The Case of the Radical Recap

Episode Summary

Simone is a founder in a challenging situation. The only financing she can raise comes with a catch – she needs to do a recap. Heidi reviews how Simone landed in this position, what a recap entails, and the best path forward for the company and investors.

Full Transcript

HEIDI: Welcome to the Startup Solution and "The Case of the Radical Recap." I’m Heidi Roizen from Threshold Ventures.

Most entrepreneurs have never come across the term recap – until they’re told that they can’t raise money without one – like this entrepreneur I’ll call Simone.

. . .

SIMONE: Hi Heidi, I hope you’re well. I’m just calling to ask you something. I finally got a new investor to say he’d lead a round, but he said he’d only do it if it was a pretty radical recap. I didn’t want to act like I didn’t know what he was talking about – but I actually didn’t know what he was talking about. So, I started to do some research – and it looks like recaps sound awful. Can you help me understand why I’d want to do this or what alternatives I might have? Thank you so much.

. . .

HEIDI: Recap is short for recapitalization. A recapitalization, in its simplest definition, is a financing that forces a change in the terms of the debt and equity that came before it.

As you can imagine, to get prior investors to voluntarily give up terms that are beneficial to them – is pretty hard to do. It only happens when those investors come to the conclusion that it’s better to own a smaller piece of something than to wind up with a bigger share of nothing. In other words, it only happens in challenging situations. And unfortunately, that’s what Simone is facing.

Simone raised a total of 25 million dollars since starting her company five years ago. Unfortunately, about a year ago, a competitor came along and blew Simone’s product out of the water. Her sales evaporated and it looked like they were going to have to shut the company down. But she still had about a year of runway left, so she and her team threw everything they had at a pivot. And, lucky for them, the new product got some impressive early traction.

But the revenue from it wasn’t going to be enough to get to profitability any time soon, and there was only enough money to keep the lights on for another six months. So, Simone went out to try to raise another 10 million dollars. And got zero offers – until she got the one with the recap.

. . .

I’m not surprised by Simone’s reaction to a recap. When anyone first learns about recaps, they usually focus on the parts that sound really bad. But remember, there’s also some good news here – because someone is willing to invest new money into her company. And that isn’t all bad. It just comes with some conditions that she may find hard to stomach.

The basics of a recap work like this: a new investor agrees to put in money, usually at a lower valuation than the last round, and sometimes at a much lower valuation than the last round – but only if the prior investors give up some or all of their preferences. If those prior investors want to keep some of those old preferences, then they have to put in additional money alongside the new investor. Otherwise, their preferences are reduced or eliminated. There are all sorts of other bells and whistles that can be incorporated, but this is the basic construct.

Now, you might ask, why would a new investor even care about the terms of the old investor’s money? Can’t they just make their new investment senior so they get paid back first? Well, sure, they can – and they probably will. But just holding a senior preference usually isn’t enough, because most investors don’t just invest to get their money back. They’re in the business of generating returns, and those prior preferences could put a big dent in their ability to do so.

In challenging situations like this, where lots of money got wasted and built no additional value, a new investor may propose a recap because he or she doesn’t want their new investment to, in essence, be used to recover that wasted money for the prior investors. Remember, even if that old money is junior to the new money, it still has to be paid back before the new investor sees anything more than just their money back. And of course, that old investment is also standing between any liquidity event and the common shareholders when it comes to getting any benefit, so the new investor may see that as bad for the team’s motivation as well.

. . .

Let me pause for a minute to respond to the cries of “unfair” that may be emanating from the ether right now. I’m speaking from the perspective of someone who has been both the “crusher” and the “crushee.” I’ve participated in recaps and invested more money, and I’ve also chosen not to invest and seen my preferences disappear.

So, from my experience, there’s no fair or unfair here if all the proper procedures have been followed in arriving at a recap. If a recap’s been chosen, it should have been the most attractive offer that the market came up with, as determined by the board and then a vote of the shareholders. And also, all prior investors should be offered the choice to either participate or not in the recap financing – again, presuming this recap is being done legally and properly. And yes, it involves pain for some, if not all, of the investors, but that pain is a result of the failure of the company to perform, which is a risk all investors take when they put money into startups in the first place.

I’m not arguing that recaps are always good or always the right thing to do. They’re simply one of the many tools entrepreneurs and investors can use to keep companies alive through difficult times. And if you’re in a tough situation like Simone’s, you and your board should thoroughly consider all options for keeping your company alive. Plus, the process of consideration you undertake should be well run and well documented. And if you do end up going the recap route, you’re going to need an experienced attorney to make sure you do it properly. Recaps are complicated and fraught with the potential for lawsuits after the fact, so make absolutely sure you get everything right.

. . .

But what exactly are those other options an entrepreneur should consider? The most obvious alternative is to not take any financing at all, and try to keep the company alive without any new money. I’ve seen many entrepreneurs make difficult decisions to cut their teams, go without income themselves, and shave down to the bare minimum to feed only the product with the most promise. And yes, that route is impossible for some kinds of companies, particularly those with long R&D cycles or capital-intensive business models. But it can work for some, and for those, it’s worth considering.

I’ve also seen situations where the company gets a recap offer and then that prompts a competitive offer from the existing investors. This isn’t that surprising since those investors are usually also on the board and are well aware of the details of both the company’s situation and the recap proposal. A competitive offer from existing insiders is usually in the form of a bridge loan to allow the company to grow more and then to go back to market again when there’s more progress in the new direction. Since it’s a loan, it doesn’t change the company’s current valuation. And it doesn’t mess with the old preference stack – it just adds more on top.

Of course, the existing investors still have to convince their partners that this is a good idea. And given the negative signal from the market that got them here in the first place, those partners will usually demand some punitive terms of their own – like a big discount on the conversion rate or a higher than 1x multiple on the new money. And, of course, these financings pile on even more preferences, so they aren’t solving the same problems that a recap does. But they do kick the can down the road on restructuring preferences or requiring the company to have a decrease in its valuation, which can be attractive to the existing players.

. . .

Another option for the entrepreneur is to simply wind the company down and bid to buy out the new product in the closing process if they want to continue to pursue it. This is an interesting option, and I’ve seen it work a number of times. Threshold’s done a few of these, where we agree to a wind-down of the company or a sale of its main assets but then agree to let the entrepreneur buy out the residual interest in the IP by paying us and the other shareholders with common stock in their new venture. Our preferences, of course, go away, but at least we end up with the common-share upside if the new company takes off.

As you can imagine, any deals like this could be challenged years from now by any prior shareholder who doesn’t think the outcome was fair and proper. And especially if the entrepreneur is so lucky as to have their new company turn into a huge hit, their old investors might come knocking with their attorneys in tow. So same as with a recap, you really need to do everything by the book and with a good legal team if you’re going to go this route.

. . .

Let’s say you and your board have decided that a recap is your best way forward. What happens next?

As I’ve already said, recaps involve investors giving up some rights. So, there’s normally a process that lays out for those investors what the terms of the recap will be and what will happen to the company if it doesn’t get this financing done – which is usually a wind-down. Then, there’s usually a shareholder vote to approve the recap. Once approved, there’s a rights offering. This provides all the old investors the opportunity to put in more money to protect or “pull up” some or all of their prior preferences.

There are lots of other features that can be thrown in here, but fundamentally, each investor can choose to invest alongside or not. If they do, they benefit from the new deal (though they’ve also usually given up something in the process). And if they don’t choose to invest additional money, they’re usually still left with something, but it’s a whole lot less of something than they had before. That said, if the alternative truly was a complete zero, this is still better than voting down the recap and seeing the company die as a result.

What’s often the hardest part of the recap for the entrepreneur is not all the legal stuff – it’s the emotional toll that this process takes. For the entrepreneur, a recap can feel like they are screwing their early investors, especially if those investors don’t have enough money to participate in the rights offering. And often, those early investors are friends, mentors, or even family.

Unfortunately for Simone, she can’t go back in time and not take those investments. But for those of you just starting out, I’d encourage you to think hard about this. I did an episode in season one called "The Case of the In-law Investors," where I explained why I think letting friends or family bet the farm on your startup is a bad idea – and I’d encourage you to have a listen to that before you load up with their money. And as for the treatment of those investors in a recap – one of the cardinal rules is that you can’t treat some shareholders differently from others just because you like them more or because they’re your family. My point is that the only way to absolutely prevent this from potentially happening is to not take their money in the first place.

. . .

Recaps can also force a lot of harsh reality on everyone involved. Even your institutional investors might not have the capital to participate and will have to write down their investments. Your preferred and common valuations will go down, sometimes dramatically so. In the most severe cases, the common shares may also be reverse-split to reduce the amount of stock outstanding. This is painful for all common holders, but especially for those who are no longer with the company and won’t benefit from any new stock incentive programs. The recap may also signal instability or trouble to your employees or even your customers. So yeah, lots of issues here to navigate.

But hey, if you’re in this situation, it’s probably still better than the alternative. So, even though I’ve just made recaps sound terrible, let me explain why I still believe that sometimes recaps are the best solution.

Many of the harsh realities of wasted money, inflated valuations, and prior engineering efforts that amounted to zero, are just that, they’re realities. And so, taking the bitter pill of a recap acknowledges that there were mistakes made. But bringing in the new money it allows, also affirms that there’s still a potential worth pursuing – and it resets the valuation and the cap table to better drive towards that future potential success.

The recap almost always reduces the preference stack, which reduces the return necessary before the common benefits – which is usually a pretty good thing for the employees. If the company then performs, it should ultimately be able to raise future rounds at healthier market terms and valuation, which is also a positive thing. Reducing the shares outstanding also creates capacity to issue new shares to existing and future employees – the people who will build that new value. And, of course, Simone’s message to me that kicked this all off points to the biggest benefit. A recap brings in new capital to grow the business – capital that the market process indicated was not available otherwise. So yeah, I still think a recap can be a good thing.

But I’ll say it one more time, recaps are complicated and a potential breeding ground for lawsuits if you don’t do them right. Plus, some entrepreneurs and VCs think that they’re a terrible idea, and they recommend against them. I’ve put links to some great information about recaps in the show notes including some of these negative perspectives, and I encourage you to read them.

. . .

But let’s get back to Simone. I gave her my full download on recaps, and she and her board weighed the recap option against their other alternatives. They determined that the recap was still the best way forward for them, and with only four months of runway left, decided it was time to get the deal done.

The hardest part of all of this for Simone was letting down her earliest investors, including her parents, who didn’t have the extra money needed to participate in the rights offering. Because of this, they lost all the preferences they had from their seed investment. Simone felt terrible about this, but she knew she couldn’t treat them differently from any of the other shareholders in terms of the recap itself. What she could do, though, is gift them some of her founder shares, which is exactly what she ended up doing.

Simone told me, after all this got done, that she wished she had kept all of her investors a little more informed about what was actually going on with the company before they got to this do-or-die situation. She admitted that when things had started to go south, she was embarrassed to say so, so instead, she put out quarterly ‘investor updates’ that only included the positive highlights. And because she was so upbeat in all these updates, it came as a real shock to those investors when she had to tell them that the only way to keep the company alive was through a punitive financing. Many were shocked and angry with her, and she had to own that.

Simone learned a few painful lessons through the process, including the need to be more transparent with her investors, good news or bad. But in the end, she got the deal done, the money is in the bank, and she’s on to her second act.

. . .

And that concludes "The Case of the Radical Recap." For the record, this situation is real, but Simone is a composite. And no startups were harmed in the making of this podcast.

Thanks for listening to The Startup Solution. We hope you’ve enjoyed this episode, and if you have, please pass it along to someone who could use it. I’m Heidi Roizen from Threshold Ventures.

The Case of the Radical Recap

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