This Week in Startups
Navigating SAFEs, Pay-to-Play Rounds & Risks with Becki DeGraw | Wilson Sonsini Startup Legal Basics
Thu Jul 20 2023Description
Startups in Silicon Valley adhere to legal standards and work in good faith to build companies together. Founders should understand industry standards and work with a great lawyer. Legal documents should follow standard templates. Convertible notes provide protection to investors. Companies that took a lower growth approach may need to raise funds soon. There is a valuation disconnect between investors and founders. Pay-to-play provisions are becoming more prevalent. Conflicts arise in financing transactions. Investors sometimes have to make tough choices to save a portfolio company. Hope for normalcy by 2024 as new exciting companies emerge.
Insights
Convertible notes provide protection to investors
Convertible notes are a debt instrument that provides protection to investors in case of dissolution, liquidation, or sale of the company.
Valuation disconnect between investors and founders
There is a significant valuation disconnect between investors and founders, leading to challenges in raising funds.
Pay-to-play provisions are becoming more prevalent
Pay-to-play provisions, which require existing investors to participate in a financing round or risk losing their preferred stock status, are becoming more common.
Conflicts arise in financing transactions
Financing transactions often involve conflicts at the board level, with existing investors leading down rounds and founders being conflicted due to their net worth being tied up in the company.
Investors sometimes have to make tough choices
Investors may have to make tough choices, including aggressive terms of investment and full recaps of companies, to save a portfolio company.
Chapters
- Legal Standards and Documentation
- Convertible Notes and Funding Challenges
- Valuation Disconnect and Pay-to-Play Provisions
- Conflicts and Tough Choices in Financing
- Tough Choices and Hope for the Future
Legal Standards and Documentation
00:00 - 06:58
- Startups in Silicon Valley adhere to legal standards and work in good faith to build companies together.
- Founders should understand the industry standards and work with a great lawyer to keep everything standard.
- Being creative in business is encouraged, but being creative in the legal space can be costly and viewed as an outlier.
- Legal documents like stock option plans, employment contracts, trademarks, and investment documents should follow standard templates for efficiency.
- The safe agreement was introduced as a middle-of-the-road approach for fundraising rounds, providing a fast and cheap option for smaller investors.
- The safe agreement replaced convertible notes for many startups but is less protective for investors.
- In the current market, convertible notes are becoming more popular again between equity rounds due to their debt instrument nature and clear conversion terms.
Convertible Notes and Funding Challenges
06:43 - 13:43
- Convertible notes are a debt instrument that provides protection to investors in case of dissolution, liquidation, or sale of the company.
- Convertible notes include an interest rate, which is typically higher now due to investor-favorable terms.
- The interest on convertible notes gets converted into equity when the principal converts.
- Convertible notes have a maturity date, unlike safes which can remain outstanding indefinitely.
- The maturity date allows parties to come back to the table and discuss next steps and the path forward.
- Interest on convertible notes accumulates over time and increases the investor's ownership percentage in the company.
- In a downside scenario, convertible note holders have priority over other investors or shareholders.
- Companies that raised high valuations without revenue may face challenges in justifying their worth in a down market.
- Seed and A stage startups are still experiencing strong activity, but later stage deals have slowed down significantly.
- Investors are looking for more metrics and assurance before investing in series B and C rounds.
- Companies that conserved cash and took a lower growth approach may need to start raising funds soon as they exhaust their previous funding.
Valuation Disconnect and Pay-to-Play Provisions
13:16 - 20:29
- Companies that took a lower growth approach in 2020 and 2021 may need to raise funds this year as they exhaust their previous funding.
- There is a significant amount of dry powder on the sidelines waiting to be invested, but there is a valuation disconnect between investors and founders.
- Investors are ready to write big checks, but founders may not agree with the lower valuations.
- The current environment poses challenges for both fund managers and founders in terms of raising future funds and determining the value of their companies.
- Down rounds and pay-to-play provisions have become more prevalent, with down rounds accounting for 40% of all private company financing in Q1.
- 'Pay-to-play' refers to a provision that requires existing investors to participate in a financing round or risk losing their preferred stock status.
- The drivers of pay-to-play provisions can vary, but typically involve input from founders, new investors, and the board.
Conflicts and Tough Choices in Financing
20:05 - 26:53
- Conflicts arise in financing transactions at the board level.
- Existing investors often lead down rounds, pulling down the valuation.
- Founders may be conflicted due to their net worth being tied up in the company.
- Employees are conflicted and may require an option refresh or management incentive plan.
- Industry experts on the board can also be conflicted if they have a relationship with investors.
- Ultimately, good faith and urgency lead to transaction resolutions.
- Existing investors may choose to save a portfolio company despite potential conflicts.
Tough Choices and Hope for the Future
26:33 - 29:24
- Investors sometimes have to make tough choices to save a portfolio company
- Terms of investment can become aggressive in order to justify the decision
- A full recap of the company may be necessary to right size the cap table
- Founders can still find support and belief in their company, just at a different price
- Examples of companies surviving down markets include Facebook and Apple
- Next episode will cover options re-pricing and taking care of employees
- Pendulum swings both ways in startup world, with ups and downs
- Hope for normalcy by 2024 as new exciting companies emerge