Market Update and Trends w/ Becki DeGraw | Wilson Sonsini Startup Legal Basics

Key Concepts

• Dry powder
• Down rounds
• Pay-to-play provisions
• Preferred stock redemption clause
• Preferred stockholder consent over aqua hires
• Key person insurance
• Liquidation waterfall
• M&A regulatory environment
• Talent wars
• Protective provisions

Market Overview and Ecosystem Dynamics

• Fundraising Boom and Subsequent Slowdown: Funds experienced record-breaking fundraising years in 2020-2022, leading to a surplus of "dry powder." However, deal flow slowed down, particularly in Series B and later stages, creating a deployment challenge for funds.
• Company War Chests and Return to Market: Companies that raised significant capital in 2021 are now returning to the market as their cash reserves dwindle.
• Valuation Correction: Many companies have not "grown into" their high valuations from 2021, leading to down rounds and increased use of structured deals.
• Deployment Schedules: Funds are under pressure to deploy capital according to their schedules, driving increased activity in the market.

Pay-to-Play Provisions: A Deep Dive

• Trigger: Pay-to-play provisions are often triggered when existing investors bridge a company in a down round, requiring all investors to participate in the new round to maintain their preferred stock rights.
• Rationale: Insiders use pay-to-play to encourage other investors to participate in the round.
• "Plain Vanilla" vs. Punitive Terms:
  • Plain Vanilla: Investors who don't participate convert their preferred stock to common stock on a one-to-one basis, maintaining the same percentage on an ownership basis other than future dilution.
  • Punitive: Conversion ratios can be adjusted to significantly reduce the ownership stake of non-participating investors (e.g., 10 shares of preferred converting to one share of common, or even 50 to 1).
• Consequences of Non-Participation: Investors who don't participate in a pay-to-play essentially write off their investment, retaining only a small chance of recovering some value if the company succeeds.
• VC Psychology: A VC's decision to participate in a pay-to-play is influenced by the performance of their fund and the stage of the fund's lifecycle. VCs with older, successful funds may be more willing to write off a struggling investment.
• Investor Resistance: Resistance to pay-to-play can stem from a lack of available funds within a specific fund or a general lack of exits and blockbuster returns in the market.

M&A Landscape and Regulatory Environment

• Mid-Market M&A Renaissance: Due to increased regulatory scrutiny of large tech companies, there may be a shift towards more M&A activity in the mid-market (smaller acquisitions).
• Regulatory Hurdles: Large companies face significant regulatory hurdles in pursuing M&A, including potential breakup fees if deals are blocked.
• EU vs. US Regulation: Regulatory environments differ between the US and the EU, with deals potentially facing challenges in either jurisdiction.
• Opportunity for Bold Acquirers: There is an opportunity for a company to aggressively pursue multiple acquisitions, even if some are blocked by regulators.
• Private Equity Interest in SaaS: Private equity firms are showing interest in acquiring SaaS companies with revenues in the $10-25 million range, potentially taking them private to retool or combine them with other assets.
• Antitrust Thresholds: The technical threshold to trigger antitrust review is relatively low (around $410 million), which may need to be revisited.

Talent Wars and Investor Protection

• Skyrocketing Valuations Based on Key Talent: Investors are concerned about high valuations driven by a single key individual, particularly in the AI space.
• Preferred Stock Redemption Clause: A protective provision that forces the company to buy back preferred stock at a multiple greater than one time if the founder leaves.
• Preferred Stockholder Consent Over Aqua Hires: Requires preferred stockholder consent for aqua hires, as these transactions may not trigger liquidation preferences.
• Key Person Insurance: Traditional key person insurance is being supplemented by contractual protections.
• Non-Competes in California: Non-competes are generally unenforceable in California, except in connection with the sale of a company.
• Contractual Rights to Shares: While non-competes are limited, contractual rights related to shares can be used to incentivize key employees to stay.

Conclusion

The current startup landscape is characterized by a valuation correction, increased use of structured deals like pay-to-play provisions, and a complex M&A regulatory environment. Investors are seeking greater protection against talent risk, while companies are navigating a challenging fundraising environment. The market may see a shift towards more mid-market M&A activity as large tech companies face regulatory hurdles. Attorneys are seeing a lot more of the market and are able to provide experience to founders.