Creative Structures w/ Becki DeGraw | Wilson Sonsini Startup Legal Basics

Startup Basics: Navigating the "Have" Market & Avoiding Pitfalls

Key Concepts:

• "Have" vs. "Have Not" Companies: Differentiation between companies thriving in a competitive funding environment versus those struggling.
• Founder Proxies: Granting founders voting rights over investor shares, especially in secondary sales.
• Governance: The structure and processes for managing a company, including the role of the board of directors.
• Due Diligence: The process of investigating a company before making an investment.
• Dry Powder: Available capital for investment.
• Protective Provisions: Contractual clauses that protect the rights of investors.
• Power Law: The concept that a small number of investments generate the majority of returns.
• Secondary Sales: Transactions where existing shareholders sell their shares to new investors.
• FOMO (Fear of Missing Out): The anxiety that an investor may miss out on a potentially profitable investment.

The "Have" Market: A Return to 2021

• The market for high-performing "have" companies resembles the boom conditions of 2021.
• These companies experience high demand, multiple term sheets, and founder-friendly terms.
• Investors are willing to compromise on standard terms and reduce diligence to gain access to these deals.
• There's a lot of dry powder available, leading to intense competition for promising startups.

Off-Menu Items: Unusual Terms in Hot Deals

• Founder Proxies: Investors are granting founders voting proxies over their shares, particularly in secondary sales.
  • Example: An investor buys shares from employees in a secondary transaction and then gives the founder a proxy to vote those preferred shares.
  • This is driven by the power law, where investors prioritize owning a piece of potentially transformative companies like SpaceX, even if it means ceding some control.
  • These proxies often exclude votes on director seats or specific protective provisions.
• Absence of Preferred Directors: Some companies that have raised over a billion dollars have no preferred directors on the board.
  • This trend is seen as a departure from good governance practices.
  • Experienced board members can provide valuable guidance, connections, and support during challenging times.
  • The speaker argues that the idea that investors are the enemies is the opposite of the game on the field today.
  • Having reputable individuals on the board lends credibility and can facilitate future funding or M&A opportunities.

Forced Future Investments: A Risky Trend

• Some seed-stage companies are requiring investors to commit to participating in their next funding round (Series A) at a predetermined valuation.
  • This can be dangerous for both parties.
  • If the company fails to meet milestones, the investor may have grounds to refuse funding, leading to potential lawsuits.
  • If the company significantly outperforms expectations, the investor benefits from a below-market valuation.

Crypto: A Resurgence with Lingering Uncertainty

• There's a renewed interest in crypto, with increased activity and hiring in legal firms specializing in the area.
• However, uncertainty remains regarding the long-term stability and regulatory landscape of the crypto market.
• The speaker draws a parallel between the speculative nature of crypto and unregulated poker games, highlighting the potential for risky behavior and lack of investor protection.
• The importance of protective provisions, boards, governance, Delaware law, all of this stuff became codified, refined, and the rule of law is so important is so that people feel comfortable investing.

Due Diligence: Are Investors Cutting Corners?

• While early-stage (seed, Series A) companies generally undergo thorough due diligence, there's a trend of reduced diligence for highly sought-after companies.
• Investors are hesitant to ask too many questions or demand extensive information for fear of being excluded from the deal.
• The speaker emphasizes the importance of preparing startups for due diligence from an early stage (year 0, 1, and 2).
• Common issues identified during due diligence include missing IP assignments, undocumented equity structures, and lack of vesting schedules.

The Importance of Legal Counsel

• Navigating the complexities of the startup ecosystem, especially during boom-bust cycles, requires the guidance of experienced legal counsel.
• A good attorney can help founders understand the risks and opportunities, prepare for due diligence, and ensure compliance with legal requirements.
• The speaker emphasizes the value of having a knowledgeable attorney who can provide practical advice and support throughout the startup journey.

Conclusion

The current market for high-growth startups is characterized by intense competition and unusual deal terms. While founders may benefit from favorable conditions, it's crucial to maintain sound governance practices and avoid risky arrangements. Investors should be cautious about cutting corners on due diligence and prioritize long-term value creation over short-term gains. Experienced legal counsel is essential for navigating the complexities of the startup ecosystem and protecting the interests of all stakeholders.