This Week in Startups - Navigating SAFEs, Pay-to-Play Rounds & Risks with Becki DeGraw | Wilson Sonsini Startup Legal Basics

Episode Date: July 20, 2023

Todays show: Wilson Sonsini Partner Becki DeGraw joins Jason on the latest edition of Startup Legal Basics! In this episode, they break down legal standards in the startup ecosystem(2:19), SAFE agreements and convertible notes(5:41), conflicts faced by founders and investors(20:58), and much more! Time Stamps: (00:00) Wilson Sonsini Partner Becki DeGraw joins Jason (2:19) Breaking the box or sticking to widely accepted frameworks (3:47) General trends and the adoption of safe agreements (5:41) Differences between SAFE agreements and convertible notes (10:34) Companies that raised high valuations during a hot market and need to raise funds again (15:43) The impact of down rounds and pay-to-play provisions on investors, founders, and employees (20:58) Conflicts faced by founders, existing investors, and new investors (27:58) Surviving down markets * Check Out Wilson Sonsini: ⁠https://www.wsgr.com/en/⁠ * ⁠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

Hey, everybody, welcome back to the show. I get legal questions all the time. I get so many legal questions. It is crazy. It's like right after product market fit. And so what we'd like to do here on this week in startups is do our startup legal basics series. And I bring my own attorney, Becky DeGra, from Wilson-Sinia on. She's a partner over there. She works with startups across all stages and helps me with all kinds of issues. We've been on tons of adventures, some of them crazy, some of them delightful, everything in between. Some of them a little anxiety producing even, Becky. But we always seem to work it out in the end, yeah?

Yeah, and that's what keeps it fun too. It keeps it fun. It's really, when we think about startups and law and startups, it's a bit of the Wild West at times, but we've codified so much of it in standards, and these standards are based on trust. What I'm always amazed by, I don't know if you have the same amazement in America and in the law is that, and especially in our industry, Silicon Valley, is that we've created over decades these standards.

And people, even though they could be standards breakers and they can do all kinds of stuff and, you know, jump the fence and go crazy, everybody 99% of the time obeys the standards and just works in good faith to build companies together. Isn't that amazing to you? It is, and there's a whole ecosystem around it, the way, from how we do the deals to who's involved, to the time, the structure, the terms. I mean, there is definitely a market around all of that. And you can certainly tell when players that aren't used to it kind of come into the ecosystem. And, you know, they get identified pretty quickly as not necessarily understanding how it works. Yeah. And it's important for founders to understand that there are people who've been working. working for 10, 20, 30, sometimes 40 years in the industry. And they know the standards. So get a great lawyer, know the standards, come in, try to keep everything standard terms as a founder when you're

doing these things. And deviating from the standards and getting creative, yeah, I would say in the legal space, not a great idea. Maybe we can talk a little bit about, you know, people saying, I want to try to do something new. Yeah, we change the system. Like, I always say, like, from a business perspective, yes, break the box, disrupt, do something new. From a legal perspective, not the place to do it. It's just, it's not worth it, right? And in the long run, you're going to spend so much more money going down that path.

You're going to be viewed as an outlier in terms of what everybody is expecting to see. And at the end of the day, when you get that two minutes in front of, investor, don't spend a minute and a half talking about your creative legal structure. Like, that should be the last thing that should be the 10 second blurb. This is what I've got. I'm good to go. I understand this. Let's talk about the business.

It's just so well said, Becky, you know, if you're going to be creative and you want to do unique things, your startup, the culture of your startup, the product, how you, you, you know, interface and disrupt an industry, all that's available to you. You're doing your stock option plan for employees or employment contracts or trademarks or corporate structure, board structure, investment documents. This is a place to enjoy the absolute efficiency of the standard docs. Yeah, it's been tried and true over time and time again. Like, there's a reason why this is where everybody has gravitated toward and it works.

You know, the interesting one as we get into this, because I wanted to talk. you today just about the general trend. So we got so many to go through. But one thing that was interesting when somebody tried something different was the safe agreement, right? We had convertible notes and then YC worked on the safe. And the safe has become a bit of a standard. But there are some things with a safe agreement that have been challenging on the margins. Maybe you could talk about that innovation and how it got sticky. And then maybe what founders should think about when they do a too, if any. Yeah, yeah, absolutely. I mean, when the, when the safes first came out, people were like, eh, I don't know about this. Let's just stick with our convertible notes. And then they started gaining

traction. And the reason they started gaining traction was YC really pitched it as, look, this is supposed to be a fairly middle of the road approach. It's not going to be, solve all the best terms for investors. It's not going to give companies all the best terms. You both are kind of going to meet in the middle. But the beauty of it is when you're doing these rounds, particularly like if you're investing 50,000, $100,000, right? And you have multiple folks coming in over that. You don't want to spend a ton on legal fees. It's meant you go to the YC website, you download it, you fill in the blanks. It's not meant to be renegotiated, right? And that's the beauty of it. And people were like, hey, this is a great instrument to use. We don't have to get counsel on both sides involved to review these documents,

particularly for smaller investments. And we're off to the races. So fast, cheap. And then over a couple of years, that became the norm. It definitely replaced wherever we were using convertible notes. And sure, we would still see convertible notes here or there, depending on certain circumstances. But a fast majority moved over to the safe. But the safes are certainly not as protective to investors. So it really depends on, you know, what hat you're looking at you're wearing at the time, you know, from a investor perspective, they're not, not as protective. And what we're seeing right now, in this market that is tending to switch a little bit from, you know, the last call it five or eight years that have been very company founder friendly to swaying more back toward a perhaps investor favorable market is investors are starting to use convertible notes a lot more than saves. Maybe not necessarily for that first round of like pre-seed.

Like we're still seeing safes come in at that point because we're still seeing a pretty strong seed market. But if we're using convertible notes, to bridge between equity rounds, like between your A and your B or your B and your C, that's just getting harder and harder to get. That's where we're starting to see the convertible notes come in. And is the reason because people want to know, like, hey, by this date, it's going to convert,

or I can get my money back and I'm going to get a little interest. What are the investors hoping to get with the convertible note that they don't get in terms of protections with the same? Yeah. So one, it is actually a debt. instrument. So the safe is not. The safe is, it's not debt, it's not equity. It's kind of this quasi thing in between. Really, it's a contract is, is what it is for you to get future equity. But the convertible note is debt, which means if there's any dissolution, any liquidation,

any sale of the company, debt is number one in line prior to any equity. So first and foremost, that's like the biggest protection that's out there. Other things that it includes is an interest rate. So that's a nice little benefit to investors. You know, we used to see interest rates on these things, maybe like low 3, 4% now with the interest rates going up and with the more investor favorable terms out there. We're seeing 8, 10% on these convert notes, which is much, much higher than what we have seen before. And hey, that's actually something.

It will add up over time. Generally, that interest doesn't get paid, but it gets converted. So when the principal converts, yeah. When the principal converts, the interest converts. the interest converts and the investors get, you know, a little added benefit there. It also has a maturity date that safes do not have. This is like the foreseen function from an investor perspective, right? It's like, the safes can just hang out there for as long as they want.

And they do. And they do. I'm sure. And they stack up. I mean, I've just watched some folks stack them up. And, you know, you're like, at some point, it's this going to become equity. Like, and we're going to have a cap table. And they're like, well, technically you don't own any shares. I'm like, okay, that technically is true, right?

Yeah, it becomes a little just concerning for investors, I think, if they go on forever. Yeah, and, you know, I mean, the most conferable notes, the point of the maturity date is not that the investors are actually going to come in and call the note and put the company into, you know, an insolvent position. But it's a forcing function for the parties to come back to the table. Let's talk about what's going on. Let's talk about what the next steps are and to get, you know, figure out what the path forward is. And to explain to founders, just so they understand. investors who listen to the program, let's say you put 100,000 in and you had this 8%. Okay, every year that goes by, let's take it takes three years, or let's make it 10%, so it's super easy.

Now it's at 110, then it's at 121, then it's at 100 and whatever that is, you know, 133 or something. So you've got 30,000 in interest that's built up over three years. Add it to the 100, if it was a $10 million valuation cap, instead of getting 1% of the company, you would get 1.3% of the company or so. So that little interest builds up, gets converted into equity. So this means that the value of the money, the time value of money gets accounted for.

And nobody's really in it for the interest, but in a high interest rate environment, people are saying, well, I could choose to put my money in a bank account or in the startup. Maybe there's some ground here that's even. And then if the company does become insolvent and somebody has put a convertible note on top of a bunch of safes, the person who puts the convertible note in is in a much better situation, correct?

That's right. Yeah, that gives them the priority, essentially, in any type of downside scenario or sale of the company. And, you know, when you have a short sale, getting sold for less than the amount that was invested, let's say $5 million has been invested in a company, it's being sold for $4 million, there's not going to be, somebody is not going to get their money back, or some group of people are not going to get, you know, a dollar for dollar,

but the later stage ones might. And so this is why in a tight market like we're in now, capital gets a little bit of an advantage. And a crazy market like we experienced for the last, let's call it, 2019 to 2021, the terms went completely the other way. Pick good partners, I think, have thoughtful conversations about this. And just, you know, you've got to understand both sides of the table. So tell me what you're seeing in terms of, um, that raise that high valuations during the hot market.

What do they call it? Like you make hay when the sun shines. And some founders were like, J-Cal, Becky, I'm getting this crazy offer. And then we said to them, okay, that is a delightful offer. Sure, you can take it, but you have no revenue, and now your company's worth $50 million. In order in a down market or in a reasonable market,

you might have to have $5 or $10 million in revenue to justify that. So just understand you're going to have to use this money to get there. And if you don't, there could be issues, including a down-round. So explain broadstrokes. Obviously, you're not going to talk about a specific company, but you see a lot of activity. What has life been like for you at Wilson-Sensini and working with startups who did raise at high valuations and now find themselves needing to raise again? Yeah. So it's not a pretty picture right now.

you know, the seed in A stage stuff is still pretty strong. We're seeing a lot of activity there and that market is good. But for the type of company that you're talking about, right, it typically was like they raise their B or their C or even a D at these really high valuations and they raised a lot of money during that time. And, you know, what I'm hearing when I set in on the board meetings is, you know, call it maybe even two years ago or a year and a half ago when folks, well, maybe, yeah, maybe about a year and a half ago, when folks started talking about, hey, maybe we need to be a little careful here. Maybe we need to conserve cash. And that became a big topic of every board meeting of what's our runway, how much are we using, how long do we have? Do we, you know, look at sacrifice growth to preserve cash for a little bit longer and really analyzing different types of proposals and trajectories for the company to figure all of that out?

A lot of those companies have been able to use the money that they raised in 2021 to kind of to set on the sidelines right now. The later stage market is largely significantly shut down, right? The closer you get to IPO stage, the less deals that are happening. So the crossover stuff is hardly ever happening. The really late stage stuff is also really slowed down. But even doing like a series B and C, even if you're still fairly far away from, you know, an IPO, they're just more difficult to do right now. Investors are looking for more metrics and

to make sure, like, yes, this is, this is going to be it. What is interesting, right, is like, by choosing to kind of take a lower growth approach and maybe conserve cash a little bit more, those companies that are about time, like a lot of them looks like maybe later this year are going to have to go out and start raising because they've exhausted, you know, they're about to exhaust the money that they raised in 2020, 2020, 2021. And when they do, they may not have, you know, those awesome hockey stick metrics that folks are used to seeing because they purposefully kind of restrained, pulled, tightened things down and pulled back a little bit. So it'll be interesting to see, you know, how the market reacts to that. But that all being said, right, like,

There's another dynamic here that's really interesting, too, that we haven't seen in the past when we've had, you know, one of these type of slowdowns. And that's, there's a lot of dry powder setting on the sidelines, right? So, like, you look at 2020, like biggest funds raised ever. 2021. Oh, we broke those records by investors raising even bigger funds. And guess what? Even though 2022, half of the year was kind of a difficult year, funds still broke, you know, fundraising records. But that can't. capital is being deployed at a much, much slower clip than it was. So there's a massive amount of dry powder on the sidelines that want to invest. And at the end of the day, like, need to invest. Like, there's usually time bombs on those of, hey, we got to invest by a certain, you know, time period. And you've got these in the companies now that raised and need to come back to the market for their next fundraising. What we're seeing, though, is a big valuation discount. connect between the two parties. Investors are like, hey, I'm here. I'm ready to write big checks. I'm

ready to jump in. But I think your valuation is not quite what it was the last round. And the founders don't necessarily share that view, right? Or the boards and previous investors, because they have some input as well, depending on how the board and governance was structured. Exactly. Yeah, absolutely. And, you know, I mean, particularly like on the, the founder side, right, and investors, too, so many of these folks, even if you've been doing this for 10 years, you may not have seen like a down round environment. Like, you're used to up up and up. I mean, I started investing as an angel, as a scout for Sequoia in 2009, 10, right after the great financial crisis. I only knew an up market. Now, I had been through it as an entrepreneur a couple of times, the dot com craze and the great financial recession. but not as an investor. So these investors now, they have a concern if you were a previous investor.

Okay, I marked this at a billion dollars in my past fund. I'm on my next fund or I'm raising my next fund like I am right now. Okay, I'm raising my next fund. This thing's marked at a billion.

Okay, if somebody offers 200 million for this and it's an 80% haircut, like Peloton or some public market company's got a haircut, you know, of 80%. Okay, I've got to mark that down in my books.

Now my, rate of return for my last fund has gone down and is that going to impact my ability to raise the next fund? There are so many dynamics for fund managers that happen. And then you have the founders and the employees. Maybe the price of this next round that people are willing to pay crushes the valuation.

And you said correctly, some of them went to conserve cash, so they conserved cash, so they slowed their growth rate. So now we're like, huh, this thing's growing 20% a year instead of 3x. Where these things not grow what is it actually worth?

Maybe it has to be sold. So this all is going to happen in the next 12 months. It's going to get crazy. It's coming to a head. And I mean, we're definitely seeing it more. I mean, like the end of 2022 and first quarter of this year, I was having a lot of conversations about down rounds and pay to plays. And we're dusting off the playbook as to what are all those other features and, you know,

levers you might be able to, you might need to, to pull on to get a financing done. And a lot that revolved around education, I think initially. We started to see a little bit of, you know, you know, down rounds coming in and, but the conversations were happening much more, right? Like, okay, maybe, maybe I need to revisit that. Well, we saw a really big increase, um, from just in, in Q1 of down rounds. Well, but, well, first of all, like, It was like 40% of all the private company finances that we see. And that's both on the company and the investor side were either flat or down. That's a huge number for not being up.

And then- That's a lot of medicine people are taking. That is, right? And then when we saw like pay to plays being used in down rounds, that increased from something like 15%, like 40%. Okay, so we should pause here for a moment and define pay. to play because if you've been in the industry for but 15, even 20 years, you've never heard this because the last time pay to play game and two effect was either in the great financial

crisis on the margins, but that was a shorter duration and it wasn't as hard actually, I think, as this has become, and this isn't as hard as the dot com. So I think this winds up, I think you might agree between the great recession and the dot com bust is where this all nets out to be in terms of pain and suffering. But let's define pay to play. Yeah. So if a company, company is doing a financing, let's call it their Series B financing, basically you would put this provision in place that essentially says you as an existing investor, you have to participate in the Series B financing and you have to buy your pro rata share or it could be a percentage of your pro rata share. All of these terms are customizable. But usually it's you got to buy

your pro rata portion of the series B or else something bad's going to happen. Usually the something bad that happens is all of your preferred stock is going to get converted to common stock. So the idea is you have to pay by participating to play, to continue to be a preferred stockholder and keep all of the rights, all the bells and whistles that you have. And there's all sorts of ways that this can be structured, but that's the basic concept and it can get more or less aggressive. Orerous, yeah. So when this happens, a founder drives it typically the new investor drives it, the board drives it,

it would be against the board's best interest. So in my experience, boards sometimes say, hey, I don't advise this because they want to keep their preferred chairs without having to put more money up. So who becomes the drivers of this, practically speaking,

does counsel pull aside a founder and say, listen, here are your options, and this is but one of them, because if you did the Series A, and you own 10% of the company, and now they say, hey, new round's going to be $3 million, you've got to put up 10% of that,

300,000, they don't want to, that funds deployed, whatever it is. Or your 300,000 becomes common and, you know, your 300,000, your whatever 10%, your 300,000, your 10% goes down to 1%. You know, net at the end of the day. How do these conversations go down?

It's super uncomfortable, huh? That's uncomfortable and it's complex. Like, there's a lot of technical legal issues that come up across us. And what you're alluding to around a lot of it is conflicts. There are lots and lots of. of conflicts at all the levels. Let's break, let's talk about the top two or three conflicts that a founder,

existing investors, and new investors are going to have to navigate because there's going to be two or three of these. We might as well put them on the table here. And then after we discuss what the conflicts are, how the resolution gets done, practically speaking. Yeah. So one of the biggest ones is going to be at the board level, right? Like any transaction, any financing transaction has to get approved by the board.

So the first thing we're going to want to understand is who on the board is conflicted. And a lot of that is going to depend on what type of transaction it is. These down rounds, if we're talking about kind of a traditional like, this isn't, okay, a little bit of a step down from the last round. We're talking about, okay, you were, in your example, a billion dollar post money coming off from your last financing, and we're about to do something at a 200 million pre or something. we're talking about significant down rounds here. Quite often, they're insider-led. Lots, lots, lots, lots, time.

They're insider-led. And what that is, is like the insiders, the existing, when I say that, like the existing investors who are on the cap table are the ones that are coming to the rescue to say, okay, fine, I'm going to put more money in, but here's my terms. And, you know, they are pulling down in the valuation. That can be one scenario where the. the existing investors are the ones that think, okay, maybe we did overpay in that last round. And, you know, the company's not where we expected to be or macroeconomics.

But we have some belief in it because we think it could rise or we wouldn't even make the offer. We would be writing it off and we'd be saving our time on the board. So it's not the worst situation. The worst situation is they say, good luck with the company. We're off the board. Let us know how the investment works out. Yeah. So this is somewhere between, yeah, like the debt scenario and the,

you know, some, some version of faith because they're putting some money in. Yeah. And, you know, that's, that's where we will start to see the conflicts arise, right? And that's who, and when you say, you ask like, who's driving, it's usually the company needs money and whoever is willing to put the money in is driving that initial conversation in terms of, I'll put money in, but I'm not going any higher than this valuation. And that's like where we're like, okay, now this is the scenario that we're in and we have to deal with. with this. When, when Delaware courts look at conflicts at the board level, they are very broadly defined. Absolutely. If I'm an, you know, I'm an investor and I'm setting on your board and I'm going to participate in the financing, that's a clear conflict. But even if I am not going to participate in the financing, well, let's say I co-invested with this other investor.

that is also setting on your board. And we do a lot of co-investing together. And we're in a lot of companies together. And, oh, I actually vacation with them in the summer. Guess what? Conflicts. I'm going to be conflicted, too, in that scenario. And Delaware looks at all sorts of things,

all sorts of things outside of just purely the transaction. Other transactions. Where does the founders conflict come in? Because they have their entire net worth in there, so they're obviously conflicted. And then there's the employees. So they're conflicted because they have to deal with employees. So the big conflict on the founder level is almost always when we're talking about that crazy 80% drop, that has to be coupled with an option refresh.

Otherwise, your management team, your employees aren't sticking around. So you've got to do that. So you've got either some sort of option refresh or some sort of management incentive plan that you're putting in place. as soon as you put that in place, everybody on the common side, right, the setting at the board, the founders, the management team, they're going to be conflicted.

So it's actually really hard and traditional, you're talking about kind of, this is the standard way of doing things. Yeah. Even like industry experts, and you, I mean,

you'll see them at the later stage companies, but even then they can be conflicted because they might have bought preferred stock too and they might be impacted by this pay to play. and if we decided that we're going to carve out the smaller preferred stockholders and it's not going to be applicable to them, guess what? That still means they're conflicted because they have an interest in how the terms are going to play out. If that industry expert is somebody that, again, I'm the investor and I suggest this industry expert every time I'm on a board for this type of company and we serve on five different companies together and I always bring that industry expert in. And I'm participating. He's not. Guess what? He's probably still conflicted because of that relationship that we have. Like, I am the ticket for his next board entry, right? So it, the conflicts go deep. So all conflicts all the time. And then basically good faith and having your back against the wall results in a

transaction closing or the company closing, sadly. At some point, people have to say, like, listen, this is the best we can do. There's three months, two months, one month, two weeks worth of runway, we either take it or we shut down, which are we going to do here? And in my experience, it's that, you know, being pushed towards the edge of the cliff that suddenly makes everybody say, okay, I'll take the medicine. Yep. And that's exactly right. Why investors, because sometimes people still have kind of a concept of, why would existing investors do this to themselves? Well, sometimes that's the only choice. And in order to save the portfolio company, and at the of the day, they've got to believe that the company will live to fight another day and become

the next billion dollar company and revive. Otherwise, they're not going to do it. But if they believe that, they still have to justify, like, what am I doing today? Why am I investing today on these terms? And that's where the terms start getting aggressive. And depending on what the goals of the company is, like, you know, the kind of example we've been using at this billion dollar valuation company that's getting cut down to 200 million. One of the goals of that, I imagine, is probably going to have to be like a full recap of the company. And what that means is like, we've got to like right size the cap table because the liquidation preference stack that's tied to the preferred stock that you've already sold is probably going to be higher than the value

of the company now. And that's not, that doesn't work. Right. From an economic standpoint, certainly not from raising. That doesn't put you in a good position to raise your next financing either. So in that scenario, you know, we not only need to do the down round. We may do a pay to play, but we've also got to put like this recap in place that essentially right sizes, you know, the liquidation stack and your cap table. The good news here is if you're having those discussions, people still believe in you and your company. They just believe in it at a different price. And so founders can, you know, as hard as this is, we have seen many companies go through this and, you know, rabbits be pulled out of hats on a regular basis. We have seen companies,

survive down markets, whether it's Facebook post IPO, not understanding how to get mobile going. Apple had near-death experiences, one of your famous clients, Apple, at Wilson Sincini. Larry Sincini was Steve Jobs' personal attorney, if I remember correctly. When I met Larry one time, we told me that. So, legendary. So I think this is a good place for us to pause. In the next episode, we'll talk about all this options repricing and how to take care of the employees and some of these other technical issues. Becky, thank you again for talking us through

the other side of the coin. We were here a couple years ago talking through how to pick your best term sheet and how to negotiate your best terms. And here we are a couple years later, talking about how to save your company, right? This is how it goes. The pendulum swings both ways. And hopefully, I think 2024 will start to hit some normalcy. And this is part of the process. And we have all these young companies, too, that are starting. So that's very exciting. And we'll see you all next time on startup basics. Thank you.