Navigating startup funding market trends with Becki DeGraw | Wilson Sonsini Startup Legal Basics

Wilson Sonsini Partner Becki DeGraw joins Jason (0s)

• The speaker welcomes viewers to the "Startup Basics" series of the "This Week in Startups" show.
• The speaker explains that they bring in Becki DeGraw from Wilson Sonsini to answer basic questions about startups.
• The speaker highlights Wilson Sonsini's reputation as a well-known and hardworking law firm.

Market update: Current state of startups and funding (37s)

• The current state of the startup and funding market is characterized by a period of significant change following two years of volatility and upheaval.
• The market experienced a period of high valuations and substantial investment, followed by a downturn with decreased valuations and headwinds.
• Despite the challenges, there are signs of renewed activity and investment, particularly in the field of artificial intelligence.

Consolidated investment trends and the venture capital slowdown (1m21s)

• The venture capital market experienced a significant shift in 2022, moving away from the rapid growth seen in previous years.
• While the market is still active, particularly in the seed and Series A stages, it is characterized by a slower pace and longer deal cycles.
• Growth equity investments, which were nearly absent in 2022, are starting to pick up again, likely due to the emergence of green shoots in the IPO market.
• Despite the slowdown, valuations remain high, particularly in the seed and Series A stages, driven in part by large AI deals.
• The summer slowdown, a traditional period of reduced activity, is currently underway, further contributing to longer deal cycles.
• Deal cycles have returned to a more typical timeframe of 4-6 weeks for first preferred stock financings, compared to the rapid 2-week closings seen in 2021.

The importance of due diligence, runway, and down round impacts (4m23s)

• Due diligence and runway are crucial for successful fundraising. A typical timeframe for closing a preferred stock round is 4-6 weeks, allowing for thorough due diligence and partner selection. Entrepreneurs should ensure they have sufficient time and runway to navigate this process.
• The fundraising landscape has shifted from rapid "blitz" rounds to a more deliberate pace. While the market is not as exuberant as in previous years, good companies are still attracting funding at all stages.
• Despite market challenges, venture capital funds are actively seeking investment opportunities. The record-breaking fundraising totals in recent years indicate a significant amount of capital available for deployment.
• The current market may produce a strong vintage for venture capital. Entrepreneurs who launch companies during challenging economic conditions tend to be more resilient and experienced, potentially leading to a higher success rate for investments.
• A down round occurs when a company sells stock at a lower price than its previous preferred stock issuance. This can impact existing investors and may trigger provisions like anti-dilution, pay-to-play, and recaps.

Anti-dilution provisions and strategies for investor communication (7m11s)

• Anti-dilution provisions are triggered in a down round, where new shares are sold at a lower price than previous rounds. This adjustment does not give investors more preferred stock, but rather adjusts the conversion rate of preferred stock to common stock. This means that each share of preferred stock may convert to more than one share of common stock upon exit or IPO.
• Anti-dilution provisions can be waived by existing preferred stockholders. This is often requested by new investors in a down round, as it allows them to secure a better deal.
• Down rounds are often led by existing investors, not new investors. This is because existing investors are more likely to be willing to take a haircut on their investment to ensure the company's survival.
• Pay-to-play provisions are often used in down rounds to incentivize existing investors to participate. This typically involves requiring investors to contribute a certain amount of money to maintain their existing ownership percentage. If they do not participate, their preferred stock may be converted to common stock, potentially diluting their ownership.
• Recapitalizations can be used in conjunction with pay-to-play provisions to adjust the conversion ratio of preferred stock to common stock. This can be done to ensure that the company's valuation is not negatively impacted by the down round.
• Down rounds can be difficult for existing investors, as they may result in a significant loss of value. This can lead to tension between existing investors and the company's management team.
• Founders may need to make significant concessions in a down round, including a reduction in their ownership percentage. This is especially true if the company is struggling and needs to raise additional capital.

Re-incentivizing management teams and insider-led funding scenarios (16m23s)

• Re-incentivizing Management Teams: When a company undergoes a down round or restructuring, it's crucial to re-incentivize the remaining management team. This often involves creating a new employee stock option pool (e.g., 20-30%) to compensate for the dilution experienced by existing employees. This helps retain key personnel and motivates them to contribute to the company's turnaround.
• Communicating the Changes: Open and transparent communication is essential when implementing these changes. The company needs to explain the rationale behind the restructuring, the benefits of the new structure, and the opportunities for future success. This communication should be directed towards both employees and investors.
• Legal Considerations: These types of transactions require careful legal planning and documentation. It's essential to have experienced legal counsel to ensure that all parties are protected and that the process is conducted fairly. This includes documenting all investor meetings, market checks, and board discussions to demonstrate that the restructuring was a necessary and well-considered decision.
• Potential Lawsuits: While lawsuits are less likely if the company ultimately fails, they can arise if the company successfully turns around and is later sold. This is because disgruntled former employees or investors may claim that they were unfairly treated during the restructuring process. To mitigate this risk, companies should ensure that all transactions are properly documented and that all parties are aware of the risks involved.

Importance of investor relations and board management (23m46s)

• Maintaining detailed records of investor interactions is crucial for startups. This includes documenting the number of investors contacted, the list of investors, and the content of conversations.
• Proper documentation helps avoid potential legal issues. Failing to document interactions can lead to accusations of insider deals or other improprieties, even if the accusations are unfounded.
• Board involvement in investor relations is essential. All investor interactions should be discussed and documented in board meetings, ensuring transparency and accountability. This includes providing the board with a list of investors contacted and other relevant information.