters and get our shows back. Has that happened? That was what I was going to say is the ironic thing. The vast majority, I feel like we go through all these efforts, the pay to play, the recap, whatever hoops, we might jump through the legal fees that it takes to do all of it. And then the company doesn't pan out right from there.

just say they are one and the few that do. And like, yes, success story. They pulled the rabbit out of the hat. They're doing great. That's the time when we start to worry about, uh-oh, are the stockholder lawsuits going to come because the stockholders aren't going to file a lawsuit when there's nothing there when the company did a nosedive, right? Like, you can't get blood from a stone. Exactly. So, but in the scenario where the company is actually, actually successful in turning it around, then you're like, oh boy, now I got to deal with this. And, that's where I will say I'm spending a lot of my time right now of having those conversations of the plan for the worst case scenario, well, plan for the best case scenario, which also might be your

worst case scenario from a legal perspective. And what are some things that we should be doing while we're going through this process to help mitigate those, the, the bad result that could come from that? And one of the things that I say to everybody, and that is one of the the most important things that you can do. And there's all sorts of different mitigation techniques or things that we can do, but have a good process. Make it the best process possible. Like, right, you can't, you may not be able to control the outcome in terms of like what the terms are and all of all of those, those things. But you can get everybody to sign off on it. And that is the keys to get this unanimous. So, hey, listen, you are not going to do the pay to

play, you don't want to participate, we get it, you're leaving the board, you need to sign a piece of paper that says you're leaving the board, and you need to sign a piece of paper that you had the opportunity to buy shares and you did not. Yeah, we would love to see all of that. And sometimes, right, like it's run a good process and make sure it's reflected in the board minutes too, right? So going out and doing a market check before you just, it's easier to accept the money from the insiders. I know it's a down round, but it's easier than me going out. and checking whether there's anybody else. Explain a market check.

I know what it means, but for the audience and for founders, what is a market check? Yeah. Yeah, so it's where you're, let's say you need to raise money. You actually go out and you talk to a number of investors. Maybe you hire an investment bank to help you with that process as well. And sometimes we see the companies that will do that and actually like right, you're talking to, you talk to 30 investors and every single one of them says, no, not interested. not even getting past first, first conversation, document that.

Like, I know, I know you don't want to air your dirty laundry, but that is so important to have that in the board minutes because it paints the story of this truly was a financing of last resort. The only people that were coming to the table were our insiders. We couldn't attract it from anybody else. And yeah, you know what? It was really risky and the terms were a little, a little punitive, but there wasn't anything else on the table.

I've had founders who come to me and they propose one of these things and it feels like they're self-dealing. And then I say, okay, who did you talk to for M&A? What bank did you hire? Who were the people? Where's the Google sheet that tracked all this? They're like, well, we had a couple conversations. And I'm like, great.

Let me know which ones you had. I want to see the emails from them saying they're not interested. I want you to document all that. And they're like, oh, well, yeah, you know, we, you don't trust us. And it's like, okay, let's not make this emotional, everybody. We're not in kindergarten. This is in high school. This is business.

And you need to document. We emailed these 30 investors. We followed up with each one with two subsequent emails. We got 10 meetings. We took those 10 meetings. They turned into four second meetings. Those four declined to invest at any price. These are the reasons those four people gave us of why they weren't investing.

And it's an addendum attached to, It's in a Google sheet somewhere. It's in a Notion page, whatever. I mean, this is not rocket science to do this. And man, does this cover you? And I have been through this so many times where, you know, founders do this. And I've been through it a couple times where founders don't do it. And then they propose, hey, their friends are going to put in 500K.

They're going to put in 250K. They recap the company. And I'm like, well, which investors did you talk to? Oh, you don't trust me? Oh, God. Trust but verify. And and I mean like it's it is real liability to the directors and officers that were watching that were approving like what you just said would be I would love to see that that that spreadsheet send it out to the board have the email have the board minutes say after reviewing the Google sheet that was about the investor outreach the board decided to do X. like that's that's like give our litigators a chance that's the gold standard you know and if it did

come down to litigation you have opposing counsel file or they you know you do some sort of phone call they write a letter and you say listen you know this is going to come out and discover do you have the board docs and they're like no and okay great let me let me share the board docs with you here it is um were you aware that this existed a google sheet with 30 targets and are you aware that they had second meetings with these four and these four said they were declining for these reasons. I was like, no, I wasn't aware on there.

Okay, great. So before you file, you should know that this occurred. And so these claims maybe are less valid or not valid at all. Yeah. And I mean, it may not be a complete get out of jail free card,

but it is one of the best things that we advise of like, again, we may not be able to control the terms as the company. Like, we may end up having to take some really punitive aggressive things. but at least at least control the process so that we can have have the best possible look there.

As a steward of capital, let me get free legal advice from you here. I've had a couple of situations where I disagree. And I've said, we are the launch fund with X percent ownership. This has happened, you know, five times in 400 companies, which, you know, have some number of rounds of financing. So we're talking about thousands of rounds of financing. I say, yeah, we're voting in a, we're opposed to this. So we're voting in a proposition to it. And the founder's like, really?

And I'm like, yeah, for this reason. We don't believe that this is, you know, we don't think you should be selling secondary and raising money. And we think you should have gone with the other deal that didn't have the secondary offering in it because we think it's bad hygiene. So we're voting against this. But we understand that we own 6% and, you know, whatever. You need it 80% or something to, and we're getting dragged along.

Like, oh, we talked to our council. They said you need to vote for it. And I'm like, actually we don't. This is how governance works. So maybe you can talk a little bit about. when you have somebody, like me, a conscientious objector who says, I just can't vote in this, or I'm going to abstain from voting, or I think I did abstaining once. And then I voted no, maybe twice in the history of what we've done.

It was pretty severe. I'll leave it at that. So what do you think of that situation? We have a board director who says, listen, I just can't vote for that. Yeah. I mean, ideally, from company and director perspective, is you have to have. have those conversations outside of an actual formal board approval. And you find a way to get to get there from a compromise perspective.

Like, I would be shocked. And I'd be curious to know in the case where you did vote, no, if the investor on the other side said, oh, yeah, cool. I'm all right with that still, if one of the directors that voted no. I think this was a spin out. You know,

they wanted to spin the company out. And the amount of equity they were giving. So there were like two products inside the company. The founders left to go do this other company with the asset from this company gave the existing investors like 20%. And I was like, well, what's going to happen to this shell of the company that we own 10% of? It's like, it's going to zero essentially because nobody's going to be here to run it. And I'm like, well, that seems profoundly unfair.

You just took the one asset and moved it over here. And then you got his own 80%, the existing, the new investors own 15%. They have previous investors on five? Why don't we just stay in this cap table and just shut. That other business done. Like, oh, well, because we won't own enough equity. We're like too much of an overhang. I'll say, okay, I vote no.

And you know, that's still hanging out there. And so to our point earlier, and I said no, because if our LPs came to us and said, do you allow this? I didn't want to have the liability saying I allowed it. I wanted to have on the record that I voted against it that there was an email that said, here's the reasons why. And if that company becomes worth a billion dollars, to your point before, you know, we would be able to then make a claim. Yeah, and I mean, like, there's the board vote and the stockholder vote, depending on which hat you're wearing, right, at the board level, you've got it, you're supposed to be exercising your fiduciary duties to the company into the stockholders.

And if you're like, hey, this is not a good thing for all of the stockholders for you to do some self-dealing transaction, then, then, yeah, right? Like, you got to speak up. I'm getting upset about it right now, back. You know me, I'm such a, you know, it's just, I don't know if it's my Irish Catholic I'm bringing in Brooklyn and my dad. It's just, my dad was so principled. It's a Greek business owner and my Irish Catholic mom and her family just very principled. And man, it just gets my Irish up when, literally, somebody does something that's unethical

or immoral or shady in any way. And I'm getting annoyed by it right now. But, you know, I do have one thing that keeps you from annoyed at it. people do these kind of things, they tend to fail. It is true. It is true. It's almost universal. You and I went through a couple of wars and like, that company that we had, you know,

a couple of companies we had that, you know, were a little dicey. They're no longer in existence. And we were able to secure, save our investment and watch that company. And that founder literally drive into a brick wall. And we were the only people who got off, got out of the car, you know. And when you see a reckless driver, you know, it's an indication to me that people who do something reckless are doing more reckless things that you're not aware of and they will do it again. And if they're rewarded for recklessness or bending rules, they can get the wrong message and they double down stuff, right? Yeah.

Yeah, it kind of goes to character, right? It goes to character. But then also incentives, you know, we see in our industry in order to, um, in order. to run these companies, it's an extreme, it's an extreme pursuit. And then in some cases, you know, you're bending some rules, reinterpreting some rules, you're disrupting, being a disruptor. But you just have to be careful. I don't recommend people become disruptive or destructive with legal issues and corporate issues. Just keep that one on the straight and narrow. We've had a few examples, really high profile examples, right, over the last couple of years of

perhaps bending not walking the line delicately but no you are way way over on the other side of the line

you're literally like wily coyote running off the cliff and like you just don't realize there's nothing underneath you you know

and so many of the crypto companies we looked at I said and maybe we should end on this you know and I don't have

anything against crypto but when one of our crypto companies told us meet our new Panamanian lawyers in the BVI and we're setting up a nonprofit and the nonprofit is um got five directors

but we can't tell you who the directors are because of a safety risk and I'm a director of the company that's spinning out the nonprofit in Panama through a BVI attorney and you know how I knew this might not be a good situation when the formation of the Panamanian nonprofit was a million dollars in legal peace. And I was like, wait a second. I have the best attorney in the world, Becky and Wilson Sonsini, and she'll incorporate the next company,

you know, or like the retainer. It's like, it's not what we're paying for. And I said to this woman who was doing this in the BBI, I said, I asked a question,

why is it a million dollars? She's like, well, there's some risk associated with it and it's complex. And I was like, we're paying you a million dollars because it's risky? Like, couldn't believe

she said it out loud. She's like, well, maybe that's the wrong word. It's complex. It's really more the word. And I was like, yeah, I'm good. Red flag, red flag, red flag. I mean, literally, it was like somebody just took a case of red flags and don't on the table. But it's like, I'm not in the red flag business.

All right, Becky, you're wonderful. Thank you for protecting me at all times and our startups. And if you are dealing with dicey situation, just called Becky. She's awesome. Her dance card's pretty full. but Wilson and Sanzini always has some great attorneys over there. Man, wow rides. We've been on great adventures together.

And, you know, every now and again, one of these companies wins big, and it makes it all worthwhile. So thank you so much, Becky. The joy of the ride, right? It's a little wild at times. Bring some drama, I mean, folks. If you want less legal fees and less volatility, don't be in the startup world.

It's a little bit binary here. But great counsel makes it a lot easier. See you all next time. Bye-bye. Thanks, Jason. I appreciate it.