Benjamin Qiu, partner at Loeb & Loeb, and I talk about what kind of legal issues arise when startups run into difficult economic times and funding is harder to get.
1:45 – What kind of funding environment are we in now?
4:08 – Will and how would VC funds try to back out of deals?
7:05 – Why VCs may be reluctant to put in more capital to existing portfolio companies.
12:15 – Alternatives to VC funding
14:48 – Investor veto rights – fundraising, change in business models, redemption threats
22:45 – Legal issues for startups trying to reduce costs
25:50 – Predictions on what will change post-virus
Art:
Welcome to the China business law podcast a show about the practice of law in China from real in-house and law firm professionals on the ground. And today, we're thrilled absolutely thrilled to be joined by Benjamin Qiu. Benjamin is a partner at Loeb & Loeb and he and I are long-time friends and mentors at Chinaccelerator and it's great to have you on the show Ben.
Ben:
Thank you Art. Great to be here. Hope everyone ends up staying healthy.
Art:
Yeah, it's challenging times. And we do want to get into since we both work with startups a lot in our in our legal practices. Today, we've got a lot of potential for down rounds and companies raising money under kind of adverse conditions. Before we get into that and some of the legal mechanics and other issues that are going to come up with that, Ben I want to give you a chance to give kind of an introduction of yourself and your practice.
Ben:
Hi everyone. My name is Ben. I'm a venture capital lawyer. I work with a lot of entrepreneurs and investors alike mostly in venture financing deals, but also often working with fund managers to form their venture investment funds and as most people here can imagine once a company grow bigger all kinds of needs would emerge.
I myself am from China. I'm a California lawyer studied law and trained in the Silicon Valley but have been working back in China for around 15 years now.
Art:
We've seen some startups, you know lately Lime, we've seen raise at a much lower valuation than the prior round prior to this whole virus thing. Valuations were already pretty sky high. We saw One Web file for bankruptcy after SoftBank couldn’t come through on more funding. Airbnb has raised funding at a reduced valuation. The list goes on and on so then what do you make of this? What kind of a funding environment are we in right now?
Ben:
Well the short answer is that the market is not looking very good for companies trying to raise easy money because when the market has a lot of liquidity and optimism and high valuations in the public market and the target market alike, it's a much easier to get offers and not be asked tough questions. But it's getting much harder now, especially when it comes to companies who do not have profits. Airbnb actually is already one of the lucky ones before his IPO. There's a lot of optimism still not because they are not a company that burns a crazy amount of cash, it actually has some pretty good position on the market and not profitable yet. It's a could easily switch to a profitable model unlike some of the other companies like Uber or Lyft.
Also on top of that we have the virus, well to take a step back before the virus kicks in the market has been seeing a sort of deflating where I would say deflating of the technology bubble for about a year. Now, if the virus only kicks in the new reality for a lot of startups.
Art:
And you see that that effect because when Softbank that huge Vision Fund, you know a hundred billion dollars, that really had an effect on the market of driving up valuations almost at every stage, right? It had a trickle-down effect. Do you see the opposite happening now that that SoftBank is really in kind of a whole a little bit of hurt?
Ben:
Well seems like Wework just as see what Vision fund. For refusing to closing or otherwise following through some of the deals they made in recent months quite typical scenario that investors. Now deals that they sign up in a form of term sheet were a lot of negotiations are getting delayed. So generally speaking the term sheets in the VC world in China are more real and predictable compared to the typical letter of intent in business transaction seeing in China and we do not see a lot of enforcement from the several terms that are typically enforceable under the the term. As you just mentioned confidentiality the provision about this legal cost about exclusive dealing under the term sheet really, but once in a while we do see that come up. I agree with you a hundred percent, you know, even if the given if he bulk of the terms of the term sheet itself on action on pricing and for anything that needs to go in the actual binding legal agreements when it's at the term sheets stage it's not enforceable,
Art:
But from a moral perspective and from absolutely from a reputational perspective if these VCS are in the business of doing multiple deals and entrepreneurial Community everybody knows everybody. So yeah, that's what actually makes it quote enforceable. I totally agree.
So let's get into that point that part because let's say you've already got investors in the company, you know, experienced institutional VC investors and you need more funding, you know, you're not profitable yet and you want to expand or for whatever reason your cash flow is the such you need more funding as we typically see in a startup. Let's say you’re trying to get funding quickly, in your experience would you also see a lot of bridge financing?
Ben:
Disciplined investor shareholders in a company generally speaking try not to do what they called an inside round meaning the same investors shareholders inject additional money in a company in which they already invested. The market or a third party or a new investor should validate the company's business model. Especially when it comes to a point in time when the companies are raising funding at a higher valuation historically the convertible financing has been quite limited here because many investors are not so familiar with the mechanism.
We want to keep in mind that the VC marketing China is barely 20 years old. It's still very much almost a teenager. In China you see investors. I wouldn't necessarily call it being more greedy, but just it's more bold in, you know, leading the round by excluding others a sizable serious a or seriously in investment of more than let's say more than 10 or 20 million USD and oftentimes the VC investors have enough dry powder meaning cash in their fund and they feel brave enough to go it alone. You see that a lot less in Silicon Valley, but we expect to see that a lot more in China as investors will become more conservative and more willing to let others into the deal to spread the risk and give more validation to a company's model.
Art:
Yes and I think I'm seeing that as well and that's may be a sign of a maturing market in the venture capital industry in China. I think the Venture Capital industry is, as you said a teenager, but also come a long way in that short time. And then I'll just I'll say about the convertible notes and insider rounds absolutely agree insider rounds are optically not good and also from the perspective of the funds - they never like to have too much of their eggs in one basket. They invest to keep from being diluted in their equity. The public markets aren't helping by cratering lately and valuations typically peg from that.
So because of that mismatch, I would just say that I could see a situation at least in the short term where convertible notes and SAFEs and other agreements where the valuation is not fixed until a later on - basically kicking the can down the road - I could see it's already seen a couple cases where that's been the solution. So I'm curious that we may see a little bit more of that in the short term.
Ben:
Yes, and also we want to keep in mind that oftentimes, some very good companies came about or thrived in a very difficult economic environment. Both Microsoft and Apple were founded in late 70s or early 80s when the US economy was really bad.
Art:
It’s no question new business models are going to come out of this virus situation and lead to a a lot of innovation and if you're you know, if we're talking about startups that are trying to reevaluate their business models, you know, there's one question we got when I posted this episode on LinkedIn from a from a listener and she was asking about alternatives to traditional fundraising and I think this goes to business models as well.
So can we think of some other alternatives to the standard VC funding? So the specific question she had was she was contemplating her business starting a franchise model to presumably, you know, not only does that start getting extra cash in the door, but there's no capital outlay right you have to share your know-how which of course has some risks especially in China and you have you to show your business process and you're sharing your brand name and so forth. But otherwise, it's really not much incremental cost to you. And so what do you think about an alternative like that or let's think of some other alternatives for a company that's struggling to get more funding to grow.
Ben:
The way to raise capital resources to grow the company may also see alternatives like the Kickstarter model by selling products getting and getting the consumers to prepay for the products or in some ways obtaining ownership shares in the company.
Or through say blockchain technology. Or even if say a McDonald's franchise. You need to have a team that has trust and put out some initial capital and then McDonalds is going to license you the physical your core technology equipment and the menu. Actually in some sense McDonalds is almost a technology company, you know.
Art:
Let me set up the question this way we've got I agree that usually we were talking about term sheets, you know people stick to the provisions that they have in there. What about where VC's in existing investors and and founders don't agree. Let's say on the next step forward on a change in the business model or on a change in trying to get new funding, you know, we've got a lot of provisions out there and then get your take on them.
So one of the things is you know, when a company is raising new funding, like I said before the investors need to buy into that now they don't need literally need to buy new shares but they need to approve of it. They have rights to buy those share through a right of first refusal essentially and then they also have some control over that valuation if it’s a downround like we've mentioned many times. They usually have anti-dilution protections - people can look those up in more detail. But basically they're weighted average full ratchet, which is rare, but it does it is out there to protect the investors from not being diluted too much and not having their valuation impacted as much if there's a down round.
So there's that and then I think this is some a little more things which we don't see is often. There's redemptions – that’s where under certain conditions after certain time period and investor if the company hasn't made an IPO or hasn't done a trade sale or something like that the investor basic can get their money back plus a fixed return multiple.
Now all these things Ben we see these things you and I see these in the agreements all the time. How much do they are these actually used these terms or are they just sitting there kind of as Leverage?
Ben:
VC style to hold over Founders in difficult situations, right? Well on paper the investors do have a lot of protection or if sometimes you can say a lot of power more in the way of a veto rights when it comes to companies wanting to do this or that and the investor can come in and say no sometimes you need a certain percentage of ownership threshold.
That's really to all agree that we gotta stop the company from doing this and certain things. But in reality largely, once the investor have a made investment you are exposed you do not have a whole lot of power.
In other words, let's say the company refuses to raise more funding investor. Tell us a company that you know, if the founder doesn't want to raise funding really the founders are in the drivers seat, there investors cannot do much saying with the flip side is the founder wants to reach more funding from this or that investor, the current shareholders can say no they can veto it. But if you do that what equal founder says well, I'm not going to run a company anymore. I'm going to leave this company. I don't feel interested in doing this if you keep on blocking me from making important decisions for the company.
So, you know, once the investor has already made an investment, even on paper you have a lot of rights. They're vulnerable you do not have a lot of decision power.
Only in sort of extreme cases. We see the investors launching a lawsuit or any formal proceedings against the founder of the company when that's when their company has committed fraud the founder user issue loans to himself or herself or the company completely changes business model without investor approval.
You mentioned redemption - on paper it's a powerful tool for downward protection for the investor. Maybe some people here are familiar typically under the redemption rights after some triggers, generally after a few years down the road or if something happened, for example, there's a new government regulation that really negatively affects your business model. The investor can tell the company that I want out. I want my money back. I don't want your shares anymore. Please take it back. Please cancel my shares. I'm gonna take the money out to get maybe together with interest that would be a huge potential disaster for the company, but its such a dangerous nuclear bomb that people almost never use it.
Let's say the company is mediocre. But in reality a mediocre start out the company doesn't have time together, or maybe they can pay you a little bit of the redemption money. But if the founders have a good background they may raise more funding down the road, you know, just like a Google in the early 2000s. What if at some point they found a profitable business model as an investor you might as well just wait, right?
Well another scenario of course is if a company is doing you know quite well, then of course in that case, you don't want to redeem your shares. You want to keep the shares and with into the company files for IP over get acquired by larger companies.
Art:
For sure, you run into the whole problem of valuations and things being so much in a state of flux in the markets. Generally it's hard to agree on valuations. It's hard to use past financial records with when things are changing so fast to come up with a valuation that both sides can agree on but there are also a lot, you know, they're also a fair number of companies out there sitting with cash. Apple and some of the other companies that we've seen with pretty healthy balance sheets. For companies like them, I've noticed over the last couple weeks that they're actually making quite a few acquisitions because companies are great companies with great technology. You know now the runway is so much shorter and they're stuck and they're actually perfect targets for acquisition. Sometimes even acqui-hires right where you have certain people , but for whatever reason the business just isn't working right now, but if you stuff stuck them at Apple or Google or the likes or Amazon, you know, they're great. And so we may see that.
Ben:
I agree. We may see actually in the short term a little bit of a current deals in the pipeline on hold but we also may see a lot of new deals come like you said once things start to settle down just a little bit.
Art:
So I think the last thing we were going to we were going to touch on was just some general issues for companies general legal issues for companies, which are trying to let's say reduce costs. Trying to make it maybe they're not even at the stage where they're still at the let's say the seed stage or for whatever reason venture capital funding is not going to be there and may be alternative business models aren't so plausible for them. What are some of the legal issues that are going to come up for now for them?Let's say if they're talking about terminating employees or other operational issues.
Ben:
We can start with people a lot of companies are laying off people friendly often times. There are just no choice and a lot of employees will be laid off. You want to keep in mind about some provisions and the labor contract law in China, you might need to pay people several additional months of their salary before letting go someone. On the other hand, if a lot of the important that the employees are going to be important for the future of our company especially ones that cover the sorry the market turns or the virus has subsided then instead of firing people and going through, you know, potential legal and business costs doing so maybe you keep people their position but reduced salary or key people using furlough as a solution the other hand we already imagine that in a bad economy. It could be a good opportunity for some companies to hire good people maybe even, you know poach people from other companies.
We do remind in our clients that when I hire someone especially if you do so in a hurry you want to watch out for potential intellectual property issues. We want to make sure that ideally the person you hire left the previous company on good terms. And also on legally clean terms. So that that person is not bringing or creates computer code or you know things that otherwise infringe the intellectual property of the previous company. Otherwise, we could see disasters happen.
Art:
Let's wrap it up by giving some closing each of us on what we think is going to change, you know at in the world post virus and sort of legal things that will change. I'll start one out.
You mentioned the employment issue and US labor law being so as you said flexible. I'll go a little further and say it's super company friendly. An employees have rights for sure again for about discrimination and so forth, but and I wonder on the one hand if that'll change where employees in the US who are so vulnerable with their health insurance tied up to there.
Jobs in so many cases and companies in these are kind of difficult. This is a different difficult situation economically, but also kind of at a personal level with people's health and emotional well-being. And so I even think that there's something going on there with companies being a little a little more sensitive and so the furloughs of course hurt, but they're it's different like you said from being completely laid off and really affected, it can be devastating.
So I hope that in some ways the US employment system and companies either the system itself or the law or the way companies operate will change and become a little more compassionate perhaps and I think in China what I'm seeing also on the employment front is, you know, we've seen new rules come out which actually gave companies the flexibility to essentially furlough people when that had not really been a concept before in China and it basically you are stuck with employees for life, at least that's what people try to handicap it by saying it's not quite that simple.
But it's very difficult to get rid of an employee on almost any quote legal grounds here in China. And so people realize that's almost too inflexible of the system and when trying to adapt to a crisis like this, that actually you end up killing the companies and there's no company left for the employees to work for so what good does that do.
So I think both of the systems that you and I work with the most the on the employment side the US System and the China system. My prediction is they'll start to meet each other in the middle.
Ben:
If the company while in the US the bankruptcy law is much favorable for some companies to file bankruptcy. For temporary protection rather than just as a way to dissolve the company in China. One possibly positive outcome out of the crisis could be the bankruptcy law may become more mature because until very recently, there's no such thing as a company bankruptcy even to this day strictly speaking. There is no such thing a consumer or individual bankruptcy filing in China, but in a mature market to those are very viable ways to get individuals or companies go through a rough patch. We could see that happen here in China as well.
Art:
Hmm. I think that's a very good prediction and absolutely had not thought of that at all, but that's actually I think that's spot-on and the you know, it's a good way to wrap things up to because we talked about innovation in the in business models and in and now and we're talking a little bit now innovation in law here and that's probably the theme of the show is how much things are in flux and things will change with investors and founders.And how you know governments are adapting laws to the situation employment bankruptcy and whatnot. So well been, you know, it's been a great it's been a tour de force I think of to have your knowledge on here talking about all these topics. I really want to thank you for joining us and how about if people want to reach out to you? What's a good way for people to reach out to you just you're at Loeb and Loeb. So you're on the website. You're also active on LinkedIn. I know so those are the two best ways.
Ben:
That's correct. The last thing I want to mention is you always have some optimism. I remember two days ago. I saw a tweet from Paul Graham the founder of YC saying that hey listen investors for any companies that you will you find that are, you know, still marching on in this crisis. They are the toughest the survivors in the startup world. Try not to miss out, you know, once the market gets better.
Art:
Hmm. That's a great point. It's almost like the whole virus and market situation is doing their diligence for them and vetting for them. Thanks again Ben, really appreciate it, and I hope folks will find you and reach out to you and once again a privilege to have you on.
Ben:
Thank you Art.