This Week in Startups - Navigating startup funding market trends with Becki DeGraw | Wilson Sonsini Startup Legal Basics

Episode Date: August 8, 2024

Todays show: Wilson Sonsini Partner Becki DeGraw joins Jason on the latest edition of Startup Legal Basics! In this episode, they break down the current state of startup funding (0:37), anti-dilution provisions (7:11), re-incentivizing management teams (16:23), and much more! * Timestamps: (00:00) Wilson Sonsini Partner Becki DeGraw joins Jason (0:37) Market update: Current state of startups and funding (1:21) Consolidated investment trends and the venture capital slowdown (4:23) The importance of due diligence, runway, and down round impacts (7:11) Anti-dilution provisions and strategies for investor communication (16:23) Re-incentivizing management teams and insider-led funding scenarios (23:46) Importance of investor relations and board management * 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

Hey everybody, welcome back to this week in startups. It's time for our start-up basic series. Now, when we do this series, sometimes you're nervous to ask basic questions. So I bring in my friend, Becky de Graas. She's at Wilson-Sinney, WSgir. You know that firm. They're famous. They do a really great job. They're hardworking. And Becky and I have been doing this for five or six years now. And we love doing it, right? Because this is, we have to repeat ourselves all the time with the basics. And so we We'd like to get the basics out there for people to understand. Absolutely. Thanks for having me. Let's just start with our market update. We're sitting here at the halfway market. It's half time in Silicon Valley, as it were, after two years of absolute chaos in the market, Silicon Valley Bank and First Republic and all this chaos, you know, all this chaos, you know, down rounds, after peak ZERP.

What's the state of the market today in terms of startups and funding and all of this. indigestion in the market. We saw peak valuations and large amounts of money being invested. Now we see this down market, lots of headwinds, but signs of life, obviously, and a lot of new investment occurring in AI. So what are you seeing from behind the desk at the table with, you know, these at-scale startups and even the swan ones? Yeah, absolutely. That overview is perfect, right? I mean, we were on a heck of a tear there for a number of years, right? Of just up, up, up. 2021 was kind of the top of that, maybe first half of 2022, and then we started seeing things change. And, you know, last year was a really different story to tell from the 10 prior years.

This year, the best word to describe it, I think, is just choppy. We see a lot of things still happening, a lot of action still going on, particularly at the C to A stage. I would say that side of the market is still strong. we are starting to see in the last six months movement on the growth equity side, which is great. Like last year, growth equity, and when I talk about growth equity, I'm really talking about kind of very late stage financings, pre-IPO type financing. Last year, that was almost silent. There was so little activity, and we're seeing more things happen there.

And that kind of makes sense because it corresponds to, I wouldn't say the IPO market is gangbusters or anything, but we are starting to see some green shoots there. And as we start to see that, it trickles down. The growth equity picks up, then, you know, other parts of the market do as well. The seed in the A stage, because they're so far from the IPO, that's why we continue to see those stay strong. And even in that regard, right, like the valuations are still quite high. And they are still trending up, ticking up from even 2021 levels. The amounts being raised are also ticking up. I'll put a little asterisk over that, though, and that a lot of that is being driven by these really huge AI deals that the valuations are really out there and the amounts being raised, in which case, right, is bringing the averages up. But we have looked at the data of pulling out those outliers, I'll call them, and say, what does the rest of the data look like? And the C-Day market still feels really strong. Yeah, it makes sense because entrepreneurs are always going to start great companies. Why Combinator are accelerated, the launch accelerator tech stars,

they're going to still incubate companies. And so, you know, that part of the market doesn't require massive amounts of capital. And that money is kind of locked in to venture funds and ready to be spent. But the later stage stuff, that's a little more complex, yeah? Absolutely. Yeah. And one thing that we're literally in the middle of right now is the summer slowdown. You know, traditionally, July, August, we start seeing things slow down. People are taking their vacations, where that's the management team.

the VCs, right? And it just takes longer to get attention, longer to get traction, longer to get the deals done. But even outside of the summer period, we have seen just longer deal cycles. It's not the 2021 days where it's like you sign a term sheet and we're closing in two weeks. We're kind of back to the norm. I would say four to six weeks for your first preferred stock financing. Obviously, if we're talking about saves, that can be much faster. or convertible notes, but if you're talking about your preferred stock round, four to six weeks is definitely what you should count on from the time that you sign the term sheet to closing to actually getting the money in.

Which is healthy and good, right? People are taking the time to do diligence. They're taking the time to pick a partner well. So if you're an entrepreneur, I guess the best advice is to make sure you have time and runway to close these deals because the concept of the 48-hour you know, a speed run where you do this

Blitzkrieg fundraising and nobody gets to do diligence and nobody gets information rights and there's no change in governments. All of that kind of what I consider unhealthy and just bad hygiene. That's gone.

But it hasn't been replaced with never ending fundraising. It's, you know, people are still, I wouldn't say a blitzkrieg but a brisk pace. For good deals, it's still a brisk pace, correct?

Yeah, absolutely. And I say this all the time, that good companies are still getting financed at all stages, right? Maybe the money is not being handed out like candy on Halloween, but there's the good companies are still getting plenty. Plenty of deals are happening. And if you look at the amounts that funds raised, I mean, 2020 was record breaking. 2021 was record breaking. 2022 was record-breaking, even though half the year was considered, you know, part of this kind of new down market. So there's so much money in these funds that need to be deployed, that need to get out there. You know, they're dedicated, particularly like the early stage funds. They're dedicated to doing the early-stage deals. They've got to do them. So they're looking for, for good companies to invest in. And, you know, as far as his early-stage investors concerned, I think that this is going to be one of the great vintages because anybody creates enough to start a company in a slow market, in a challenge market.

Generally, we see less tourism, less tourists, more serious people, and maybe even a consolidation of talent in the management teams. So I think it's going to be a wonderful vintage for venture because the seriousness, the ruggedness, the resiliency of this cohort of entrepreneurs feels distinctly different to me than the ones we saw funded in some cases, not all, in 19 and 20 and 21. So let's talk about down rounds. Let's define what a down round is. And then, you know, a lot of these terms, people here, anti-dilution, pay to play, and recaps.

Let's define all of these. These are important terms for founders to know. Yeah. So let's start with down round. Really, all that is is your selling stock today at a price per share less than what you originally sold your outstanding preferred stock. You'll say you have Series A. You sold it at a dollar per share.

anything that you're selling your series A-1 or B or whatever we're going to call it at less than a dollar per share, it's going to be considered a down round. So what does down rounds do? It triggers anti-dilution. Like when you signed up to those financing documents out of the couple hundred of pages of documents that got put in place at that time, one of them relates to anti-dilution that says, as an investor, hey, if you sell shares at less than what you paid or less than what I paid, then I get in a adjustment. Now, one common misperception about anti-dilution adjustments is, oh, the investor gets more shares. Technically, the investor does not get more shares of preferred stock. What happens is the conversion rate at which the preferred stock converts to common stock just gets adjusted. So every share of preferred stock is

convertible into one share of common stock. That's the default when the preferred stock is issued. And let's just say there is an anti-dilution adjustment. There is a down round where we sell stock and we adjust that conversion ratio. That one share of preferred stock, you still only have one share of preferred stock, but it now may be convertible into 1.05 shares of common stock or whatever the number is. And there's a whole formula for determining what that adjustment's going to look like. And that conversion all happens on exit or IPO. On exit or IPO, technically preferred stock can convert to common stock at any time voluntarily, but there's no reason that you would unless there was an exit or an IPO. The voting rights do change because almost all of

your preferred stock votes are done on an as-converted basis. So even though I have one share of preferred stock, when I'm voting amongst all the other classes of preferred stock, I would get that in my example, 1.05 votes for each share that I have. But otherwise, it doesn't really come into play unless the preferred stock converts. The other thing about anti-dilution is that it can be waived. Right. So your existing preferred stockholders could waive having that anti-dilusion adjustment even kick in. And sometimes we see that.

Sometimes we don't. It all depends on, you know, the circumstances as to what's going on and who's leading and all of that good stuff. And the founders have to then go ask the investors, hey, you backed us three, four, five years ago. Now we want you to waive this, even though you were the earliest investors who believed in us, And then these new people are getting a better deal than you. What is the best way to communicate that to get a chance of the investor to say yes? What is the best argument people make?

And sometimes people ask you, hey, Becky, how do I tell J-Cow that I need him to take the haircut, not the new people? Yeah. A lot of times it's the new investor that's saying, you got to get this waived in order for this whole thing to work. because oftentimes, well, vast majority of the time, like when we are doing these down rounds, it's insider-led. So it may not be the earliest investor that came in, but it's likely an investor on the cap table

is the one who's coming to the table. We don't often see a lot of new investors coming to the table to lead a down-off. Not to say that it doesn't happen, it does, but vast majority of the time, it really is insider led. And a lot of times it's, okay, I'm not putting the money in unless we can set the company up in such a way that post-financing, we're going to be able to go out and raise when we need to at the next financing round. And so often it's really trying to look ahead to what is that next financing going to be and what do we need the company to look like? How do we right-size the cap table? Do we need to incentivize people to participate?

And that's when we get into all the other terms of, do we use a pay to play? Do we do a recap? Do we not? Right. So there's multiple levers here. One of them is, hey, get everybody to waive their anti-dilution so that the founders retain more ownership. The existing investors who aren't investing in the new round take a little bit of a haircut,

but they're still in the game. But they didn't want to pay extra money to keep the company going. So therefore, that's where pay to play comes in. You either put more money in, and it's typically at, you know, your existing ownership. So if you own 5% as a seed fund, you know, and they're raising a million, okay, 5% of a million is 50,000. So we need you to put in 50,000 to pay to play. If not, your original 5% ownership is going to, you know, maybe take it on the chin, yeah? Yeah.

And the whole point of the pay to play, not every down round has to have one. Really, the reason that you would put it in place is you need other investors to come to the table. And you may have one or two insiders that say, okay, I'm putting money in and I'm going to put together, we're going to put 10 million in, but the company needs 15 million to get to the next milestone. And I'm not putting my 10 in unless I know the company is going to get to that minimum amount because otherwise you're not going to do anything with my 10 million. So then they'll say, well, if other folks around the table aren't willingly to step up, we're going to put a mechanism in place to essentially if you don't play something bad is going to happen. And there's all sorts of

something bad. You know, most times the something bad is you get convert. We were just talking about preferred stock converting to common stock. Most of the time, the way that we do this is to say, if you don't participate to your full pro rata percentage, then all of your preferred stock is going to get converted to common stock and you lose all of your preferred rights. Now, you can do that on a one-to-one basis, you can do that on a something else, like a 10 to 1. So for every 10 shares of preferred stock you have, you're only going to get one share of common stock. Right. And if we have a really big decrease in valuation, and we, and this is oftentimes where a recapitalization is coming into play in connection with that pay to play is it may be, well, we've got enough insiders who are

willing to participate. And in fact, we do this pay to play. If you participate, you get to keep your preferred stock, which means the liquidation preference, the liquidation stack that goes along with that preferred stock stays in existence, if it turns out that your total liquidation stack is higher than your new valuation, that's not really setting the company up or a good spot come next financing. So in that case, that's where we will start trying to, you know, mess with those ratios to say, even if you do participate, you're only going to get a tenth of a pull-up or 25% pull-up or whatever it might be. And this is why a lot of firms, if there's a recapitalization, a pay-to-play or a down-round,

they just don't participate because as venture capitalist, as seed funds, you have your choice of investing in the next company that, you know, has all the promise of a clean cap table and a new idea. And then you have this other company, maybe they've hit five or ten million in revenue, but you have this very hard discussion that has to occur. And a lot of VCs, you know, when I talk about it, you know, when I talk about it, you know, to them privately, I just don't want to be involved in the bad feelings. It's a lot of bad feelings. A lot of people get hurt. You know, and as a seed fund, Becky, we will be faced with situations where, hey, this is happening. We own 10% of the company. We've made four investments in it over five years. And now we're getting wiped down from, you know, 10% of ownership to 10 basis points, you know, one 10th of 1%. We're 99% of our values being wiped down and have to say, hey, wait a second. This doesn't feel exactly fair. Can we can we get somewhere between 1%?

and 100% of what we did here to help the company. But, you know, it's a difficult conversation because the company is, in many of these cases, destined for either a zero or a very small outcome. And so this is where people, you know, might feel like they're putting good money after bad. They made a bad bet on the first, and now they feel like they have good money here.

Or it could be bad money after good. You know, there's all kinds of scenarios. And it's just really difficult. So if you get yourself in this situation, the management team has to look at themselves and say, do we believe in this enough that we will go down to 0% ownership and then revest our stock over the next five years? So talk a little bit about what is expected of founders in a recap. What's the worst case for a founding team?

You know, you have three founders, let's say five executives who have, you know, over 1%. So you got these eight people, but only three of them are going to continue on. And those eight people, let's say they owned an aggregate, 50% of the business. let's say 60% of the business. Those eight people each owned eight percent-ish, maybe some own 20, maybe someone own two. What should they expect if they're going to continue on with the business and then some of them are not?

We're going to keep going for, aren't. What should they expect? Yeah. I mean, you hit on the head of one of the most important parts of all of this, right? We can, from a legal perspective, we can go in and we can put the pay to play in place. We can do the recap. We can get it to where the company is, cap table is right-sized and you're set up for.

success of whatever that might be, right? Of like best position available to go forward and fundraise. But if your management team has been wiped and is not happy, it's a hard road to hoe. Like after you do one of these, one, you've got to go back and communicate to your current base. It's going to be out there in the news. Okay, you're not going to hide it. Even if you somehow hide it from the press for a short period of time, it's going to get out.

They're going to see it in connection with, you know, future stock options. they're going to be priced at a much lower price than what the prior employees were. So I always say, like, one, a good communication plan. You got to be able to pitch it and believe it that this is setting us up. You know what? We kind of got off in a wrong direction. This is kind of a critical moment for the company. This is your opportunity to be in.

You know what? We've done the layoffs. We've done the cost cutting. We've got fun raising in the door now. And now we're able to really turn it around. And you've got to be able to believe that and communicate that to your team. And that's all to your investors too, because to your point, like, if you don't believe that as an investor, don't put the money in, have your stuff convert, right? Like, put your money into someplace else where you think that there might be a return.

But every term sheet that I do, and this is literally at the term sheet stage, whether I'm on the company side or the investor side, and we're thinking about putting one of these types of structures in place, one of the topics that needs to be really thought through is how. How are you going to re-up the team? Because you can't just expect them to be, I'm going to put in the really, really tough work now to turn this around and to make this work without reincentivizing them. So we will often see things like a 20, 30 percent employee pool being put in place to re-up the people that are staying and actually going to be the executors on making this hopefully successful for the next step. And so in this hypothetical example, 10 million in revenue company, there's something here. Maybe it's not growing. Maybe they're out of capital. They need more money.

They're burning. You know, to make that 10 million a year, they're burning $4 million a year. So they've got work to do and cutting expenses and growing revenue in a hard market. And let's say there's eight executives at the company, some combination of family. And four don't want to go. Well, you know, that part of the common pool and with the preference, that might be wiped out 60, 70, 80 percent. So those people who are leaving are going to see if they own 10% of the company, now they own 1% maybe. But the four people who are staying, hey, the good news for them is they should participate in that 30% pool and earn it over maybe five years because they're sticking around.

And so if you are part of the group that gets ground down, but you decided to get off the boat, well, you should be thankful you have anything because this thing was going to sink anyway. And that's a really hard conversation to have. It's a very real conversation to have. And it's a test. This hasn't been an easy journey. We did get to 10 million in revenue, but we're upside down in terms of profitability. But we're here at port. And that's the way I like to explain.

Hey, we're at port. People can get off the ship. If you're not feeling it, people can stay on the ship. The people who are staying on the ship get the new carry. They get the new provisions. They get the new opportunity. The people are getting off. They get a hug.

Good luck. You get to get on the next ship. You're at port. you can start a new company, you can build a ship, you can work on the port, what if you want to do? But those people who are going back out

to try to get to the new land, you know, they got to be incentivized. And so hard conversations, and make sure you have great counsel. Like Becky, when you do it, because you have to make sure

everybody's protected and it's buttoned up. Worst case scenario, if you do this wrong, do you see people taking actions later on and, you know, suing the company, getting upset,

And that kind of thing? Or do people generally in the industry just write it off and say, yeah, yeah, it's bad luck. You know, the company didn't work out. What typically happens? Yeah. So if you go through one of these and ultimately the company doesn't make it, which I will say most don't. That's usually the end of it, right? Like investors aren't going to file lawsuits to get nothing. Yeah, to get nothing from nothing. So, I mean, unless there is still something of the company left so that there is going to be either, you know, some sort of liquidation process or you're still able to sell the company quite often in these situations. It's pennies on the dollars at that point. And because there's just nothing left in the company to really, you know, revive it.

So I don't think investors go there. But the times when we do see these things come up in court cases is when it actually is successful at turning it around, right? So we go through one of these really nasty recap, downround pay-to-play transactions, and we do all sorts of stuff. And, right, some people get converted to common and all of these things happen, right? The company amazingly turns it around. Now they go out and they sell the company. Well, now that's when we'll see the lawsuits hit from years ago, right?

And any of these transactions that we talk about and the more that we couple together, if it's an insider-led down round such that we don't have a disinterested board, we're going to be held to a higher scrutiny level. Once we add an aggressive pay to play, we add a recap, we add that insiders are getting benefits that others aren't, right? Like all of these things to where at the time, it may be like, this is the only option that we had. and nobody else was coming to the table. But if that's the case, you just got to document it.

You got to have the best process that you can follow, use advisors, make sure your board records, reflect all those conversations, all the market check, that there really was nothing else there, that this is the last resort. That'll help you if you end up in lawsuit. Very simple. I mean, you've got to make sure everybody have that unanimous consent. Everybody signed off on it. And if there's an investor who is not responsive,

man, you better make sure that you have all the receipts. You FedEx them a document. You emailed them the document. They opened the document. You sent them docu signs. They clicked on it. You need to have all that buttoned up. Yeah. Yeah. You mean, like these things are very expensive. And it's like the worst time to incur legal fees because you're probably not raising a huge dollar amount. You're raising just what you need to get to that next point. But yet these, you mess these up and it's very, very costly. later. And I always tell everybody, like, hey, let's keep a record of 20 investor meetings that we did. We reached out to them. We sent them the materials. We explained the opportunity to them. We got of the 20, 12, you know, 12 took a exploratory meeting. Three took a second meeting. And we have every email in a file somewhere. We have a Google sheet, you know, our notion page with, you know, who we contacted, what dates. We did the meeting. We have why they said no. Sounds silly, but like a very simple process like that. Because when I get pulled into it and we're a small shareholder, that's the first thing I say. Tell me about the process of raising capital.

Who did we speak to? What was their reaction? What did we offer them in terms of terms? And did we follow up with them? And they're like, yeah, we talked to a ton of people. I'm like, I would like to know the number of people we talk to and I'd like to see the list. And I would like to introduce you to 10 people. So, and then they're like, oh, it's too late.

I'm like, okay. So now we're in bad hygiene. It's never too late. Never too late. And if you talk to three people who are your friends. And you didn't take a formal meeting. You didn't set back as like, this is where you could get accused of doing like some sort of inside deal. And, you know, you don't, even if you're right, it doesn't stop somebody from suing you, as we well know.

So. Yes, absolutely. And the one thing I would add to that, like all of what you said, I love that. Like, that would be amazing if we had those types of records. The one addition to that is just make sure all of that gets to the board and is in the board minutes. like it's one thing we see this all the time where it'll be like oh the CEO will say oh I had this conversation with the board member I had this other conversation with another board member I'm like did we ever have a board meeting where we all talked about it at the same time like no ah like just little things like that and I think that is also where council who is experienced in dealing with these

will be like hey just call a meeting I need to I need to get this on the record we need to show the process. Call a meeting and here's an attachment. Yeah. And here's the attachment. The list of people we contacted. I mean, it's so simple. We could put that in a, what would it call it, an exhibit or something in the board notes or the deck and you put that and attach it. Everybody signs it easy, breezy, lemon squeezy. So, you know, this is, I got a, I got a lot of scar tissue on this one. And I don't know why, but I always, like, if the founder wants to fight, I always get in there and I just fight to the last, you know, I'll be the guy in the cave. Last two guys, last three gals standing.

I'll fight all the way if the founder wants to. So I'm crazy like that, but I always like to get this documentation done. Becky, you're amazing, you're awesome, Tyler's supporter, everybody, you know, it's very easy to find her, Peggy, WSGR, you'll find her. They do a great job. They do most of my work, and I love them for it. All right, we'll see you all next time on Startup Basics. Go to this week in Startups.com slash basics, and you'll see Becky on discussing this stuff

over the years, get educated, have great counsel, and details matter. We'll see you all next time. Bye, bye, bye, everyone.