Becki DeGraw on spinouts, IP licensing & clean exits | Wilson Sonsini Startup Legal Basics

Welcome back to This Week in Startups. We're doing our Startup Basics series. What is it? All the basics you need to know to run your company— legal, accounting, marketing, you know, you name it, we go over it here. AI, a new one. thisweekinstartups.com/basics to see the entire library. I'm so lucky to have Becky DeGraw from Wilson Sonsini. WSJR on my team. She's my attorney and she helps me explain the basics to you. Welcome back to the program, Becky DeGraw.

Thank you so much. It's always good to be back. Always fun time to be here.

We always have a good time. Uh, I wanted to talk to you— I came up with today's topic: spinouts. Spinouts, spinouts, spinouts. Every week, every 2 weeks, some founders leaving a company They built something inside the company. The CEO says, wow, that's a very interesting project. They let them work on it for 6 months, 12 months, and it has an absolute interesting success, but not breakout. And it doesn't belong inside the first company, but the founder, the co-founder, or, you know, an executive wants to go pursue it. So say, sure, you can spin it out. You can spin it out. Second case, Hey, we want to get hired, but maybe Washington, DC doesn't exactly want us to sell a company and the shares in it. So we're going to do an IP license and we're going to spin it out that way. 2 different situations, very different. Uh, let's start with the first one, which keeps happening to me. I literally have 3 of these on my plate this month. And every time I've got a, you know, the one co-founder who's leaving, it doesn't, you know, there's too much equity. The holding company took too much equity. And then every CEO is just saying, why can't I leave and get 80% of this new company. This isn't fair. I, we should own 90% of the company and the co-founder leaving should get 10%. Oh, tell us a little bit about spinouts, why they happen, and then what's the best practice?

Yeah. I mean, you, you laid the groundwork perfectly. Um, that is what the situation where we see the spinouts most often, why the why behind it might be, right? It's faster to start with that technology that has already been built and tested and validated. And like you said, may not just fit within that existing entity. It may not be— it may be distracting to what the goal is there from the existing entity's perspective if they're not going to use that technology or that asset going forward and they don't really want to put the funds to it or the resources toward it to scale and grow because it's maybe not in the direction of their strategic vision where they want that company to go. it may be more valuable to them to say, all right, well, you're interested in this. If I spin it out and I agree, I'll, I'll, I'll transfer X, Y, and Z over to you. You go grow it. Maybe I'll get some benefit from that. So that's, that's really the why behind it. You know, these things take all kinds of shapes and sizes. Oh, another example is that we see all the time is university, right? So you've got—

Yes.

You've got folks working at the university to do R&D and then they're like, whoa, we're onto something. That is also a spin-out type situation where instead of negotiating with an end, you know, like the company, you're negotiating with the university in terms of what are the terms going to look like of how am I going to get that IP into a new co and be able to start a new venture. But there's a lot of considerations that go into how we would think about these and how we would structure them. They are so fact-specific. So—

Yes.

First thing I'll say is like, this is going to be pretty high level and a lot more of, you should think about this and you should think about that. And here's a few different ways to go about it rather than, oh, well, when you do this, you should do this and you should do that. I don't know. I don't know what it should look like, um, because there are just so many different sizes and, and how these things take form.

When this happens, sometimes it's at a big company. Google has famously spun out Waymo, uh, very famous. Microsoft back in the day, uh, this little site Expedia that was internal. Now that can be for economic reasons or the thing's getting so big and the existing management team is getting distracted by it. And Waymo needs to be out there on its own raising capital to validate its From what I understand, the back channel I got was, hey, we need to validate this valuation. And in order to get AI talent to work on a self-driving company, they were up against Anthropic or SpaceX, or OpenAI. We need a currency where people can say, oh, this is going to be a trillion-dollar company. So there is a real reason to spin it out. I like to run a little test when I talk to the 2 founders. I say to them, What's an amount where if this thing spun out and it became a unicorn, you would feel great about the terms that we got to? Typically, I tell people, have the existing company keep 20%, let the new team keep 80%. They want to go 51/49, whatever. Sometimes it's 25/75, 30/70. It is specific because maybe the thing's making $0 and losing money. Sometimes it's making some money. So there's all kinds of provisions you can do. Um, but when you look at that, almost universally, if it becomes a billion-dollar outcome, the, the company that spun it out, getting 20% of a billion-dollar company, you feel pretty, pretty smart, pretty savvy for having done that. But if you take 50, 60% and it goes to zero, well, you're like, well, that was dumb. And then for the co-founder, if he were to spin it out, they got 60, 70, 80% of the company, were able to build a team, raise more funding. That wouldn't feel so bad paying that 20%. Hey, we chose to do that. We could have left and just built it ourselves. Yeah. So there's sometimes you have to take people through, well, here's the possible outcomes. Do you do that where you say, here are scenarios and people ask their attorneys, like, can you play out some scenarios for me so I understand like what's at the other side of the rainbow? Practically speaking.

The consideration often takes the form of, of equity. It can also be cash. Sometimes it's a combination of cash and equity. You know, if you start getting into more complex structures, you might see earnouts based on milestones or royalties. We'll often see those in connection with IP being spun out of universities. But when it is equity, because that is where oftentimes where the either all or a big chunk of the consideration is going to be, there's negotiations definitely around the percentage, but also around what class of stock are you going to get? Are you getting common? Are you getting preferred? What rights go with that stock? Are you getting information rights? Are you getting pro rata rights? Whether you want a board seat or a board observer, we talked about that on another one of these. All of those things, kind of that as the package of things. Everybody does focus in on that percentage.

Mm-hmm.

The other stuff is like kind of like, okay, well, we'll deal with that. But the percentage really matters. And I will say there's not a market range. It varies, varies a ton. But I will say, if it gets to be too large, that's where you are going to have potential problems going forward in new co-investors. Maybe like, I imagine the reason you're spinning this out is it's gonna get spun out. Whatever group of employees are going over there, they're gonna grow it. They're gonna go ask investors to make an investment over there and hopefully it becomes that unicorn. In order for investors to get excited about NewCo and making an investment in NewCo, they wanna know the founders are motivated, the founders are invested here. If the old company, I'll call it parent or existing company, has an 80% stake or 50% stake in the company and the founders Have smaller stakes, they're probably less motivated.

Yeah, that's right.

I mean, that's the same in any, and even if you're not doing a spin now, that's the same of any, you know, investment analysis at the early days is by an investor. And that's like, I want you to grow this company and I want you to drive long-term growth and I want you to be excited about that. If you have a small stake, you may not be.

Don't break the cap table is, I think, and we see it coming into it. We will have sometimes somebody comes into the accelerator and They gave 25% of the company to the people who built the app, the first version, fully vested. And we have to tell them, you're never going to clear market with investors. We can't have you in the accelerator if you don't have a chance of pulling through. Why don't you go to them, say you'll give them $50,000 and 2 points in common shares? So if it was going to cost them $100,000 to build the app, you're giving them $50,000 in cash and 2 points in common, and you have the right to buy those back at a $10 million valuation so they can make $250,000. And they you know, wow, you guys are suckers for, you know, spending $250 building the first version of the app. And, you know, I'd say when we give them the right language, it works more than half the time, maybe 60% of the time, but it doesn't work 100% of the time. That's why it's important to like have a great attorney and think these things through before and understand the basics. What's happening with all these licensing deals? That seemed to me to be something that under A previous administration where M&A was being stifled and they weren't as in favor of it as opposed to maybe the world we're living in today. No politics here, but just the game on the field. People got creative. They said, hey, you want to, uh, you want this team on your team and you want them there tomorrow? You want them working there Monday? It's Thursday. We'll work— they'll be on site Monday. We'll just give you a global license to this technology and the shell company remains And then the license and the team goes to the company, creates all kinds of tax issues. We'll put that aside for the startup basics and accounting. But talk to me about that weird moment in time over the last couple years we had that. And is it still happening? And is that still part of the playbook? Or was that a moment in time? What's your take?

Less so, um, because it does create a lot of other problems. Um, so Only in the situations where it's like, this is the only way I can get the deal done, would you kind of resort to that, I think, because there are some negative pieces that go along with it. But yeah, I mean, you can, there's a variety of ways to transfer assets. And if that's what you're looking for is, or I want this IP along with some other, you know, list of assets, how do I get that out of one entity and into another? You know, certainly a license arrangement works. You know, it can be an exclusive license, even if it is a situation where like this is really going to kind of be a shell company. Maybe you don't care a whole lot and it is like, yeah, sure, exclusive license, here you go forever. In the situation that we were talking about kind of originally of a founder wants to take some IP out of a company and start a new co with it. But that existing entity is, it's in full force, it's staying, it's doing its thing, just this new co is going to be something different. In that situation, you know, we are thinking a lot about, and this is where, you know, getting your lawyer involved from day one is so important, is understanding that IP, right? And who is going to own that IP going forward? Is it going to be that your existing entity I don't care. I don't need this IP at all. It's going to be a full assignment. And I'm just, here you go. It's all yours now following this transaction. You give me equity, it's yours. That may be, may be, may be perfectly fine, but it really kind of depends on whether the existing entity needs to continue to use that. It may be intertwined with other things that they're doing.

Yes.

And maybe like, I'll assign it to you, but I need you to give me a license back because I still need to use it.

The example would be there to make it practical for people. If Google wanted to spin out YouTube, but YouTube might use the, uh, infrastructure and the video serving infrastructure of, you know, Google's cloud. Okay, well, we can't give you our infrastructure, so we'll give you a license to it and we'll let you use the infrastructure for 2 years. And then after that, if you want to be a customer of Google Cloud, you can. But if you want to go use Amazon, you can. I had this happen. We were investors in Groq, bought by Nvidia. It was a large purchase price. And I suppose, you know, when these distributions happen, the distance between capital gains tax treatment, which is generally lower than income, we'll have to deal with. But the buyer, if they really want it, can just raise the price a bit, some number of percentage to, you know, find that compromise, et cetera. So IP licensing, That's got to be tight. And then the cost structure has to be tight as well, because sometimes costs are being paid for by the previous, or services are being rendered by the previous company. And then you also have clients, right? Like maybe some clients are shared between the 2 entities. How does that split up? And that can get a little dicey. And then there's competition. I think you have to put in these, hey, for the next 5 years, spinout company's not going to go to the parent company's business lines or 7 years or 10 years. And that seems fair to me.

Yep. All of those things are, are part of that package of things that gets negotiated as you're moving out, right? Like if you're a founder or an employee or part of a group that is even thinking about doing one of these, it's so important to, to really think from day one and think about like, what does your separation look like as well?

Right?

Like that IP that you want was developed while you were at this existing entity. That means confidentiality restrictions apply with respect to it, the customer, any customer list, right? All of those things are owned by the existing entity. So when we do these spinouts, it's not just like, oh, well, this part of the business, how do you, how do you just circle just like very neatly?

part of the business.

There's so much more that goes to it, but you have to get very granular about that. And there are, there's the IP ownership issues, the confidentiality issues. If you were a founder director of existing entity, there may be fiduciary duty issues that you want to make sure really clear where those come into play in terms of your separation from, from the company. So.

Oh, that's interesting.

Yeah.

You want to, you could have been a board member and then you would have to exclude yourself as an interested party, I guess, or a conflicted party might be the legal term.

Interest. Yeah, conflict of interest, um, interested, um, but also just, you know, in terms of before you go off and start like, okay, you know, I've kind of talked about this, I'm just gonna start doing my own thing. Get that papered before you just start go doing your own thing, because that could actually be breach of fiduciary duty. It could be breach of your confidentiality provisions. Like, just have the clean separation before you start On the new venture, like, and it's gonna take a little time. It's not gonna be one of those things where, hey, I wanna take $100K on a safe financing.

Cool. Yeah.

We'll get it done this afternoon. This is much more in depth. Like it's gonna involve like a court case.

It's a divorce. It's a separation. Let's be honest. You know, we keep going back to these relationships, but in a separation, in a divorce, hey, what about the kids? Those are the employees. You're gonna have them for one week. I'm gonna have them one week. Doesn't work that way. You're gonna have to basically give me some of the children. You're gonna keep some of the children in this. Analogy, which is dark but true. Uh, and that could be a blocker. And I always tell the people who are leaving, hey, if you really do want to spin this out, you're going to have to have a real heart-to-heart and say, uh, heart-to-heart with yourself and with the other person. Say, is it actually worth going through all this? This sounds like a lot of paperwork. This sounds like a lot of negotiation, a lot of bad feelings. Maybe I'll just leave. I'll take 6 months to 12 months and go ski in Japan. And then I'll start my next company, and who knows what area it will be in, but you can be sure I will not be taking any of the confidential information from this company or any of the IP I developed while here. Uh, and I will start with a fresh sheet of paper and a brand new MacBook Pro. Do not keep your MacBook Pro. I keep telling developers this. I'm like, where'd you get that MacBook? Oh, I had it from my last company.

No, no.

Do not keep your MacBook Pro. Just give it back, wipe it, let them wipe it. Do not bring anything that you bring with you is what is in your big, beautiful brain. That's it.

Yeah. And if you go through one of these exercises and you get to the other side and you've got new co set up and you're ready, you've got an investor who says, I want to invest $20 million. Guess what the number one diligence exercise is going to be?

Yeah.

They want to know, they want to see a clean chain of title to that IP. And they are going to diligence the heck out of how did this get spun out? It's totally fine.

Yes.

As long as it's done right. But that is going to be diligence exercise number one for any investor.

All right. Another amazing Startup Basics. Becky, thank you so much. Wilson Sonsini, my attorneys, they do a great job. Startup Basics, thisweekinstartups.com/basics. You get the whole library. Take the time, watch it with your team, share it with your team, and we'll see you next time, everybody. Bye-bye.