Market dynamics, RIFs, and AI’s role in law with Becki DeGraw | Wilson Sonsini Startup Legal Basics

0:00All right, with me again, Becky DeGraw from Wilson Sassini. Becky and I have been through many legal adventures. Some of them were a lot of elbows being thrown around, Becky and I have been through many legal adventures. team thank you for all the late nights and weekends when we have to get on crazy phone calls especially the last couple years it's been crazy 2022 bonkers 2023 less bonkers and it's kind of a high and low right now seeing so many great young startups at reasonable valuations taking their time and being thoughtful having reasonable expectations of valuations and deals getting done green shoots everywhere for me as an early stage investor but oh lord my late stage portfolio is uh it's it's literally like i go from tending this beautiful garden becky and then i now i'm in like a war zone and bombs are dropping everywhere around me just like pick the day and you're not alone i'm not alone in this what's what's life been like for you these last six months when all All of a sudden, AI startups and everybody can't, you know, Google, Facebook, Twitter, everybody's laying off.

1:30And we know what happens when that happens. Three or four people start sitting around a cafe and say, hey, maybe we should start a company since it's so painful to work at some of these big companies and they're not hiring anyway. And now we have all these great new startups. The process has renewed itself and we're right in the thick of it. The cycle begins again, right? But yeah, I think that's exactly right. We're seeing a lot of activity in that seed and age stage where you've got really experienced talent that would typically be at perhaps one of the big tech companies and they're not. And they're deciding to do their own thing now.

2:06And that's always been the case, but I think it's been a little bit more of a foreseeing function of getting kicked out of the nest maybe a little earlier than what they thought they were going to do that. And, you know, I mean, there's a lot of doom and gloom out there. like if you read, you know, any of the blogs and look at the stats of, oh, it's down, it's down, it's down. It is absolutely down, as you said, in your later stage portfolio, don't get me wrong, the deals aren't really happening. The valuations are down. Lots, lots of doom and gloom on that side of the equation. But on the seed side, it's actually still really, really hot.

2:41And especially, especially AI. I mean, that's kind of its own, own bucket. We'll just put that by itself. We'll put it by itself. We can call it a mini bubble. Frothy, maybe? Frothy? Frothy, I think that's a good one. Like a cappuccino. Yeah. But on the seed side, you know, like, pre-money valuations are actually up. Like, if you look at the data, like, compare, and that's, like, even compared to what I call the frenzy, right? The funding frenzy that we had, like that really began in like the latter part of 2020 and certainly rolled through all of 2021 and a little bit of early 2022. Things were crazy.

3:18Things like if you if you look at quarter over quarter, year over year numbers and you're looking at, OK, how does 2023 stack up against 2021? Yes, we're going to be down. We're going to be down like crazy because that was such an outlier in terms of where the numbers were. but some of those late stage correct were um almost like ipos i mean so there's there's a lot of big numbers in there when you see those charts you're like oh my god it's down so much the number of deals is not going to be down as much as the dollar amount per deal so you might not have some 300 million dollar or 600 million dollar investment happening in some late stage company that everybody thinks is going public next year yeah yeah that's definitely true on the later stage stuff on the on the seed and the a you know i mean like those are those are pretty consistent in terms of like the dollars being invested in those those companies but but the valuations are holding um you know even compared to that that frenzy they're they're they're kind of holding and when you compare it certainly to kind of pre-frenzy we're we're up um in that market so that market is doing you know really really well still and there's a lot of activity there we'll have them pull up a chart here for a second this is a chart um that just shows the seed deal value uh in billions of dollars um angel deal value um you know sort of stacked on each other and yes if you go back to you know we were just to draw a line q1 of 2023 is going to look you know pretty comparable to where we were in 2018 2017 right if you just draw a line straight across and really the abnormal part started in 2020 2021 was really weird 2022 also a little bit weird and we're just normalizing so that slope from the peak yeah it's gone down it might go down again but uh we're seeing great companies and if you were to draw the average line here it probably would go from 2013 at 1 billion just straight to you know like the two and a half 3 billion levels so uh per quarter so yeah and and we we also um we publish what we call our entrepreneurs report you can grab it off from our website but we go through and we kind of look at the quarterly and the annual stuff and do a bunch of comparisons have some charts in there and we try to summarize like the the high level financing trends so if anybody's interested in that take a look yeah and so when uh in these later stages you know when you're starting a company you got a nice clean slate everything fresh documents there's no stack of liquidation preferences there's no preference stack of you know somebody who invested in 2018 19 20 2021 all none of that's conflicting so that's super easy um but one of the things you do have to deal with with these later stage and even some of the mid-stage ones is if they're going to do a down round um you know just figuring out how to reprice options and because people might be underwater and so people got their stock options they were given a strike price a price at which they could buy a share of the company as an employee i'm the cfo i'm the head of growth i got a million dollars in shares i got a half million dollars in shares i was pay a dollar for them but now the company's worth less than a dollar so now everything's underwater how does one deal with that mechanically legally tax implications everything Yeah.

6:48And I will say we are seeing a lot of these right now. And it's just that, right? That scenario that you mentioned of companies raised at a really, really high valuation. And even if they haven't done another financing that was a down round, like certainly if you did a down round, your valuation, your 49A valuation that's used to price your options is going to come down as well. But even some companies that haven't actually gone out and done the raise are being impacted. They have to get these foreign evaluation reports every 12 months. And just given the general macroeconomic factors that are out there, some of the valuations are dropping and dropping precipitously.

7:27exactly dropping fairly significantly yeah and so so we are seeing this a lot right now um i will say if you're in the bucket uh in that category of uh i might need to do this is it's a good time you're not going to get a lot of pr about it because everybody is doing it so um yeah the old air cover um if you i guess stripe went through this i don't know if they're a customer here so i have to be careful here but we saw stripe and some other companies say hey we're worth 100 billion one point now 50 billion we i think it's the mature thing to do because it's good for employees if the employee strike price is too high and they're underwater it's it's not uh it's hard to keep them incented because the savvy employees the top people in the company have been through this before maybe they worked at google and before that they worked at microsoft or amazon so they understand a 409a the value of these shares they understand the markets changed so who drives this at a company i'm always interested in which party drives this is this hr the board in the ceo or maybe the management team saying hey this doesn't quite seem fair the people who came here at 2018 are in at one penny we're in a dollar we know the 409 says 50 cents like i need to get my options repriced if i'm going to stick around here yep exactly it's usually the management team that that drives it um and you know a lot of times they're they're interested in in driving it because they also have you know grants that are at the the higher price.

8:52So, you know, the first thing would be to get a, you know, get a fresh 409A valuation report so that you have something from an independent valuation firm that you can say, yes, this is the value of the company and say, okay, we have options that are out there priced at a dollar per share. This says it's 50 cents per share. What are we going to do about that? What you want to think about in that scenario is like, what are the goals that you're trying to accomplish with, with a repricing. And then from there, you can back into all the various decision points that you'd have to make. Like who gets to participate?

9:26Is it just current service providers or are you going to offer it to former service providers that may still have options that are outstanding? Is it all employees and consultants or just employees? What if you have directors and officers that have options, you know, underprice or underwater options, do they get to participate? Right. So kind of depending again on what is the goal coming out of this. So the goal ostensibly would be to keep talented people at the company and not to sound like a marauder, but if you're no longer at the company, most people would say, that's not our issue. They're no longer here.

10:04They're on their own. So if you left the company on your own accord, or we laid you off and you're at a dollar, should we take the time to do this for you? The only reason to do it would be PR or to be a mensch, I guess. I'm trying to figure that out. And so most boards would have some sort of conversation like, oh, we really care about everybody who's there, but we don't have to do this, so we're not going to do it. I mean, that's what I would, that's what I've experienced. Yeah, absolutely. And it almost always is current service providers, you know, whether you pick up the consultants to is a question as to who is included there.

10:43really the only time that boards really stop and pause and say, should we offer this to former folks? And that's usually in the RIF scenario, right? Where we just let go a lot of people and it was kind of sudden. And should we give them a little something extra to maybe help them exercise their option grants before they expire and they lose the opportunity to exercise them? And this is where fairness comes in because it's a special circumstance. So these aren't people who were fired or left. They weren't fired for cause. They didn't leave for a better opportunity. This is in between those two.

11:20We did a riff because we're trying to save money, as we talked about in a previous episode. That one sounds to me like a logical thing to do. Okay, they were priced at a dollar. Maybe we give them some relief here. And then they just get a letter to them that says, by the way, your options are now repriced or something. Sign this piece of paper to be repriced. If only it were that easy. And this is where it gets more complex. Okay, tell me. So one of the big decision points after you figure out who is, do the participants have to give anything back in return? So are we just going to say your options were a dollar?

11:56We're going to just reprice them. And magically, they're now 50 cents per share. And that's it. No changes, anything else. Or sometimes it's coupled with, okay, I'm going to give you that. but in exchange maybe you take a haircut on some of the shares that are subject to the option maybe we extend the vesting on some of oh we get to keep you around a little longer so we'll put these down a little bit uh but you're going to need to vest them over instead of two more years we're going to put it back up before so life's a negotiation we're going to reprice this and everybody's best interest but we want a little more commitment that makes sense yep so a little you know quid pro quo there is i'll give you this you you got to give a little something too If you have that type of structure in place, then you will need to get the participants to opt in, right?

12:43You can't unilaterally say, I'm going to do this to you. I'm giving you a good term, but I'm also taking something. Ah, they have to opt in. So that they would have to opt in in that scenario of like, if we are going to say, we're going to extend your vesting or we're going to ask you to give back, you know, some number of shares. So they could keep the original deal or take the new one. yep it's kind of that's that's kind of the idea behind it then there's somebody at some cap table software company or a lawyer with a spreadsheet who has to then maintain a list of who's on the new deal and who's on the last deal this is mechanically a bit of work for the cfo and or law firm and and the other piece that goes into this is you probably have more than five or ten people that are impacted by this if you're talking about these later stage companies right maybe there's 50, 100 folks that may fall into this category.

13:34When you are making that offer to them, that basically is covered by what we call tender offer rules. And anytime you're in tender offer land, it just means we have more disclosures that we have to do to those stockholders and we have to keep the offer open to those optionees, in this case, not stockholders, but optionees for a period of at least 20 business days. So there's more process around it. There's like an actual whole formal process that has to be followed with this disclosure and this opt-in. They have like an election. So they have to be informed to make a rational decision, which means you have to tell them your revenue, maybe how much you're burning, the growth rate.

14:13Is that right? Some amount of data? And that's where it gets into the little bit of the gray area. Like certainly if you're a public company, it's really clear what you have to do on the private company side. It's less clear as to what you have to provide. And that's where, you know, really understanding the very specifics of where you're at with the business, what you're asking them to do may also determine how much disclosure is comfortable or not. So definitely a little bit of a gray area, but that's a whole topic of conversation and something that lawyers will need to prepare and go through that tender offer process.

14:42I will say, all that said, not very many right now in this environment are asking for something in return. Most are just saying, you know what, we need to keep you. This is a huge step down. we're just going to give you the 50 cents in our example makes sense life is hard right now people are fried post-covid post-market correction you know it's it's been a lot of seesawing i think everybody could use some normalcy and getting a nice little thank you you know somebody sending you you know a little ice cream you know in that little frozen container somebody somebody sent me a celebrity sent me some ice cream and uh i was like hassan minaj sent me ice cream after i went to see his show and he sent me this beautiful box of jenny's ice cream i'm like you gave me tickets to your show but i just always thought like what a classy guy right and this is a classy thing for a board and for the founders to do for their management it's classy it's unexpected it's just a little ice cream it's a nice thank you send somebody a box of chocolates and just do the right thing in this and so for management teams that want to broach this with there the way to do this is not through the board but to go to your founders the ceo and say and cfo and say hey you know as a group we're underwater yeah we listen to becky and jay cal discuss this on this week in startups uh here's the video anyway we could maybe be thoughtful about this process you want to be gentle there because you don't want to come across as being like a union leaders or you know being uh aggressive or aggro you want to have it feel constructive yeah yeah Yeah, for sure.

16:22And there is no good D goes unpunished. That goes along with this too. If the company just gives it away with no consideration received, there is a potential corporate waste claim that could be made. And so there's fiduciary duty considerations that need to happen and have the board talk through what are the justifications and why should we be doing this. Even if we do that where like, I'm not asking for anything from you. If folks hold an ISO, an incentive stock option that only employees would hold, if they hold that, basically, a repricing of that would be considered a regrant. It's considered a modification.

17:09So what that means is we basically have to reset the holding, the, the holding period for time from time of grant to receive the beneficial tax treatment. So there is a little give there because depending on how long these ISOs have been outstanding. Long-term tax treatment versus short-term. And just whether they qualify for that better ISO treatment upon exit. So, there's a lot of, there really is, it's why I was like, oh, if it's only that easy, we just send you a note. Yeah, I mean, so now the board's got to decide, hey, as we've talked about in previous episodes, hey, we got a certain amount of runway, we got to do a down round, where do we even prioritize this, right?

17:55And we've got to keep this company up and running, and we've got competitors, and we've got this AI threat. and this is you know what makes our lives so interesting and it's great to just have awesome counsel with you along the rides uh with these riffs just as we wrap up here um has there been just broadly in the industry not talking about your specific customers and clients this is always general just you know me and becky just you know chewing the fat discussing the broader topics we're not talking about any specific companies have the riffs caused blowback um and what have we learned anything about like how to do them as a best practice because i don't think i've ever seen at scale riffs like this at big companies obviously these smaller companies go out of business but this has been a lot of riffing i must say there have there have been and i think like that air cover is a good good uh analogy here too you know like when when a company does does a riff and they're kind of the only ones doing it they catch a lot of heat from it like oh my god what's going on over there um we're seeing very widespread we're seeing multiple rounds of of riffs at very respectable companies um so so that is happening i mean it's a it's a difficult area right now i would say one of the most difficult things is because of COVID, we have had our workforces remotely distributed.

19:23Employment law, and that's including RIFs, is governed by the state where the employee is located. Oh, my Lord. So I would say, if you're doing a massive RIF, get an employment lawyer involved. You can call me, and I will get an employment lawyer involved. That's not my area of expertise, but I know enough to know you really need somebody to hold your hand. One of the things I learned from this process was that some startups and midsize companies didn't know where their employees were. So employees, you know, they didn't tell employees they could move, but then they found out, hey, you know, this employee's tired all the time.

20:01It's like, yeah, they're on a different time zone. or six hours ahead four hours no literally people went to Hawaii people went to you know London or Italy and you're like yeah you know you got a background that's blurred or whatever it's one thing but you know you start to see Florence behind you're like what time is it over there 11 o 'clock at night you're working um and this then leads to employment tax uh jurisdiction issues and and how much you have to give in severance and the process and then also some employees, I think, were not very thoughtful about this either. And they're living in a different country.

20:35They're not considering their visas, their taxes, et cetera. So people kind of freelanced this a little bit, got a little loosey-goosey. It was a technical term in the business. Yes. I would say that that definitely took place around the employment situation over the last couple of years and still has having impact now with most recent topics of risk. um and then this long-term work from home i mean we all have feelings on it just personally like i do like to be at home with my kids sometimes i do like to be able to go to tahoe and do a little skiing a little extra skiing is always nice but i also i'm going back to an office because i want to be with people a little bit more putting aside our personal preferences as in terms of best practices and then and legal processes what's changed for startup founders is it really about having like a great uh personal employer organization peos or great provider to help you with that on the on the technical sides um or how are law firms dealing with this is this becoming like a practice internally where you got to start up with 20 people and you're like my lord employment agreements have to change because we have people in japan florence you know and hawaii and you know wherever yeah so your offer letters your employment agreements your IP assignment agreements, they're all governed by the state where the individual is located.

21:55So the California form is different than New York, right? Like New York can have a non-compete in it. California cannot, otherwise it's invalidated. Certain states require certain things to be included or not included. So that was a pain point for a lot of clients, particularly startups of like, I have somebody in Montana and now I have to pay my law firm to put together a custom form for one person in montana well what we did we we are always trying to kind of push the envelope a little bit on the innovation side of things we have a platform it's called neuron where we're trying to automate a lot of things and one of the first things that came out on that was in corporations we do like board consents for you know option grants and some other kind of routine uh things but what we launched uh earlier this year was actually a 50 state employee consultant onboarding process where if you're a client you can go into the neuron platform you can say i want to hire an employee in montana and here's the information you can walk through online it'll tell you ask you the right fields we have all of the templates now and then basically it's not it's not a um basically think of it as a automation with a white glove service like there's a real person that will get that input and say oh there's a red flag here or no this is all great put it in the form and let's go so we we specifically work to create that to deliver what folks need to just get people hired and have them on the right forms to not cause problems later as we wrap here uh how do you uh the firm look at ai a lot of people are are well let's let's take the firm out of it let's speak just generally speaking are attorneys using chat gpt and other ais to um you know are they playing with them right now is anybody using them in practice and when you've you know played around with them are you impressed uh are you in awe are you concerned what's the what's the general vibes as the kids say these days what's the vibes in the legal community about ai not replacing lawyers but augmenting lawyers yeah all of the above concerned oh scary yeah i'm impressed all that um so no we we are and i will say like uh a lot of companies um including uh law firms including us like have put out a ai policy um you cannot give legal advice based off from chat gpt do you oh wow you have to remind everybody in your company just just a reminder We're paying you, not open-air.

24:37That's not what we're allowed to do. We still have ethics and illegal practice of law matters if you do that. But that aside, it's fun. We definitely are playing with it. So I recently moved into the role of a co-chair of our emerging companies practice. And one of the things that we are focused on is, like I was saying, this whole innovation, automation, and we're looking at all sorts of stuff. And we are certainly looking at AI in terms of supplementing things that we can do as well. When I play with it myself and we have our chief innovation officer go through and play with it and kind of come back to the co-chairs.

25:19And we have looked at it quite a bit. It gets you a much better answer than Google does, right? There's always going to be the little nuances, you know, like the high level stuff. it's doing pretty good at and it's it's pretty scary like when i compare that to maybe like if i asked my one of my first year associates a question yeah chat gpt it's probably probably got a leg up that makes sense um and ultimately what my thesis is we're going to see a lot more startups that are able to have more efficiency so they'll do more with less a 10 person company will do the work of a 20 person company a 20 person company will do the work of a 40 person So I think we're just going to see a lot more startups because there's so many problems to solve.

26:03What happens in legal? Is it a lawyer can service more clients and charge less money for things that are de minimis to do that are boring for lawyers? I mean, you guys are, you know, you're the top lawyer, so you're always going to have the top clients. There's always going to be a lot of nuance for major customers and innovative customers. But, you know, I guess this impacts like maybe the lower end law firms, the more affordable ones. How does it shake out for the industry, do you think? I mean, I think it'll be a good thing, you know, overall, right? Like there's a lot of stuff that for particularly for startup clients that is very routine, but man, it's got to be done right.

26:42Like option grants, like you mess that up, you have bad tax consequences. It's not like, oh, we'll just go back and ratify it now. Like it's real dollars when you mess that type of stuff up. So we can, but it's very simple. Like once you, like if you follow these steps every single time, if you get it right, we can automate a lot of that and we can kind of put in triggers to make sure the bad thing, the red flags are getting, you know, flagged and processed the right way. So I think, I think it's a good thing. I think, I think the way that you said it is right is like, there's a lot of things that you don't, you don't need to pay my hourly rate for.

27:18Like my hourly rate is to provide hopefully valuable strategic advice about complex transactions. You're probably right. I've seen those bills. Becky. I've had those bills land on my data. Whoa, Becky. But you want to make sure that the simple stuff, but you want to make sure the simple stuff is done right too. Sure. Which means, yes, we pass it down to the lowest level that we can, but why not automate some of it? And that's really where we're focused on saving some time because at the end of the day, we only have so much time and we'd rather be doing the cool, more complex stuff too rather than, okay, you have 20 safes.

27:55Let me go in and type in each one of them and send them out. I mean, sometimes the work being done by lawyers is clerical, data entry, double checking. And I don't know what percentage of a young lawyer's time that is, but it's gotta be 20 % or 30 % wrote, something like that, I'm guessing. And we're basically trying to squeeze that to where you gotta learn how to do it. But once you learn how to do it, let the computers do it. They're a little bit better with mistakes. I mean, I don't know if you, I think you caught the tail end of this. Like I did, there was a typing pool. There was a messenger pool in the building.

28:30I don't, did you catch the end of that where people were typing stuff up and there was a doc, a document, a photocopy pool and a document delivery service in the, in the building or no. I mean, we have, we, we still have a document processing center that helps with various things, um, whether it's deliveries or couriers or whatnot. not but it's um in far less use than it ever used to be i just remember coming in and installing the computers at like i don't know if it was cahill gordon or sherman sterling somewhere in the 90s when i was installing local area networks and document management systems and they were like see this room where they photocopy everything and see this room where they type everything like document management is going to get rid of all this and i was like oh what are you gonna do with all those people like they used to be like the mail rooms that some of these places were huge and there was a person who would walk around before email with inter-office mail there was a thing called inter-office mail did you catch the inter-office mail you missed it yeah i've always been on email so inter-office mail i'm a little bit older than you becky there was you had you had envelopes and you would write the number of a person's office and put the document in and then somebody would walk around and pick up inter-office mail you put it outside your office in a little folder and person would bring it to another floor and drop it off for somebody and then you would cross out the person's name and then you write jacal you know room 512 and then you cross it out becky room 617 and that was email before email all right listen that that sounds like a nice slower pace of life it was it was different yeah you would be like oh let me run those documents up to you walk up get a cup of coffee drop the documents off have a little chit chat everything was yeah it was super slow and charming now everything's the speed of life all right everybody go to thisweekinstartups.com slash basics very simple to remember thisweekinstartups.com slash basics to see all the basics i do with becky uh over the years so many of them uh we've done together just to help founders we'd love to help founders becky and i both are aligned in that and if you want a great partner wsgr wilson sincidi great firm my lawyers thanks becky Thank you.