This Week in Startups - Understanding Financing Structures: SAFEs, Convertibles Notes, Priced Rounds & more with Becki DeGraw | Wilson Sonsini Startup Legal Basics

Episode Date: December 3, 2020

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Welcome back to Startup Basics. I am here with my friend Becky DeGraw from Wilson Sonsini. Their domain name is WSGR.com. They are one of the top law firms in the history of the Silicon Valley. They represented everybody from Apple to Google. They incorporated Google. They did the incorporation Google documents. You don't need to know anything else.

And we're talking about basic things that you can screw up as a first-time founder. And I love doing this series. I do it every 10 years or so on the pod, and I do it with Wilson Sincini since they're my friends, and they teach me a lot. And these things do change. The thing I want to talk about is financing structures, because that is something. Maybe corporate structure, maybe term sheets, they've changed a bit, but nothing has changed more than financial structures. We got safes, we got convertible notes, we got price rounds. just walk us through what each one of those are

and what are the broad strokes pros and cons. Yeah, happy to. So I'm going to start with convertible notes. My favorite. These were really created as a faster, cheaper alternative to doing an equity round. The expectation is that the notes are going to convert into shares of preferred stock in the next round rather than actually be repaid. It's not, nobody takes out a convertible note with the expectation of I want to get my money back. They really want to convert into shares in the future.

So while the convertible note is outstanding, it is a debt instrument. So it does not show up on the cap table. It is a liability on your balance sheet. A lot of people are like, well, no, like I'm giving a certain percentage to my investors. Not really, okay? No. Those convertible notes do not become stockholders. They do not own a percentage.

they are not on your cap table until they convert. So it's really important to understand that. I'm going to kind of do a compare and contrast alongside safes because they're very similar instruments. So first of all, what is a safe? It's a simple agreement for future equity. It was created by- Who made it? Who created?

Right here. Why combinator? Okay. So they came up with this and they came up with it as an alternative to the convertible note. The idea is that you download the form, you fill in the form, you fill in the, the blanks and you're good to go. There's not a lot of negotiation. There's not my form, your form. We're going to have comments and go back and forth and get lawyers involved and lots of markups. You get the money into the company cheap and vast. And that's the idea behind it.

So what exactly is this safe? It's not debt. It's not equity. It's something quasi in the middle. It's basically just a contract that you have where the company is promising and agreeing that we're going to issue you, the investor, some sort of equity in the future in connection with the next round. It's very similar to a convertible note in that they both have conversion terms, right? Like you can have discounts in both. You can have valuation caps in both. You're going to have an automatic conversion feature or trigger in both.

Some of the big differences are because the safe is not a debt instrument. it does not have interest. So there is no interest rate. It does not have a maturity date. So what that piece of it is is there's kind of there's not a forcing function for the next financing to have to happen within a certain period of time. The other big difference between the two is the YC safe is set up to convert into a shadow series of preferred stock. So what does that mean? Basically, when your, your new investor comes in and buys, let's say, series A preferred stock and the YC safe converts into that same round, the safe is going to convert into what we call a series A-1 preferred stock. It's going to be exactly the same as a series A, with the exception of the economics. The economics are going to be

tied to the conversion price as opposed to the new money price. In convertible notes most often, you can structure them to also convert it to shadow series, but more often convertible notes actually convert into the actual series, the Series A in my example, that the new money is purchasing. So what does that mean? They get a step up in liquidation preference. If they convert it at 80 cents per share and the new money is being put in at a dollar per share, you do the calculations based on 80 cents per share, but their liquidation preference is based on a dollar per share. Which is good for the investor. Good for the investor. These investors took more risk than the later investors.

They were there a year or two earlier. And now, the safe was named safe. It feels really safe for a founder. But having been both of these things, I have seen the safes not be completely safe for the investors. And one of those issues is, the conversion date. When I do a convertible note, we say, in 24 months, I think is the standard, we're going

to either have the option as the investors to take our money back. Never happens. But it has to be in there, I believe, because it's a debt instrument and the IRS needs to believe that you have a debt instrument here. Or it converts with a little bit of interest to minimis, two, three, four, five percent. amount of interest that the IRS would consider legitimate, not put in there as a way of circumventing the fact that this is a loan. So people do not put in 0.001% interest, correct? Correct. What would you say the typical interest rate is? It varies. Or range? I would say it's probably actually,

like on most convertible, it's probably six to eight. It's usually a real interest rate. It's a real interest rate. It's pegged off of. not the low crazy mortgage interest rates we have in the world, but not a credit card. So put it somewhere between those two numbers. And it generally is not very material because if you put it 100K and a year later you got 8%, now you're putting in $10,000, so you got this eight little K spiff, little bonus, little icing on the cake for being early. But what happened with these safe agreements is they don't have a definitive, at least in the default, correct me if I'm wrong, a default conversion date and they don't have an interest

rate. Am I correct? That's right. That's good for the founder. It's terrible for or bad for the investor, correct? Is that what most people would think? Yeah, absolutely. So Y Combinator, this is my view, created this to neutralize, neuter, ankle, whatever word you want, investors. They wanted to take power away from investors and put more power

in the hands of founders. It would be considered a much more founder-friendly of the two documents. Am I correct there? Yes. And then famously in a video, Carolyn Levy, who is the partner at Y Combinator, also happened to be an associate at Wilson at one point in time. So you may have worked with her. I did. I did. I'm sure a delightful person. I don't know her personally. When she created this with obviously good intention to protect founders and Y Combinator is known for being anti-investor pro founder. They really do have an axe to grind with investors.

That's me saying that, not you. But they really want to try to protect the founders. Somebody asked her, well, what happens if you never convert to equity? What happens if this conversion, this magical conversion of the next round doesn't occur? And she said, that will never happen. That's ridiculous because the company's going to get bought. And then lo and behold, a company called TopTal, top talent, I had them on my podcast, never converted. And the company went supernova.

And now there is a group of people who invested in a safe. The company is in all likelihood their best investment in all time. And they still don't own equity. And the founder can sweep all the cash. out of that company that has never converted and taken as profit. This edge case must be the talk of the town amongst attorneys. I don't know if you represent TopTel or either side of it. So I don't want to get you in trouble.

You don't. I don't know that Wilson does. Okay. So just putting aside, let's pretend there's a new company called Queenamon Pastries. And Queen Amon Pastries, which are delicious, we both agree. Yes. Shout out B. Patisere. Queen Amon Enterprises were to do this, and it became the next, you know, a great company in America, a billion dollar company.

What would be the recourse of those people who gave the money through the safe? Does anybody even know at this point? Is it ever been tested? No, no. That's kind of the tricky part. You're nailing on a very important piece from an investor perspective. The other piece is what happens in a dissolution. The safe likes to say in a dissolution, you got to treat me like debt,

but everywhere else it says I'm not debt. We haven't had a big case actually come through where it was prominent investors that actually took it to, you know, court to figure out what would actually happen with these safes. So there is some uncertainty to investors. And when the safes first came out, a lot of investors were like, I'm not touching these. I'm not, I'm not interested in them. I will say that that mentality has changed. And we see safes and convertible notes almost equally at this point. And investors have largely gotten on board

with it. I think a lot of that has also to do with the overall climate of being a little more founder friendly and tending that way over the last few years. And I think a lot of investors are saying, look, I'm investing such a small amount in this, you know, first instrument. I don't really care. It actually helps me because I don't have to have any legal involved either. So I'm putting 100K and so be it. What comes of it comes of it. Now, there's something called a side letter. Yes. One of my favorite things in the world. Investors love them. I love a good side letter. To me, good side letters like you go to a great restaurant, they give you some olives, you know, some nice olives on the side. You didn't ask for it, but get this little side, a little side order you didn't ask for it.

It's the muse bouch of the venture world for me, a little petty for at the end of the meal, if you will. And in my side letter, I say, listen, I'm Jason Calacanus. I'm good at this. You want to do a safe, Mosulov, you do a safe. I have an expiration date. It's got to convert at this dollar amount by this date. And I have to get equity because I'm not getting myself in a top-tel situation and then having my reputation ruined with my LPs.

And I also would like some information rights. And I want an update every month from you. Now, I'm not, I've never sued a founder for not sending me a monthly update. But when you have an agreement that we're going to get a short monthly update and we have a decent amount of information rights, I don't need to know what time people got to work every day. But I would like to know if I needed to, what the bank statement says and how many months of runway you have.

I ask for those three simple things. A monthly update, a conversion date on the safe where I know I will have equity by this date at this number. And yeah, just send me an update and if I need it, can I understand how much money we're making? Are you starting to see other investors do what I did? which is just create a backstop against the possibility of the top-tale situation reoccurring all the time. I'm not. Wow.

I think what most investors kind of mentality is when they invest in the safe is, this is a small dollar amount, and that's such a corner case that I'm not going to overnegotiate it. At what point will the dollar amount be worth bringing this up? Obviously, at 25 or 50K people may not bring it up. Is there a dollar amount when people need to grow up and put in some more controls in your mind? And what would that dollar amount be for you, if you were advising the investor side? Yeah, I think if, and this has changed recently, you know, if you would ask me this question five years ago, I would have given you a different answer.

I think it has to actually pretty high. If you're putting in a couple million, maybe you start considering doing a note instead and you don't do the safe. That said, I will tell you, I mean, we see safe rounds in the five to 10 million range that are done on safes. And there's not side letters in place that have these, you know,

conversion time, period. And this is because Silicon Valley runs on trust. It really does. It's a community and reputation is everything on both sides of the table, founder and investor. And word gets around quickly. Yeah. I have an expression that you may have heard in your illegal career before. Trust but verify.

Yes. And anything worth being, any endeavor worth being done. and this is what I tell both sides of the table. If we're going to do this, let's do it right. Let's paper it correctly because this is a 10-year, sometimes 20-year relationship. Let's do it right. All right. Let's explain briefly, now that we've gotten through the convertible, we've gone through the

safe. Convertibles are safer than saves for investors. Saferers are more founder-friendly. There's a lot of stuff that has not been tested with safes. but in our crazy community, people feel safe with safe. So I don't. I need to have some backstops there. I think ones that are going to be, you know,

I think these backstops are important. But finally, priced rounds. Pricing around results in a legal bill of $30,000, $40,000. Typically, am I in the ballpark range? Probably a little more. $40.50. If you're doing your first round, you know, your investors are going to ask that, your lead investor is going to ask that you pick up their legal fees.

And their fee caps are usually 25 to 50. And you can generally say, based on that, that your company council is probably going to be twice the investor council fee. And it usually ends up being pretty close to that because if the investor is saying, I need 50K, they're probably going to turn over every stone, kick every tire, look at everything three times, which means, the company council is going to have to respond to all that deal with all that diligence requests. So you can be looking at $75,000, $100,000 on a $10 million series A type event. Yes. Yep.

I would say that's pretty accurate. Founders who are in demand can say, you've got a billion dollar fund. You pick up your own legal fees. Some founders do that. Pretty rare. Pretty rare. I'm one of them. I guess I'm rare.

But the times I've raised money, I said, what? Or I said, yeah, I'll pick up up to 10. And I just want to let founders know that could be negotiated if you do have a strong round. People try to understand why this is. The VCs are trying to get a return on their investment. If they have to spend a lot of money each time, it can screw up their returns, right? The returns can get muted because they have more expenses. Putting that aside, what's the proper time to absolutely, no questions asked, do a priced round?

Oh, that's a hard question. I don't know that there is a definitive. A hard and fast. Yeah. Right, well, let's talk about the range then. When you see people decide to do it, who's driving it typically? Is it the venture capitalist says, I want a price round. I want to know my price per share because I want to be able to put it in my audit and I want

to be able to start the clock on something like qualified small business or whatever it happens to be, capital gains. What is the driving force there? And what is the range of, you know, when these things start to what I'll just call grow up and do a price round? Yeah, I think it is the investor that drives it. Okay. I think it's the size of the check that an investor is willing to put in.

I mean, I tell founders that I work with don't even think about doing a, a priced round unless you're in the millions, right? If it's, if it's a million or less, it's not worth it. Like, as we just talked about, you know, it could be 75 grand in legal fees, you know, to put, put this in place. If you're talking about a $500,000 round, do a convertible note or a safe that we just talked about. It's not worth it. So, so part of it is going to be demand, right, as to what are investors willing to, to put in? If an investor comes to the table and says, I'm super excited, I want to invest, here's a $5 million check, I would say that's a good time to start thinking about getting out of the convertibles and getting into a price round if the valuation works.

So then you talk about valuation. And usually, you know, the investor is the one who kind of shows their carts first and says, hey, this is this is kind of what I'm thinking. And this is the percent that I want to end up with with my two, three, five million dollar check. And if that sounds good to the company or if I think that's fair, then I think it's a good time to do the priced round. If where you're at as a company, you know you're so close to hitting like the next milestone. And if you just had $500,000 in three months, you can hit this next milestone that's really going to make a difference to the next investor, then maybe you don't do a price round. Maybe you just take the $500,000. you do it as a save or a convertible note,

you hit that next milestone so that when you do the price round, your valuation is much higher. I see this as such an astute point, Becky, because I see this all the time. I'll have the founder who's like, you know, they're growing 10% a month and they're like, God,

if I just had another 500K to put into Facebook ads, or if I could add three sales executives or, you know, four SDR sales development reps, this thing would rip. And I'm like, okay, you've raised 5 million, already, you've got a base of 26 investors, that's 20K each. And one of them might jump the fence and take the whole thing because they're greedy.

Did you offer to just do a 500K top off? They're like, no. You know, and I do, one of the reasons I've gotten really successful in the last half of my investment career is I study the revenue numbers of the companies. When I see somebody growing 20% a month for three or four months, I look at the numbers, I go check out the product. I have a cup of coffee or a little zoomie. I do a little zoomy roomy. And I say, hey, how's it going, pal? How's our business going?

They tell me how the business going. I'm like, how would you feel if, I don't know, the last round was 15, if we put a million in at 20, just so you don't have to go out and meet a bunch of people, would you like that? Because I might be able to work it out. I've done this seven times. How many times do you think we wound up closing of those seven times? Seven?

Six. Six. Six. Six. Now, five immediately. One tested the waters, did three or four meetings, was like, this is extremely painful. I'll take it. And the seventh, God bless them.

They said, you know what? We're going to try to increase revenue 50%. And then we want to go back to you and see if you hit the number. They did it. And you know what I did? I had offered $2 million at $50. They doubled the revenue. And I said, how about $2 million at $90?

And they said, well, how about $2 million at $100? And I said, how about you give me a deal because I've been with the cost. company since you've been four million and let me make my investors some money. And they were like, okay, J-Cal, 90. And I was like, great. Now I own 14% of this rocket ship. And I'm happy, right? And this is the reality of how these things go down. Sometimes a little top off, a little convertible note, that's just a great way. And you kick the can down the road on the price round. That's okay. Because you can kick the can down the road if the business is going well. That's the key. At the end of the day, the business has to be going well.

And, I mean, there is risk to that, right, of if you have an investor at the door who says, look, I want to, I'm willing to do a price round. I'm willing to put in a larger check that maybe you just don't need right now. It's hard to say no to money at the door, but it may be the better strategy sometimes. You know, I've developed this strategy after 30 years in business. I call it take the money. If it's there, take it. It's very interesting. It's basically somebody shows up and they put a bag of money on your door.

And what I advise founders to do if it's at a reasonable valuation is to open the door and drag the bag of cash into the house, shut the door, lock it and turn the alarm on. Take the money because you and I have been at this for 20 years. How many times have we watched capital markets go from what it is right now, lightning hot, to being turned off. I mean, six months ago, post when COVID started, how scary was that moment?

How many companies did you see fold up shopping and let go of half their employees? It's been very scary. I mean, looking back where we are today, a lot of things have actually normalized, but nobody knew what was going to happen

when it first hit. And on both sides of the table, people were scared. I mean, the deals that were in the works where, oh my God, get this closed as soon as possible. I don't care, accept all of the terms that we've been fighting over. Just close. That's from the founder's side.

That's from the founder's side. That's from the founder's like, here's seven things that are really important to me. And then it's like, you can't leave your house for 30 days. They were like, rip that up. Get the money. Let's go back. And you're like, I mean, it's got to be frustrating for you. And the founder's like, I want to die on this hill.

This is a point. I will not give an inch on. And it's a point that doesn't matter. It is. And that's where, to be honest, like good counsel who have seen this over and over and over again, can provide some advice on that and try to guide them in the right direction in terms of, okay, what is it that you're really concerned about? What are you really trying to protect against?

And here's all the other ways that you can do that. This isn't the one to fight over. Also, when you're the CEO founder, how many times in your career will end on this? Have you seen a VC magically decide they're going to replace the founder with themselves and start running the business? Not with themselves. They may say, yes, we do a founder search. Yeah, they may say, you're not the right person for this role. Let's bring somebody else in.

But even that, I mean, it doesn't happen. An extraordinary founder, an extraordinary founder has so much leverage by being good at what they do. It transcends all legal. It transcends all legal points. Yes, and I will say, high performance. I get asked this question all the time of how can I make sure that I continue to have control? How do I make sure that I'm not going to get kicked out? How do I make sure that all of these rights that I'm giving to investors that aren't, they're not going to be abused?

And I think there is actually just one really simple answer. And that's just kick ass at the business. If you do that, if you do that, investors are going to be happy. They're not going to try to get you out. They're not going to try to abuse. are not going to try to do crazy stuff. If the business is doing well, you're going to have an easy route.

I mean, if you watch the last dance, Dennis Rodman got away with a lot of shenanigans because he knew how to rip down 22 boards in a playoff game. I'll leave it at that. Becky, thank you so much for doing this. If you want to get in touch with Becky, it's never too early. I mean, maybe not in the idea stage,

but if you're starting a company, R-D-G-R-D-E-G-R-A-W at W-S-G. They're my attorneys. They do a great job. And you can tell just from the passion here in the startup basics we do every decade that you really care about this stuff. And you love doing it, don't you? Absolutely. This is the fun part.

This is the fun part. All right. We'll see you all next time. Thanks, Becky. Bye, bye.