Startups in a Down Economy: Legal, Business, and Financing Strategies

© 2020 Haynes and Boone, LLP
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1

Summary
 Short history of recession
 New Fund formation in Down Economy
 Startup Financing in Down economy
 What if are unable to perform your contractual obligations
 Force majeure, impracticality and impossibility
 Liability of the Management
 Business interruption insurance
 Venture capital terms
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Are we in a recession? (it’s complicated)
 NY Times: Feb 1, 2021 - The Economy Is Improving Faster Than Expected, the U.S. Budget Office Says
 Barclays: March 25, 2021 - Q2 2021 Global Outlook: All systems go
 Pharmaceutical Technology: March 22, 2021 - US economy experiences the deepest recession of all times
– leading macroeconomic influencers
 Reuters: May 4, 2021 - Is it over yet? Still no recession end date as U.S. economy hums along
 Crunchbase: April 7, 2021 - Global Venture Funding Hits All-Time Record High $125B In Q1 2021
 Variables:
 Labor markets
 Inflation (oil)
 Interest rates
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History of Recession
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History of Recession
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Transitional Recession
• 1948 – post-war economic recovery
- elimination of price controls
- war time production did not serve economy
- shortage of production capacity
- surge of inflation
• 1953 – end of Korean war caused less government
spending
• 2020 – covid lockdown
• 2022- post-covid transition
Recession caused by structural problem
• 1980 – energy crisis caused by Iranian revolution
- Latin American debt crisis
- Deregulation in the banking section led to
increased lending. 42 banks failed by 1982
• 2000- Dot.com recession
- speculative tech startup investment

Post-war time recession v COVID
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Post War-time economy COVID
Industry Shortage of capacity
Sector transition Support military peace economy Lock down economy Open economy
Government spending Decreased spending Stimulus checks
Fed’s quantitative easing, repo ops
Discontinued Lending programs
Inflation High High
Unemployment rate Low Low

Businesses that are doing well
 Ecommerce
 Online services
 Food safety
 Telemedicine
 Insurance tech
 Housing
 Supply Chain
 Cyber Security
 Ed-Tech
 Transformative Tech
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Businesses that did not do well
 Energy sector
 Small businesses (restaurants, gyms, entertainment etc)
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Conclusions
 Transitional recession
 Industry needs to adjust
 Focus may shift to other industrial segments
 Historically not longer than a year
 We can expect milder contraction
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What does it mean for the venture capital industry?
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NASDAQ historical

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Publicly traded stock vs. VC funds
• Some publicly traded stocks are down 70-90%
• Fundamentals are good
• Liquid Investment opportunity
• Less risky than Venture Capital investment
NBER – VC return is average 700%
Probably it makes more difficult to raise new funds, but it does not have
immediate effect

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Fund Counts and Capital Raised During the Financial Crisis
NBER – VC return is average 700%
Probably it makes more difficult to raise new funds, but it does not have
immediate effect

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Effects of Recession on Startups
• The dry powder

Planning for a Downturn
 Sequoia Black Swan memo of 2008
 Sources of follow on capital
 Bain & Company recommends organizing around 6 urgent priorities
 Protect employees and customers
 Financial Modelling
 Defend revenue
 Stabilize operations
 Reduce costs
 Play offense
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Alternative Sources of Financing
 Express Bridge Loan-small businesses who currently have a business relationship with an SBA
Express Lender may access up to $25,000
 Debt Deferment on existing 7(a) loans
 California Statewide Certified Development Corporation (CDC) – working capital loans up to
$250,000 for 5 to 10 years at prime plus 6.25 – 9.25%
 CDC Small Business Finance loans up to $500,000 between 7.25% and 14.5%
 SBA 7(a) loans – up to $5 million for short or long term working capital
 504 Loans up to $5.4 million long term fixed rate loans
 SBA micro loans
 https://calstatewide.com/community-advantage-lending/
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Workouts
Convert debt to equity
Settle debt at discount
Convert preferred to common
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Cancellation of Indebtedness
 Cancellation of indebtedness (“COD”) income
 Debt forgiven or satisfied for less than adjusted issue price
 Debt modified or exchanged for other debt
 Conversion of debt to equity
 Target is treated as satisfying the debt with an amount of money equal to the fair market value of the
stock issued. Code Section 108(e)(8).
 Debt Purchased by related party
 Creditor forbearance
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Personal Investment and Guarantees
 Springing recourse guaranties - default by the borrower.
 Bad boy guaranties
 filing of a bankruptcy case by the borrower;
 diverting cash generated by the borrower from payment of the borrower’s obligations while the borrower is in
payment default to the lender;
 lies on the loan application; and
 transfer of the borrower’s assets to non-creditors
 Limited guaranties:
 only a certain dollar amount of the debt, a percentage of the debt, a portion of the lease term, or any other fraction of
the obligation created by the guaranteed contract.
 Personal guaranty defenses
 Fraudulent inducement
 Revocation - Cal Civ Code 2815
 Increase in guarantor's risk of loss
 Defense of debtors
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Force Majeure
The parties’ performance under this Agreement is subject to acts of God, war, government
regulation, terrorism, disaster, civil disorder, curtailment of transportation facilities, or any other
emergency beyond the parties’ control, making it impossible to perform their obligations under this
Agreement. Either party may cancel this Agreement for any one or more of such reasons upon
written notice to the other.
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Impracticality
 Impracticability means the excuse in performance of a duty. Under the common law of contract,
impracticability is a defense that can be relied on when the duty to be performed becomes
unfeasibly difficult or expensive for a party who was to perform.
 UCC - Delay in delivery or non-delivery in whole or in part by a seller who complies with divisions
(B) and (C) of this section is not a breach of his duty under a contract for sale if performance as
agreed has been made impracticable by the occurrence of a contingency the non-occurrence of
which was a basic assumption on which the contract was made or by compliance in good faith
with any applicable foreign or domestic governmental regulation or order whether or not it later
proves to be invalid.
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Frustration of Purpose
An unforeseen event undermines a party's principal
purpose for entering into a contract such that the
performance of the contract is radically different from
performance of the contract that was originally
contemplated by both parties.
California law: Performance remains possible but:
 the fundamental reason of both parties for
entering into the contract has been frustrated by
an unanticipated supervening circumstance; and
 it destroys substantially the value of performance
by the party standing on the contract.
 the frustration must be so
severe or substantial that it is not fairly to be
regarded as within the risks that were assumed
under the contract.
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Business Interruption Insurance
 Business interruption insurance is insurance coverage that replaces income lost in the event that
business is halted for some reason, such as a fire or a natural disaster. This type of insurance
also covers operating expenses, a move to a temporary location if necessary, payroll, taxes, and
loan payments.
 Lost revenue, rent, employee expenses, relocation etc.
 Restoration period
 Mitigation
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D&O Insurance
 Directors and officers (D&O) liability insurance
 Protects personal assets of directors and officers
 Suits by shareholders, employees, creditors, competitors, investors, customers, or other parties
 Willfulness carveouts
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Alter Ego Claims
 Corporate entity may be disregarded and officers and directors may held personally liable for
corporate debts and obligations
 Factors:
 failure to complete formation of the company;
 failure to properly capitalize the company;
 use of company assets for personal use; and/or
 commingling of company funds with personal funds.
 Follow the money
 Reverse veil piercing
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Fiduciary Claims
 Business judgement rule
 Entire fairness standard
 Loyalty
 Care
 Good faith
 Obedience
 Disclosure
 Confidentiality
 Duties to common and preferred stockholders
 Duties to creditors
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Troubled Company Terms-
Reset The Cap Table
 Forced conversion to common
 Optional conversion clause can be triggered on a stated vote
 Pull Up
 New money pulls up some prior preference
 Reverse split
 Reduce number of shares
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Pay to Play
 Pay to play
 requires existing investors to invest on a pro rata basis in subsequent rounds or they lose preferential
rights (anti-dilution, liquidation preferences, voting rights)
 Applies to future rounds but can be added in current financing
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Troubled Company Terms - Full Ratchet
 Down rounds
 Trigger anti dilution protection unless waived
 Three types of anti dilution:
 Broad based weighted average
 Narrow weighted average
 Full ratchet
 Full ratchet
 adjusts the conversion price of the preferred stock to common stock to reflect the new down round price.
 Foreign anti dilution terms can be worse
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Option Repricing
 Option exercise price may be above value
 Repricing reduces the exercise price
 ISOs are treated as regranted
 Securities law issues under Rule 701
 Tender offer rules
 Accounting charges
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Unsuccessful Exits
 Zombie Companies
 In re Trados Inc. Shareholder Litigation
 Bankruptcy or Insolvency Reorganizations
 Fire Sales
 Management carveouts
 Fiduciary duties: shareholders, optionees, preferred and creditors?
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In re Trados Inc. Shareholder Litigation
 Board adopted a management incentive plan (MIP) that was
structured so that once an offered sale price for Trados exceeded the
venture capitalists’ liquidation preference, compensation to the
preferred stockholders would increase substantially at the expense of
common stockholders.
 Preferred received most of their preferences, MIP got $7.8 million,
common got nothing
 Interested director transaction
 Fair process
 Fair price
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Best Practices
 Duties to common and preferred
 Independent boards
 Good process and minutes
 Bankers
 Separate votes
35

AUSTIN
600 Congress Avenue
Suite 1300
Austin, TX 78701
United States of America
T +1 512.867.8400
F +1 512.867.8470
CHARLOTTE
101 S. Tryon Street
Suite 2250
Charlotte, NC 28280
T +1 980.771.8200
F +1 980.771.8201
CHICAGO
180 N. LaSalle Street
Suite 2215
Chicago, IL 60601
T +1 312.216.1620
F +1 312.216.1621
DALLAS
2323 Victory Avenue
Suite 700
Dallas, TX 75219
T +1 214.651.5000
F +1 214.651.5940
DALLAS - NORTH
2505 North Plano Road
Suite 4000
Richardson, TX 75082
T +1 972.739.6900
F +1 972.680.7551
DENVER
1050 17th Street
Suite 1800
Denver, CO 80265
T +1 303.382.6200
F +1 303.382.6210
FORT WORTH
301 Commerce Street
Suite 2600
Fort Worth, TX 76102
T +1 817.347.6600
F +1 817.347.6650
HOUSTON
1221 McKinney Street
Suite 2100
Houston, TX 77010
T +1 713.547.2000
F +1 713.547.2600
LONDON
1 New Fetter Lane
London, EC4A 1AN
United Kingdom
T +44 (020) 8734 2800
F +44 (020) 8734 2820
MEXICO CITY
Torre Esmeralda I, Blvd.
Manuel Ávila Camacho #40
Despacho 1601
Col. Lomas de Chapultepec,
DF 11000
Mexico City, Mexico
T +52.55.5249.1800
F +52.55.5249.1801
NEW YORK
30 Rockefeller Plaza
26th Floor
New York, NY 10112
T +1 212.659.7300
F +1 212.918.8989
ORANGE COUNTY
600 Anton Boulevard
Suite 700
Costa Mesa, CA 92626
T +1 949.202.3000
F +1 949.202.3001
PALO ALTO
525 University Avenue
Suite 400
Palo Alto, CA 94301
T +1 650.687.8800
F +1 650.687.8801
SAN ANTONIO
112 East Pecan Street
Suite 1200
San Antonio, TX 78205
T +1 210.978.7000
F +1 210.978.7450
SHANGHAI
Shanghai International
Finance Center, Tower 2
Unit 3620, Level 36
8 Century Avenue, Pudong Shanghai
200120, P.R. China
T +86.21.6062.6179
F +86.21.6062.6347
THE WOODLANDS
10001 Woodloch Forest Drive
Suite 200
The Woodlands, TX 77380
T +1 713.547.2100
F +1 713.547.2101
WASHINGTON, D.C.
800 17th Street NW
Suite 500
Washington, D.C. 20006
T +1 202.654.4500
F +1 202.654.4501
36

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