Legal must-haves before raising capital with Becki DeGraw | Wilson Sonsini Startup Legal Basics

0:03all right it's time for startup basics go to this week in startups.com slash basics we're doing our legal basics with becky degraw we've done a dozen of these over the years she's with wilson cincini wsgr they are premier legal advisors to tech life science all the great companies funds myself a bunch of folks just a great firm and becky's a straight shooter she does this work every day has done it for a little bit and i wanted to talk today about kind of growing up as a startup you do your notes you do your safes you're raising money uh you don't have a cap table yet but you got all of these loans and or promises for future equity and now it's time the moment has occurred you hit a million in arr two million in revenue and i don't know fred wilson or rule off at sequoia some david sacks bill gurley comes and says we're doing a price round we want to join the board and it's time to grow up and convert all those notes what do you need to do this is like a an elite moment for startups that most startups don't get to yeah yeah absolutely and thanks for having me and all the kind words as always um and i will i promise i'm not going to say this thing first to you know try to plug uh lawyers but i will say get legal counsel involved get them lined up and get them up to speed.

1:25That's one of the first things to do. Oftentimes we'll get brought in. I'll be like, I have a signed term sheet. We are already behind the eight ball then, right? Like you really need to get your counsel, whether it's us or someone else, get them involved early. Part of that process is just getting the company ready, right? Oftentimes I work with startups day in and day out. I know that you don't have a legal budget to do everything perfectly from a legal perspective, that's fine. But at the preferred stock round, that's often the time of reckoning. That's often the time when it's like, okay, time to grow up, all the stuff that we might have done that wasn't quite up to par, you're likely to get asked to get it cleaned up now.

2:10So if you wait to get counsel until you have that term sheet in hand, you might have heard us on other episodes talk about it takes four to six weeks to close one of these things. If you have cleanup, Just add, add time. And that could be weeks. It could be months to do whatever you need to do. So, you know, trying to get the counsel involved so that they can do kind of a pre-look. And we can do lawyers, not just us, but we can do these pre-looks quickly. You know, we can kind of look at, hey, here's a diligence request list. Gather all of your documents. You come back with three things. I'm going to be like, okay, we're definitely missing some stuff here.

2:51Try again. Go look for this stuff. And if the answer is we don't have it, okay, then we should start talking about how to put that in place. IP assignments, cap tables, vesting schedules, lots of little ticky tacky blocking and tackling items that you may have just missed. Now, we as an accelerator and as, you know, early stage year zero fund, we try to educate people on this. But, you know, we see founders, they're strong willed individuals, they might just sign a safe without counsel. they'll just print it out fill it i mean you're seeing this more and more i assume and maybe they don't know what's in it or maybe they change it or maybe the investor changes it and they say it's a standard safe but then they read the fine print and maybe the investor or the founder might have changed something so i've had angels come to me and say oh you know i did i signed the safe and then they find out that i had this one instance where i won't in the name of the company obviously the founder pretty cutthroat founder put in the documents edited the safe to say when we convert we have the right to pay you back with this interest or something and they just wrote it like in plain english we have the right to pay it back and that at our option as opposed to where we'd normally be at the investor's option to take stock or to take their money back with interest and they did an up round they paid everybody their 1.7 or 1.12 percent uh and they were like wait a second i waited my whole angel career to hit a big winner this was my big winner and i got cash back the opposite of what you want and they came to me check out what's going on i said did you have a lawyer did you redline this and they're like what's a red line oh my lord here we go like this one-on-one folks and that's on the investor side where people put 50k or 100k into it and didn't spend 500 bucks or a thousand bucks on a lawyer to review the docs so what are the most common mistakes or things in diligence people screw up that need to be cleaned up that are not let's just say so ticky tacky you could do it in an hour things that take more than an hour of lawyer time and founder time to get cleaned up top three yep easy so cap table ip assignment stuff and employment agreements those are the ones because So I represent companies about half the time and investors half the time.

5:14So I'm constantly flipping back and forth. And particularly on your first financing, almost every single investor out there is going to look at those three things. okay you don't have the perfect contract you didn't get your privacy policy you haven't filed for trademark your terms of service you copied from someone else and even has their other name in there those are all things that will work itself out nobody's walking away from the deal from those nobody's saying i'm not funding until those things are taken care of there may be a whole hey let's let's let's figure out good governance and how we're going to do things on a going forward basis conversation, but those aren't things that hold up closing cap table, IP assignment, employment agreements, they will hold up closing.

6:01So like on, let's start with like the cap table stuff. You know, this as well as any investor, you want to know exactly what percentage you're getting, not about 10%. I want 10.76%. That's what I'm expecting to come out of this. Two decimals, please. Right. Like we, we, we know it like the cap table has to be perfect. It has to be pristine. And you want to know who they want to know who each item is like so when they see we do this ourselves, you know, the incubator level, because we do our little mini diligence and we give them like, here's the grown up diligence. Here's our mini diligence of what we need.

6:38Just so you know, and we'll find somebody on the cap table with 17 % ownership. Who's that? And oh, that was the company that built the 1.0 of the app we made that we pivoted away from because we started as a dating app. I'm like, I didn't know you started the dating app. Oh, yeah, we started the dating app. We got sued. And then we pivoted. I'm like, whoa, whoa, whoa, whoa. Where's the lawsuit? Who built it? Who's the third founder I never met? Like, this is the kind of stuff that could kill a deal. There's a third founder out there. There's a legal letter hanging. You pivoted. And there's an IP assignment for, you know, missing.

7:12Okay, you're a venture firm. You're going to join the board. You're going to own 20%. You don't want to catch a knife. You want all the knives put away neatly in the draws. not falling from, you know, five feet onto my foot. I can't tell you how many times we have seen a very similar situation to what you just explained. And then when we start digging into it, you know, we'll say, okay, so where's the documentation behind this? They'll say like, okay, here's my cap table. I'll say, okay, do you have, can you pass along the board consents and the stock purchase agreements? And then they'll send like an action by incorporator.

7:46I'm like, no, no, like the actual like stock purchase agreements. And where did the board approve this? Oh, we don't have any of that. I'm like, okay, well, then we don't have a cap table. That's what we don't have. That's hard because sometimes you may say like, oh, I downloaded this from Google and the document's really bad and it's got blanks and stuff. At least you have a document and we have something to go from. When it comes to stock, if we have nothing, that's even harder because there is no valid issuance, which means you might have thought that you bought your shares a year ago when the company is worth nothing.

8:24But because we didn't actually have the board approve it, and we don't have a valid issuance, that means we have to issue you your shares today. And now you have a term sheet in hand that says the company is worth$20 million. Uh-oh, tax people getting involved now. Uh-oh. Exactly. So then it's like, okay, we got to figure out what the valuation is today we got to get tax involved there's going to be a bigger payment the cleanup that goes along with that just gets messy particularly because taxes are real dollars in that situation turns out the irs they're not like a um loosey-goosey creative organization they're kind of by the books and kind of by the books individuals and if you owe them something they're going to find you and so this is where like being educated especially as the two or three founders on vesting schedules and issuance of shares and maybe even buying your shares and setting the clock on capital gains it's this stuff can be mind-numbing you may have to have it explained to you three or four times but you know what you'll get it either on the second third fourth or fifth time you'll get it there's lots of articles online and so you can do your own research and then when you get to you have counsel you know you may start with some friend of yours who's counsel who does it for 300 bucks an hour but eventually you might have to clean stuff up um and it's kind of the job of founders to learn this i'll call it 20 of the job of starting a company and you know what it's kind of like if you were in a restaurant or you watch this tv show the bear becky ever uh-uh watch this tv show the bear it's just a wonderful television show But if you work in a kitchen, you need to know how some of the basic sauces work and how the front of the house works, how the stove works, how the temperature works.

10:17Just even if it's not your station or whatever it is, it's just good to be well-rounded and to understand the basics. And that's why we do this series. It's just so you understand those basics and just take a little joy in learning it. It's like it makes you good at your job to understand how to clean the oven properly and how to set the temperature in the walk-in box and what certain sauces are and why they're considered the quintessential base sauces. Like just learn the basics, understand it. Even if it takes an extra hour or two of your time, it's well worth it. Yeah. Oh, yeah, absolutely.

10:48And I think just what you're talking about with the lingo too, right? Like when you get in that investor meeting, they start throwing around what's your fully diluted and oh, are we talking pre or post valuation? Like if you haven't heard these terms or have some familiarity with them, you know, you're going to be at a little bit of a disadvantage in that initial negotiation. Now, we can come back and we can help and, you know, get you up to speed and all of that. But doing a little bit of the pre-planning in that regard of how are these, how is this process going to work? What are some of the terms that are going to come up?

11:21What is a liquidation preference? What are people talking about with that? like just having that basic understanding when you go in because at the end of the day there's a whole lot of other things you're going to be talking about and negotiating just having like i can understand the things that the investor are saying i think is really helpful for founders i just love founders taking out an excel or a google sheet and actually building their cap table from scratch ground up and understanding how to do a couple of formulas and just understanding how dilution works. One example comes up all the time.

11:52Oh, you don't have a stock plan for employees. You don't have your E stop stop employee stock option plan ESOP. Okay, I remember them explaining to me, okay, when does when do we create the ESOP? I'm like, Well, why does that matter? It's we're creating a 10 % thing. So well, who's if Sequoia just bought 30 % of the company, and then you do a 15 % ESOP, they're going to get diluted 15 % once that gets distributed. Okay, so they want you to do the ESOP before they invest. So it only affects the 100 % the founder zone, or so the founders are taking their shares and they're carving out the ESOP. That one decision could be extremely meaningful to everybody might be one of the most meaningful moments of dilution you have outside of financing grants, correct?

12:38Yeah. And you know, to that point, one of the things that I also encourage companies to do in that pre-planning stage is to put together what we call a pro forma cap table, which just means it's your cap table today, but we're going to project out what it's going to look like after a financing comes in, right? So we can play with some numbers, you know, and it can be toggles of like, here's the percentage of whatever your option pool is going to be. Investors are going to ask you to have one. So we know that's a given that work is not going to be not used, but this will help founders really start to understand, particularly if you have, you mentioned earlier, what happens to those safes and those convertible notes that you have?

13:17It's hard to visualize if you haven't gone through this before, you know, as a startup of like, okay, I've got these convertible notes or I've got three different rounds of safes. I've got one from friends and family, one from an accelerator incubator, one from angels. They're on different terms. What do they convert into? Oh, I got this new pool. And then I have the actual financing, the preferred stock financing that's going to come in. Okay, quiz, what percentage do you own now? I don't know. Right? I mean, like, that's a lot of variables to just map out in your head, if you haven't done this before.

13:50So putting together that pro forma, you might not be able to do it in your head. And that's why having the ability to do this yourself, there are plenty of online tools to do it, you know, every YC or tech stars class, some ambitious person learns this and makes a calculator, she typing cap table calculator, And then every single service provider out there who has cap table management will have all kinds of pro forma. But what I like to do is ask the attorneys, okay, we're talking about a sale. You know, I'm on the board of this company. Great. What's the sale price? What are the terms? Great.

14:21Let's see a pro forma and show me what everybody gets paid. And then the founders don't ask for this. I think in some cases, they're scared to see what happens and how little they get. if they've raised 30 million and they sell for 50 and they have liquidation preferences and all of a sudden it's like huh you did participating preferred you raised 30 okay and now all of a sudden wait oh is there any money left oh wait there's no money left common gets zero okay what do we do here and then bank debt and transaction fees and all of that like has got to come out of there yeah and you got closing costs or whatever oh and there's some cash left in the account how much cash is left in the account what happens to that so running m &a scenarios also like a really nice thing to do sometime with your management team so everybody sees what your actual goals are because i was on a board one time uh one of the investors lost faith they want to sell their shares they just want their money back they all of a sudden made that decision and the founders want to keep going that so much money had been raised the market was so bad that it would have meant the management team got nothing and so i said hey if you're agreeing with them to sell the company at this number you do realize your five years of work is nothing and then the acquiring company is going to want you to sign up for a two or four year thing so it's going to be seven years of your life to get seven years of salary and maybe a little bonus from the new company but they'll probably fire you anyway so in that case you might want to carve out so do you want to negotiate a carve out with me now as a board member they're like what's a carve out and i said you know like listen i'm doing this for my own reputation management um and because i love these founders um you should ask for a 30 carve out whatever the company gets sold for you get if it's a 50 million dollar sale the management team gets 15 million no matter what carved out for the management team based on performance and their equity plan And that will at least keep some hygiene here for you to stay.

16:25Because I'm worried you're going to quit. And then nobody gets an exit. Now, of course, this is where the dynamic of your board composure comes into play. Yeah, Becky? Of course. Yeah. And also, like, what is that? Depending on when you're negotiating that carve out, are you negotiating in connection with a down round? And what's the next step? Are you using this down round? Are you using this bridge financing to get to a sale? Are you using it to get to the next step? You know, like if you're using it to get to a sale, which we do see often, right, some sort of bridge to a sale. It's like, okay, what do we really expect that sale to look like?

17:04And putting together that waterfall to know, common, are you going to get anything from a sale in that range? You may have hired bankers and they're telling you this is the range that we could expect to see. and okay we're on board with that but then once you start all those deducts you're like oh uh what am i getting yeah five percent of the bankers with a minimum of two million you know then you have legal fees accounting fees whatever it is you know that's another million bucks and then all of a sudden there's 30 million in overhang oh some people there was a note that was done with you know a 3x liquidation preference on it and that was a two million note so now that six million's got to come off the top you just start having all this stuff happen and the waterfall shows the water being money and how it flows down uh everybody's agreements and and you know just make sure you understand that and that's where alignment comes in and it is one of the strange things if you make it to an ipo and everybody converts nicely into common that's why that exists right am i right in the history of that that just hey we all get to the finish line everybody shares are the same we all get to sell our shares or hold them if we want to keep being spotify shareholders we keep being spotify shareholders want to clear whatever your personal preference is but in any other scenario this waterfall really is meaningful it really it really is and and oftentimes you know again depending on what the the board dynamics are and who's represented have the founders been through this before do they even know to ask for these types of things it is it's it's it's understanding what's the goal of where we're going to go.

18:44And if we end up there, what does that look like? And what should I be asking for today? And those are really important. And if, you know, as a founder, you're feeling like you're not getting the right education in that moment, talk to somebody else, talk to, you know, if you don't feel like your board members are the ones that are there, like, reach out, there's a whole network of folks to get educated on, what should I be thinking about? this is where your counsel matters you know and we say this all the time your counsel is going to matter in these kind of situations because i will tell you there is somebody at that late stage venture fund private equity fund that dips down or whoever and they got four wonky you know mbas doing all these scenarios explaining it they're spending an hour talking about it before they get into the meeting they're spending a half hour on text knowing exactly how much and then the founder is it's at a disadvantage because they don't have that team and they haven't done 12 transactions in the last year and had these discussions now a venture firm has to do that they have lps they have to protect their interests so yeah they're going to look at the totality of their portfolio for fund five and say you know what let's just get our money back on this one and return it to our lps because we're already in the money and we get 20 carry on everything going forward so even though this is only going to be 10 million back we're getting 2 million of that because we're already over our hurdle for our venture firm now an entrepreneur has no insight into that zero insight into that that they by just getting their money back they're making two million bucks or something you know um really important uh for you as a founder to run these scenarios have great counsel and to get educated just look at this as like your chores and you know what if you got kids you want to teach them to do chores these are the chores you know you got to do your chores somebody gotta empty the dishwasher somebody gotta load the dishwasher somebody gotta clear the table just call it what it is these are chores they're arduous they're painful you know what you get good counsel you got a good accountant it's gonna be a lot easier so do the work becky you're amazing thank you for countless countless weekend late night calls to clean this stuff on behalf of the launch funds founders and all the other founders out there uh you're awesome uh everybody go to thisweekandstartups.com slash basics thanks jay cal really appreciate it always good to chat with you about these things and hopefully founders can take something away from it and avoid some pain that we have seen with others.

21:12Absolutely. You don't have to make the same mistakes as everybody else. We'll see you next time, everybody.