Unnatural modifications of your capital structure

Demystifying “recaps”

Recently, I was asked to answer this question on Quora: What is a recap in the context of Venture Capital? I am not a lawyer but my practical view of “recaps” is that it is an unnatural modification of the capital structure of the company.

Imagine a current ownership structure of say 100 shares. A “natural” course of events: you want to raise more capital so you decide to sell some more equity in the company. The sale of 10 new shares (at any price) results in the dilution of all existing share holding (by %). So if you as a founder held 10 out 100 shares previously you would now hold 10 out of 110 shares. Note that I have not mentioned valuation here — it is entirely possible that this round happens at a share price less than the previous round, but that in and of itself does not constitute a recap.

However, ownership of the company can change in several other ways:

• Investors typically seek protection from dilution by future sale prices being at prices lower than what they paid (“anti-dilution clauses” in share purchase agreements). If any such anti-dilution clauses get triggered, new shares are issued to reduce the effective share price of the protected investor and hence every body else gets disproportionately diluted. Ownership levels have changed although no cash was raised by the company in this case. In the above example, say 50 additional shares were issued to previous investors as a result of anti-dilution protections then you would be left with 10 out of 160 shares (100 + 10 new shares + 50 anti-dilutive shares).
• When a company is in distress (typically), certain investors can choose to participate in a round but others may not. In such scenarios the participating investors can choose to ascribe superior rights to the newly issued shares such that all other shares see their economic interests diminished. In the above example, the recap could then look as follows: everybody who bought 10 new shares gets disproportionate rights to any cash at exit, and founders or important employees can get options or RSUs on a new class of shares. So as a founder your original 10 shares could be devalued all the way to zero, or you may get a new set of shares which are in no way related to your original shareholding. Everything is up for negotiation all over again!
• The third (more drastic) method is when the original company is pretty much shut down and the team and/or technology re-emerges as a brand new company with new investors and brand new ownership structure.

All three scenarios (and I am sure there are others) are “recaps” and are legal minefields but have been tried and tested often enough that there is a level of comfort among practitioners and their lawyers.

First appeared on Quora.

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