Navigating Challenges in Distressed Companies with Becki DeGraw | Wilson Sonsini Startup Legal Basics

0:02all right everybody welcome back to this week in startups it's time for startup basics with my friend becky de brah she is counsel from wilson cincini goodrich and rosati wsgr as we call it people say wilson cincini here in the valley becky one of the things we're seeing is distressed companies i'm on the board of some of these and this crazy moment happens when it's pretty clear that this plane is not going to make it across the atlantic ocean and land safely to use a dark metaphor it's not life or death but all of a sudden i look to my left and my right and two vcs and an independent director just took their parachutes and jumped out the back of the plane and i'm sitting in the cockpit with the two co-founders and we got to do something with this plane so maybe you could talk about why do some certain vcs just leave the board company's not out of business but they're clearly struggling and there's just like perception hey we're not going to make it it's going to be a pretty rough landing so let's talk about distress companies in that final six months.

1:07Yeah. Now, unfortunately, we're having more of these conversations in this macro environment that we're in. But I think if you find yourself either as a director or officer in one of those companies heading in that direction, your job becomes much more difficult, right? On a number of fronts. Anytime you start taking actions, they're going to be looked at with greater scrutiny, right? Oftentimes, it's insiders that come to the rescue from a financing perspective. And we've got insider-led down rounds and recaps and these things because it's like, hey, you're running out of money. There's no other options.

1:49The terms get more aggressive, more punitive, more dilutive, higher risk for claims later. The other thing that goes along with that, right, we tend to be more complex, more creative. Whenever you do that from a legal perspective, your legal fees start going up and it's like, that's the worst time to have bigger and bigger legal fees. But oftentimes, you know, you start having more regular board meetings because you need to, you need to have a good record showing what you're doing, that you're paying attention, that you're well-informed, that you're looking at all of these things. But man, it takes a lot of time, a lot of resources and starts starts pushing up and to your point some investors say all right i've already written this investment off the whole point of me staying on the board was somewhat of an oversight function for my investment if i've written it off and me staying on as pure liability i think that's something to to weigh uh you know from a company perspective that's when people pull the ripcord it's like we've written this down to zero and it's going to take my time it's going to take energy and these situations are 50 times more distracting and they have a hundred times the bad feelings pay to play keeps happening maybe you could explain to the audience what this pay to play scenario is this last-ditch effort in some companies that creates massive bad feelings and you know why people do it and should they do it you know what's your take here yeah yeah i mean we are seeing more pay-to-plays um particularly in connection with down rounds it's usually you know the company needs money nobody else is coming to the table the insiders are doing this pointing to each other like are you gonna go because i'm not going by myself i'm not going to carry carry the full weight of this you got to come along and help too and some investors are like i'm not helping no no i'm not putting good money after bad money and but at the end of the day like the company needs needs a certain amount of money too to to get to whatever that next hopeful step is is going to be so when we put a pay to play in place we're essentially saying we want you to participate in this financing for your pro rata.

4:14And if you don't, something bad is going to happen. There's all sorts of what we can fill in the blank with that something bad, but oftentimes it's, we're going to convert your preferred stock to common stock. And it may be not that we're converting on a one-to-one basis. We can start messing with that ratio too. Say for every 10 shares of preferred, you're only going to get one share of common. And then for the folks that participate, maybe we pull up, we call it, essentially like turn that common stock back into preferred stock. Again, it may not be a one-for-one basis, but that's kind of the general concept of the pay-to-play and why it comes into place.

4:55This company needs money and I'm kind of going to use a stick to force you to help support this company at this time. It's really rough. I've been in a lot of these situations um the last two years and i have never seen a pay-to-play round result in a win for the company afterwards it's it's few and far between it's very risky as a permanent investor perspective putting money in at that point yeah and you know i think you learn i'm going into my second decade as an investor here and i think what i've learned is if we are at that point this is not going to work out and so we really should be talking about a sell or a shutdown but you know hey founders might have a white knight and they say hey we've got you know a million in revenue we've got a broken cap table and this white knight wants to put a million in and that million will get us to profitability i want to keep going you say well there's already 10 million dollars in overhang in the company and that 10 million represents 40 percent of the cap Well, you know what, of that 10 million, you know, each person who put in a million now they're 10 % of that new round, right?

6:05Or something to that effect. Let's say that if I were to do the math, that 10 million bought, let's say 20 % of the company, each point would be 2 % or each million would be 2%. Therefore, you have to take 2 % of the new round, which means if you put in 5 million, you got to put in 2 times 510, you're going to put in some money to this next round. in order to keep your shares and if not you got a common and some people just might not be willing to do that that fund is fully deployed or they just see this as super liability if they are successful have you seen people or amongst your contemporaries other firms other situations when you're chewing the fat and having a beverage after libation drown the sorrow of some of these days i can go pretty long you have a double mccallon um or whatever your jam is do you see legal action afterwards hey you guys did this pay to play around it worked out it's one of the one in 50 or 100 that do work out hey you know what maybe we'll send a couple legal letters and get our shows back has that happened that that was what i was going to say is the ironic the ironic thing is vast majority i feel like we go through all these efforts to pay to play the recap whatever hoops we might jump through the legal fees that it takes to do all of it and then the company doesn't doesn't pan out right uh from there let's just say they are one in the few that do and like yes success story they pulled the rabbit out of the hat they're doing great that's the time when we start to worry about uh-oh are the stockholder lawsuits going to come because the stockholders aren't going to file a lawsuit when there's nothing there when the company did a nosedive right like get blood from a stone exactly so but in the scenario where the company is actually actually successful in turning it around then you're like oh boy now i got to deal with this and that's where i will say i'm spending a lot of my my time right now of having those conversations of the plan for the worst case scenario well plan for the best case scenario which also might be your worst case scenario from a legal perspective um and what are some things that that we should be doing while we're going through this process to help mitigate those the the bad result that could come from from that um and one of the things that i say to everybody and that is one of the most important things that you can do and there's all sorts of different mitigation uh techniques or things that we can do but have a good process make it the best process possible like right you can't you may not be able to control the outcome in terms of like what the terms are and all of all of those those things but you can get everybody to sign off on it and that is the keys to get this unanimous so hey listen you are not going to do the pay to play you don't want to participate we get it you're leaving the board you need to sign a piece of paper that says you're leaving the board and you need to sign a piece of paper that you had the opportunity to buy shares and you did not Yeah, we would love to see all of that.

9:05And sometimes, run a good process and make sure it's reflected in the board minutes too. So going out and doing a market check before you just, it's easier to accept the money from the insiders. I know it's a down round, but it's easier than me going out and checking whether there's anybody else. Explain a market check. I know what it means, but for the audience and for founders, what is a market check? Yeah. Yeah. So it's where you're, let's say you need to raise money. You actually go out and you talk to a number of investors. Maybe you hire an investment bank to help you with that process as well.

9:44And sometimes we see the companies that will do that and actually like, right, you're talking to, you go out and you talk to 30 investors and every single one of them says, no, not interested, not even getting past first, first conversation. Document that. Like, I know you don't want to air your dirty laundry, but that is so important to have that in the board minutes because it paints the story of this truly was a financing of last resort. The only people that were coming to the table were our insiders. We couldn't attract it from anybody else. And yeah, you know what? It was really risky and the terms were a little punitive, but there wasn't anything else on the table.

10:23and i've had founders who come to me and they propose one of these things and it feels like they're self-dealing and then i say okay who did you talk to for m a what bank did you hire who were the people where's the google sheet that tracked all this they're like well we had a couple conversations and i'm like great let me know which ones you had i want to see the emails from them saying they're not interested i want you to document all that and they're like oh well yeah you know, we you don't trust us. And it's like, okay, let's not make this emotional. Everybody we're not in kindergarten. This is in high school.

10:57This is business. And you need to document. We emailed these 30 investors. We followed up with each one with two subsequent emails, we got 10 meetings, we took those 10 meetings, they turned into four second meetings, those four declined to invest at any price. These are the reasons those four people gave us of why they weren't investing. and it's in an addendum attached to it's in a google sheet somewhere it's in a notion page whatever this i mean this is not rocket science to do this and man does this cover you and i i have been through this so many times where you know founders do this and i've been through it a couple times where founders don't do it and then they propose hey their friend's gonna put in 500k they're gonna put in 250k they recap the company and i'm like well which investors did you oh you don't trust me oh god trust but verify and and i mean like it's it is real liability to the directors and officers that were watching that were approving like what you just said would be i would love to see that that that spreadsheet send it out to the board have the email have the board minutes say after reviewing the google sheet that was about the investor outreach the board decided to do x like that's that's like give our litigators a chance that's the gold standard you know and if it did come down to litigation you have opposing counsel file or or they you know you do some sort of phone call they write a letter and you say listen you know this is going to come out and discover do you have the board docs and they're like no and okay great let me let me share the board docs with you here it is um were you aware that this existed a google sheet with 30 targets and are you aware that they had second meetings with these four and these four said they were declining for these reasons i was like no i wasn't aware of that okay great so before you file you should know that this occurred and so these claims maybe are less valid or not valid at all yeah and i mean it may not be a complete get out of jail free card but it is it is one of the best things that we advise of like again we may not be able to control the terms as as the company like it may we may end up having to take some really punitive aggressive things but at least at least control the process so that we can we can have have the best possible uh look there as a steward of capital let me get free legal advice from you here i've had a couple situations where i disagree and i've said we are a launch fund with percent ownership this has happened you know five times in 400 companies which you know have some number of rounds of financing so we're talking about thousands of rounds of financing i say yeah we're voting uh in we're opposed to this so we're voting in opposition to it and the founder's like really i'm like yeah for this reason we don't believe that this is you know we don't think you should be selling secondary and raising money and we think you should have gone with the other deal that didn't have the secondary offering in it because we think it's bad hygiene so we're voting against this but we understand that we own six percent and you know whatever you needed eighty percent or something to and we're getting dragged along like oh we talked to our council they said you need to vote for it and i'm like actually we don't this is how governance works so maybe you can talk a little bit about when you have somebody like me a conscientious objector who says i just can't vote in this or i'm going to abstain from voting or i think i did abstaining once um and then i voted no maybe twice in the history of what we've done it was pretty severe you know i'll leave it at that um so what do you think of that situation we have a board director says listen i just can't vote for this yeah i mean ideally from company and director uh perspective is you have those conversations outside of an actual formal board approval and you find a way to get to get there from a compromise perspective like i would be shocked and i'd be curious to know in the case where you did vote no if the investor on the other side said oh yeah cool i'm all right with that still if one of the directors that voted no i think this was a spin out you know they wanted to spin the company out and the amount of equity they were giving so there was like two products inside the company the founders left to go do this other company with the asset from this company gave the existing investors like 20 and i was like well what's going to happen to this shell of the company that we own 10 of it's like it's going to zero essentially because nobody's going to be here to run it and i'm like well that seems profoundly unfair you just took the one asset and moved it over here and then you guys own 80 the existing the new investors own 15 the previous investors on five why don't we just stay in this cap table and just shut that other business down like oh well because we won't own enough equity like too much of an overhang i was like okay i vote no and you know that's still hanging out there and so to our point earlier and i i said no because if our lps came to us and said do you allow this i didn't want to have the liability saying i allowed it i wanted to have on the record that i voted against it that there was an email that said here's the reasons why and if that company becomes worth a billion dollars to your point before you know we would be able to then make a claim yeah and i mean like there's there's the board vote and the stockholder vote and depending on which hat you're wearing right at the board level you've got it you're supposed to be exercising your fiduciary duties to the company into the stockholders and if you're like hey this is not a good thing for all of the stockholders for you to do some self-dealing transaction then then yeah right like it's you gotta you gotta speak up i'm getting upset about it right now you know me i'm i'm such a you know it's just i don't know it's my Irish Catholic upbringing in Brooklyn and my dad it's just my dad was so principled it's a Greek business owner and my Irish Catholic mom and her family just very principled and man it just gets my Irish up when literally somebody does something that's unethical or immoral or shady in any way and I'm getting annoyed by it right now but you know I do have one thing that keeps me annoyed at people do these kind of things they tend to fail it is true it is it's almost universal you and i went through a couple of wars and like that company that we had you know a couple of companies we had that you know were a little dicey they're no longer in existence and we were able to secure save our investment and watch that company and that founder literally drive into a brick wall and we were the only people who got off got out of the car you know and when you see a reckless driver you know it's an indication to me that people who do something reckless are doing more reckless things that you're not aware of and they will do it again and if they're rewarded for recklessness or bending rules um they can get the wrong message and they double down on that stuff right yeah yeah it kind of goes to character right it goes to character but and then also incentives you know we see in our industry um in order to run these companies you have to be an extreme it's an extreme pursuit and then in some cases you know you're you're bending some rules reinterpreting some rules you're disrupting being a disruptor but you just have to be careful i don't recommend people become disruptive or destructive with legal issues and corporate issues just keep that one on the straight and narrow we've we've had a few examples uh really high profile examples right over the last couple of years of perhaps uh bending what not not walking the line delicately but no you are way way over on the other side of the line you're literally like wile e coyote running off the cliff and like you just don't realize there's nothing underneath you you know and i so many of the crypto companies we looked at i said and maybe we should end on this you know and i don't have anything against crypto but when one of our crypto companies told us meet our new panamanium lawyers in the bvi and we're setting up a non-profit and the non-profit is um got five directors but we can't tell you who the directors are because of the safety risk and like well i'm a director of the company that's spinning out the non-profit in panama through a bvi attorney and you know how i knew this might not be a good situation when the formation of the panamanian non-profit was a million dollars in legal fees and i was like wait a second i have the best attorney in the world becky wilson cincini and she'll incorporate the next company you know or like the retainer it's like it's not what we're paying for what and i said to this woman who was doing this in the bvi i said can i ask a question why is it a million dollars she's like well there's some risk associated with it and it's complex and i was like we're paying you a million dollars because it's risky like couldn't believe she said it out loud she's like well maybe that's the wrong word it's complex is really more the word and i was like yeah i'm good red flag red flag red flag i mean literally it was like somebody just took a case of red flags and dumped it on the table i'm not in the red flag business all right becky you're wonderful thank you for protecting me at all times and our startups uh and if you are uh dealing with dicey situations just call becky she's awesome um her dance card's pretty full but wilson sonzini always has uh some great attorneys over there man wow rides we've been on great adventures together and uh you know every now and again one of these companies wins big and it makes it all worthwhile uh so thank you so much becky the joy of the ride right it's a little wild at times bring some drama mean folks if you want less legal fees and less volatility don't be in the startup world it's a little bit binary here but uh great counsel makes it a lot easier see you all next time bye-bye thanks jason appreciate it