Navigating SAFEs, Pay-to-Play Rounds & Risks with Becki DeGraw | Wilson Sonsini Startup Legal Basics

0:00Hey, everybody. Welcome back to the show. I get legal questions all the time. I get so many legal questions. It is crazy. It's like right after product market market fit. And so what we'd like to do here on this week in startups is do our startup legal basics series. And I bring my own attorney, Becky DeGrasse from Wilsonson senior. And she's a partner over there. She works with startups across all stages and helps me with all kinds of issues. We've been on tons of adventures, some of them crazy, some of them delightful, everything in between. Some of them a little anxiety producing even Becky, but we always seem to work it out in the end.

0:36Yeah. yeah and that's what keeps it fun too it keeps it fun it's it's really when we think about startups and law and startups it's a bit of the wild west um at times but we've codified so much of it in standards and these standards are based on trust what i'm always amazed by i don't know if you have the same amazement in america and in the law is that and especially in our industry silicon valley is that we've created over decades these standards and people um even though they could be standards breakers and they can do all kinds of stuff and and you know jump the fence and go crazy everybody 99 of the time obeys the standards and just works in good faith to build companies together isn't that amazing to you it is and there's a whole ecosystem around it the way from how we do the deals to who's involved to the time, the structure, the terms.

1:35I mean, there is definitely a market around all of that. And you can certainly tell when players that aren't used to it kind of come into the ecosystem and, you know, they get identified pretty quickly as not necessarily understanding how it works. Yeah. And it's important for founders to understand that there are people who've been working for 10 20 30 sometimes 40 years in the industry and they know the standards uh so get a great lawyer know the standards come in try to keep everything standard terms as a founder uh when you're doing these things and deviating from the standards and getting creative yeah i would say in the legal space not a great idea maybe you can talk a little bit about you know people saying i want to try to do something new

2:27like i always say like from from a business perspective yes break the box disrupt do something new from a legal perspective not not the place to do it it's just it's not worth it right right in the long run you're going to spend so much more money going down that path you're going to be viewed as an outlier in terms of what everybody is expecting to see and at the end of the day when you get that two minutes in front of an investor don't spend a minute and a half talking about your creative legal structure like that should be the last thing that that should be the 10 second blurb this is what i've got i'm good to go i understand this let's talk about the business it's just so well said uh becky you know if you're going to be creative and you want to do unique things your startup hey the culture of your startup the product how you how you um you know interface and disrupt an industry all that's available to you but you're doing your stock option plan for employees or employment contracts or trademarks or corporate structure board structure investment documents this is a place to enjoy um the absolute efficiency of the standard docs yeah yep it's been tried and true over time and time again like there's a reason why this is where everybody has gravitated toward toward and it works you know the interesting one as we get into this because i wanted to talk to you today just about the general trends and we got so many to go through but one thing that was interesting when somebody tried something different was the safe agreement right we had convertible notes and then yc worked on the safe and the safe has become a bit of a standard but there are some things with a safe agreement that have been challenging on the margins.

4:10Maybe you could talk about that innovation and how it got sticky. And then maybe what founders should think about when they do a safe, if any. Yeah, absolutely. I mean, when the safes first came out, people were like, eh, I don't know about this. Let's just stick with our convertible notes. And then they started gaining traction. And the reason they started gaining traction was YC really pitched it as, look, this is supposed to be a fairly middle of the road approach. It's not going to be solve all the best terms for investors, it's not going to give companies all the best terms. You both are kind of going to meet in the middle.

4:41But the beauty of it is when you're doing these rounds, particularly like if you're investing$50 ,000,$100 ,000, right? And you have multiple folks coming in over that. You don't want to spend a ton on legal fees. It's meant you go to the YC website, you download it, you fill in the blanks. It's not meant to be renegotiated, right? And that's the beauty of it and people were like hey this is a great instrument to use we don't have to get counsel on both sides involved to review these documents particularly for smaller investments and we're off to the races so fast cheap and then over a couple of years that became the norm it definitely replaced wherever we were using convertible notes and sure we would still see convertible notes here or there depending on certain circumstances but a fast majority moved over to the safe but the safes are certainly not as protective to investors.

5:36So it really depends on, you know, what hat you're looking at, you're wearing at the time, you know, from a investor perspective, they're not, not as protective. And what we're seeing right now, in this market that is tending to switch a little bit from, you know, the last call it five or eight years that have been very company founder friendly to swaying more back toward a perhaps investor favorable market is investors are starting to use convertible notes a lot more than safes maybe not necessarily for that first round of like pre-seed like we're still seeing safes come in at that point because we're still seeing still seeing a pretty strong seed market but if we're using convertible notes to bridge between equity rounds like between your a and your b or your b and your c that's just getting harder and harder to to to get um that's where we're starting to see the convertible notes come in um and there's the reason because people want to know like hey by this date it's going to convert or i can get my money back and i'm going to get a little interest what are the investors hoping to get with the convertible note that they don't get in terms of protections with the same yeah so um one it is actually a debt instrument so the safe is not the safe is it's not debt it's not equity it's kind of this quasi thing in between um release a contract is is what it is for you to get future equity.

6:59But the convertible note is debt, which means if there's any dissolution, any liquidation, any sale of the company, debt is number one in line prior to any equity. So first and foremost, that's like the biggest protection that's out there. Other things that it includes is an interest rate. So that's a nice little benefit to investors. You know, we used to see interest rates on these things, maybe like low 3-4 % now with the interest rates going up and with the more investor favorable terms out there we're seeing eight ten percent on these these convertible notes um which is much much higher than what we have seen before and hey that's actually something it will add up over time generally that interest doesn't get paid but it gets converted so when it's not free yeah when the principal converts the interest converts and the investors get you know a little added benefit there um it also has a maturity date that safes do not have this is like that the forcing function from an investor perspective right is like the safes can just hang out there for as long and they do and they do i'm sure and they stack up personally know that i mean i've just watched some folks stack them up and you know you're like at some point is this going to become equity like and we're going to have a cap table and they're like well technically you don't own any shares i'm like yeah okay that technically is true right yeah it becomes a little disconcerting for investors i think if they go on forever yeah Yeah.

8:21And, you know, I mean, the most convertible notes, the point of the maturity date is not that the investors are actually going to come in and call the note and put the company into, you know, an insolvent position, but it's a forcing function for the parties to come back to the table. Let's talk about what's going on. Let's talk about what the next steps are and to get, you know, figure out what those, what the path forward is. and to explain to founders just so they understand and investors who listen to the program uh let's say you put a hundred thousand in and you have this eight percent okay every year that goes by let's take it takes three years or let's make it ten percent so it's super easy now it's at 110 then it's at 121 then it's at 100 and whatever that is you know 133 or something so you've got 30 000 in interest that's built up over three years added to the hundred if it was a 10 million valuation cap instead of getting one percent of the company you would get 1.3 percent of the company or so so that little interest builds up gets converted into equity so this uh means that the the value of the money the time value of money gets accounted for uh and nobody's really in it for the interest but in a high interest rate environment people are saying well i could choose to put my money in a bank account or in the startup maybe there's some some ground here that's even and then if the company does become insolvent and somebody has put a convertible note on top of a bunch of safes the person who puts the convertible note in is in a much better situation correct that's right yeah that gives them the priority essentially in any type of downside scenario or sale of the company and you know when you have a short sale getting sold for less than the amount that was invested let's say five million dollars has been invested in a company it's being sold for 4 million there's not going to be uh somebody is not going to get their money back or some group of people are not going to get you know a dollar for dollar but the later stage ones might and so this is why uh in a tight market like we're in now capital gets a little bit of an advantage in a crazy market like we experienced for the last let's call it 2019 to 2021 the terms went completely the other way pick good partners i think have thoughtful conversations about this and um just you know you got to understand both sides of the table so tell me what you're seeing in terms of um companies that raise that high valuations during the hot market uh what do they call it like you make hay when the sun shines and you know some founders were like jacal becky i'm getting this crazy offer and then we said to them okay that is a delightful offer um sure you can take it but you have no revenue and now your company's worth 50 million in order in a down market or in a reasonable market you might have to have five or ten million dollars in revenue to justify that so just understand you're going to have to use this money to get there and if you don't there could be issues uh including a down round so explain broad strokes obviously you're not going to talk about a specific company but you see a lot of activity what has life been like for you at wilson cincini and working with startups who did raise at high valuations and now find themselves needing to raise again Yeah, so it's not a pretty picture right now.

11:36The seed in A stage stuff is still pretty strong. We're seeing a lot of activity there and that market is good. But for the type of company that you're talking about, it typically was like they raised their B or their C or even a D at these really high valuations and they raised a lot of money during that time. and you know what I what I'm hearing when I set in on the board meetings is you know call it maybe even two years ago or a year and a half ago when folks well maybe yeah maybe about a year and a half ago when folks started talking about hey maybe we need to be a little careful here maybe we need to conserve cash and that became a big topic of every board meeting what's our runway how much are we using how long do we have do we you know look at sacrifice growth to preserve cash for a little bit longer, and really analyzing different types of proposals and trajectories for the company to figure all of that out.

12:35A lot of those companies have been able to use the money that they raised in 2021 to kind of just set on the sidelines right now. The later stage market is largely significantly shut down, right? The closer you get to IPO stage, the less deals that are happening. So the crossover stuff is hardly ever happening the really late stage stuff is also really slowed down but even doing like a series b and c even if you're still fairly far away from you know an ipo they're just more difficult to do right now investors are looking for more metrics um and and to make sure like yes this is this is going to be it um what what is interesting right is like by by choosing to kind of take a uh a lower growth approach and maybe conserve cash a little bit more those companies that are about time like a lot of them looks like maybe later this year are going to have to go out and start raising because they've exhausted you know they're about to exhaust the money that they raised in 20 2020 2021 and when they do they may not have you know those awesome hockey stick metrics that folks are used to seeing because they purposefully kind of restrain pulled tightened things down and pull back a little bit.

13:55So it'll be interesting to see how the market reacts to that. But that all being said, there's another dynamic here that's really interesting too that we haven't seen in the past when we've had one of these type of slowdowns. And that's, there's a lot of dry powder setting on the sidelines. So you look at 2020, biggest funds raised ever 2021 oh we broke those records by investors raising even bigger funds and guess what even though 2022 half of the year was kind of a a difficult year funds still broke you know fundraising records but that capital is being deployed at a much much slower clip than it was so there's any map a massive amount of dry powder on the sidelines that want to invest and at the end of the day, like need to invest.

14:45Like there's usually time bombs on those of, Hey, we got to invest by a certain time period. And you've got these in the, the companies now that raised and need to come back to the market for their next fundraising. What we're seeing though, is a big valuation disconnect between the two parties. Investors are like, Hey, I'm here. I'm ready to write big checks. I'm ready to jump in. But I think your valuation is not quite what it was the last round right and the founders don't necessarily share that view right they or the boards and previous investors because they have uh some input as well depending on how the board and governance was structured exactly yeah absolutely and you know i mean particularly like on the the founder side right um and investors too so many of these folks even if you've been doing this for 10 years you may not have seen like a down round environment like you're used to i mean i started investing as an angel as a scout for sequoia in 2009 10 right after the great financial crisis i only knew uh an up market i had been through it as an entrepreneur a couple times the dot-com craze and the great financial recession but not as an investor so these investors now they have a concern if you were a previous investor okay i marked this at a billion dollars in my past fund i'm on my next fund or i'm raising my next fund like i am right now okay i'm raising my next fund this thing's marked at a billion okay if somebody offers 200 million for this and it's an 80 haircut like you know peloton or some public market company's got a haircut you know of 80 okay um i've got to mark that down in my books now my you know rate of return for my last fund has gone down is that going to impact my ability to raise the next fund there are so many dynamics for fund managers that happen and then you have the founders and the employees maybe the price of this next round that people are willing to pay um you know crushes the valuation and you said uh correctly some of them went to conserve cash so they conserved cash so they slowed their growth rate so now we're like huh this thing's growing 20 a year instead of 3x where this thing's not growing what is it actually worth maybe it has to be sold so this all is going to happen in the next 12 months it's going to get crazy it's coming it's coming to a head and i mean we're we're definitely seeing it more i mean like the end of 2022 and first quarter of this year i was having a lot of conversations about down rounds and pay to plays and we're dusting off the playbook as to what are all those other features and you know you might be able to, you might need to, to pull on to get a financing done.

17:31And a lot of it revolved around education, I think, initially. We started to see a little bit of, you know, down rounds coming in, but the conversations were happening much more, right? Like, okay, maybe, maybe I need to revisit that. Well, we saw a really big increase from just in Q1 of down rounds well but well first of all like it was like 40 percent of all the private company financings that we see and that's both on the company and the investor side were either flat or down that's a huge number for not being up and then that's a lot of medicine people are taking that is right um and then when we saw like pay-to-plays being used in down rounds that increased from something like 15%, like 40%.

18:21Okay, so we should pause here for a moment and define pay to play because if you've been in the industry for about 15, even 20 years, you've never heard this because the last time pay to play came into effect was either in the great financial crisis on the margins, but that was a shorter duration and it wasn't as hard actually, I think as this has become and this isn't as hard as the dot com. So I think this winds up, I think you might agree between the great recession and the dot-com bust is where this all nets out to be in terms of pain and suffering but let's define pay to play yeah so if a company is doing a financing let's call it their series b financing um basically you would put this provision in place that essentially says you as an existing investor you have to participate in the series b financing and you have to buy your pro rata share or it could be a percentage of your pro rata share all these terms are customizable but usually it's you got to buy your pro rata portion of the series b or else something bad's going to happen usually the something bad that happens is all of your preferred stock is going to get converted to common stock so the idea is you have to pay by participating yeah to play to continue to be a preferred stockholder and keep all of the rights all the bells and whistles that you have and there's all sorts of ways that this can be structured um but that's the basic concept and it can get more or less aggressive onerous yeah so when this happens a founder drives it typically the new investor drives it the board drives it would be against the board's best interest so in my experience boards sometimes say hey i don't advise this because they want to keep their preferred shares without having to put more money up so who becomes the drivers of this practically speaking does counsel pull aside a founder and say listen here are your options and this is but one of them because if you're if you did the series a and you own 10 of the company and now they say hey new round is going to be three million dollars you got to put up 10 of that 300 000 they don't want to that funds deployed whatever it is or your 300 000 becomes common and you know your three your whatever 10 your 300 000 your 10 goes down to one percent you know net net at the end of the day how do these conversations go down super uncomfortable huh it's uncomfortable and it's complex like there's a lot of technical legal issues that that come up across this and what you're alluding to around a lot of it is conflicts there are lots and lots of conflicts um at all levels let's break let's talk about the top two or three conflicts that a founder, existing investors and new investors are going to have to navigate because there's going to be two or three of these, we might as well put them on the table here.

21:08And then after we discuss what the conflicts are, how the resolution gets done, practically speaking. Yeah, so one of the biggest ones is going to be at the board level, right? Like, any transaction, any financing transaction has to get approved by the board. So the first thing we're going to want to understand is who on the board is conflicted. A lot of that is going to depend on what type of transaction it is. These down rounds, if we're talking about kind of a traditional, like, this isn't, okay, a little bit of a step down from the last round. We're talking about, okay, you were, in your example, a billion dollar post money coming off from your last financing.

21:50We're about to do something at a 200 million pre or something. we're talking about significant down rounds here quite often they're insider led lots lots lots time they're insider led and what that is is like the insiders the existing when i say that like the existing investors who are on the cap table are the ones that are coming to the rescue to say okay fine i'm gonna put more more money in but here's my terms and you know they are pulling down in the valuation that can be one scenario where the existing investors are the ones that think okay maybe we did overpay in that last round and you know the company's not where where we expect it to be or macroeconomics but we have some belief in it because we think it could rise or we wouldn't even make the offer we would be writing it off and we'd be saving our time on the board so it's not the worst situation the worst situation is they say good luck with the company we're off the board let us know how the investment works out yeah so this is somewhere between yeah like the debt scenario and the you know uh some some version of faith because they're putting some money in yeah and you know that's that's where we will start to see the conflicts arise right and that's um who and when you say you ask like who's driving it's usually the company needs money and whoever is willing to put the money in is driving that initial conversation in terms of, I'll put money in, but I'm not going any higher than this valuation.

23:17And then that's where we're like, okay, now this is the scenario that we're in and we have to deal with this. When Delaware courts look at conflicts at the board level, they are very broadly defined. Absolutely. If I'm an investor and I'm sitting on your board and I'm going to participate in the financing, that's a clear conflict. But even if I am not going to participate in the financing, well, let's say I co-invested with this other investor that is also sitting on your board, and we do a lot of co-investing together, and we're in a lot of companies together. And, oh, I actually vacation with them in the summer.

24:02Guess what? I'm going to be conflicted too in that scenario and delaware looks at all sorts of things all sorts of things outside of just purely french transaction other transactions where does the founders conflict come in because they have their entire net worth in there so they're obviously conflicted and they're and then there's the employees so they're conflicted because they have to deal with employees so yeah so the the big conflict on the founder level is almost always when we're talking about that crazy 80 % drop, that has to be coupled with an option refresh. Otherwise, your management team, your employees aren't sticking around.

24:43So you've got to do that. So you've got either some sort of option refresh or some sort of management incentive plan that you're putting in place. Soon as you put that in place, everybody on the common side, right, the setting at the board, the founders, the management team, they're going to be conflicted. So it's actually really hard and traditional you're talking about kind of this is the standard way of doing things yeah even like industry experts and you i mean you'll see them at the later stage companies but even then they can be conflicted because they might have bought preferred stock too and they might be impacted by this pay-to-play and if we decided that we're going to carve out the smaller preferred stockholders and it's not going to be applicable to them guess what that still means they're conflicted because they have an interest in how the terms are going to play out um if that industry expert is somebody that again i'm the investor and i've i suggest this industry expert every time i'm on a board for this type of company and we serve on five different companies together and i always bring that industry expert in and i'm participating he's not guess what he's probably still conflicted because of that relationship that we have like i am the ticket for his next forward entry right so the conflicts all the time and then basically good faith and having your back against the wall results in a transaction closing or the company closing sadly at some point people have to say like listen this is the best we can do there's three months two months one month two weeks worth of runway we either take it or we shut down which are we going to do here and in my experience it's that you know being pushed towards the edge of the cliff that suddenly makes everybody say okay i'll take the medicine yep and that's that's exactly right why why investors because sometimes people still have kind of a concept of why would existing investors do this to themselves well sometimes that's the only choice and in order to save the portfolio company and at the end of the day they've got to believe that the company will live to fight another day and become the next billion dollar company and revive otherwise they're not going to do it but if they believe that they still have to justify like what am i doing today why am i investing today on these terms and that's where the terms start getting aggressive and depending on what the goals of the company is like you know the kind of example we've been using at this billion dollar valuation company that's getting cut down to 200 million one of the goals of that i imagine is probably gonna have to be like a full recap of the company and what that means is like we've got to like right size the cap table because the liquidation preference stack that's tied to the preferred stock that you've already sold is probably going to be higher than the value of the company now and that that's not that doesn't work right from from an economic standpoint certainly not from raising that doesn't put you in a good position to raise your next financing either so So in that scenario, you know, we not only need to do the down round, we may do a pay to play, but we've also got to put like this recap in place that essentially right sizes, you know, the liquidation stack and your cap table.

27:58The good news here is if you're having those discussions, people still believe in you and your company. They just believe in it at a different price. And so founders can, you know, as hard as this is, we have seen many companies go through this uh and you know rabbits be pulled out of hats on a regular basis we have seen companies survive down markets whether it's facebook post ipo not understanding how to get mobile going apple had near-death experiences one of your famous clients apple uh wilson cincini um larry cincini was steve jobs's personal attorney if i remember correctly when i met larry one time he told me that so legendary um so i think this is a good place for us to pause in the next episode we'll talk about all this options repricing and how to take care of the employees and some of these other uh technical issues pecky thank you again for talking us through the other side of the coin we were here a couple years ago talking through how to pick your best term sheet and how to negotiate your best terms and here we are a couple years later talking about how to save your company right this is how it goes the pendulum swings both ways and hopefully i think 2024 we'll start to hit some normalcy and and this is part of the process so and we have all these young companies too that are starting so that's very exciting and we'll see you all next time on startup basics