Down Rounds & Recaps: When & Why to Push the Reset Button
Putting an equity financing round together is about to get more complicated than many founders and investors have ever seen. Attracting investors is hard enough in good times. Now add the complication of down rounds, cram downs, pay-to-plays, and other forms of recaps, and you may be facing the most challenging fundraise of your life. But you’re not alone, and you shouldn’t fear what’s coming.
In this article I’ll explain what down rounds, cram downs, pay-to-plays, and other forms of recaps are, when and how they come up, and why it may actually be smart to seriously consider them instead of avoid them.
Why we’re here
The reason we’re having this discussion in Q2 2023 is because we are coming out of a historically heavy funding cycle into a historically light one, as this chart from a recent CB Insights reports shows. The reality many founders and investors see on the ground is even more bleak.
When times are good, capital is cheap, and valuations only go up, it’s relatively easy to put together a financing round. The pie (the valuation) grows and there’s something for everyone. The only pitched battles are between investors fighting for allocation in oversubscribed rounds. But what happens when the pie stops growing or starts shrinking?
Why there are 200+ pages of legalese per deal
VC/PE deals are more complicated than most people realize. A closing binder for a priced preferred equity round is 200+ pages of downside protection. No one needs 200+ pages to spell out what happens when things go well.
In times like this downside protections can emerge as down rounds, cram downs, pay-to-plays, and other forms of recap. Furthermore, because unprecedented amounts of capital went into startups over the past few years at historically high valuations, there is an even greater likelihood of encountering these now that the capital markets have rapidly cooled. For a primer on the points below, see Matt Levine’s Bloomberg Opinion article Private Markets Don’t Like to Go Down.
Down Rounds
The most common anxiety when the capital market outlook turns negative is the down round. This happens when the current share price dips below the last round price. The tough part about times like this is a down round can actually happen while a business has grown in revenue. Many founders are discovering that they raised pre-product pre-seed rounds in 2020–2021 at higher valuations than they could raise at today with substantially more market traction.
Down rounds trigger a host of negative reactions. For one, current investors avoid them because they require investors to “mark down” their investments to the new round’s share price. Another consequence is they can scare away new investors because few like to “catch a falling knife.” Team morale can also suffer as employees question their job security and the value of their options.
However, the actual mechanism of effecting a down round isn’t so bad. Most companies using standard NVCA documents have “broad-based weighted average anti-dilution.” Rather than effecting a “full ratchet” (repricing the last round to the current round), the “partial ratchet” of the BBWAAD mechanism takes into account the gap between the last round price and current round price, as well as the amount of shares issued at the current round price, to adjust the preferred price at the slight expense of the common stock. The effect, while a bit complicated to model, is not as bad as you may think.
Most companies and investors try to avoid a down round if at all possible, causing them to pause fundraising until revenue catches up, or the financing environment recovers to when the last valuation was set. Sometimes they’ll raise a “non-priced” convertible note or SAFE to avoid a down round. More on this later.
By contrast, a down round may be the right thing to do, and shouldn’t be treated like it’s the death of the company. Being overvalued will eventually catch up to you in the form of a failed financing. I’ve written about this in a blog post titled How To Value Your Startup:
The more you can do to make the VC’s internal discussion about the merits of the business itself, and the less “I like the company but I don’t like the terms,” the faster you will get to a yes, and the sooner you can go back to building your business, talking to customers, iterating on your product, and growing the fundamental value of your business.
So if there’s an opportunity to reset the valuation and increase the chance of success at the next round, now is the time to seriously consider taking the medicine early. Financing deals only get more complicated the more parties you add to the mix over time. At a certain point people throw in the towel and walk away from deals they deem too complicated.
Cram Downs
A more complicated version of a down round involves “cramming down” the preferred shareholders. Like the down round, the cram down can actually be a good thing for the company. In fact, it is generally in the common stock’s interest, and can offset some of the anti-dilution impact from a down round.
For context, the more a company raises, the greater the liquidation preference on the company, which is the capital first in line to get paid out in a modest exit. The more money a company raises at ever higher valuations, the more likely an exit pays out “liq pref” instead of proceeds from converted stock, since the “conversion point” gets pushed ever upward. So in a perverse way, the higher the valuation, the more the preferred equity functions like debt.
This is especially important when the founders and employees who hold common stock are “underwater,” meaning an exit today would pay them nothing after the liq pref is satisfied. This can demotivate the founders and team unless action is taken to cram down the preferred stock. Expect to see cram downs for companies getting serious about setting themselves up for success.
Pay-To-Plays
One way to cram down the preference stack is with a pay-to-play. These come into play when a company financing isn’t going well. The company and lead investor “entice” existing preferred holders to invest their pro rata of the current financing round, or else be converted to common stock.
In addition to reducing the liq pref “overhang,” savvy lead investors invoke the pay-to-play as a way to reduce the “freeloader” problem of one investor investing capital to save the company while the other investors don’t.
Generally speaking, pay-to-plays, while adding complexity to already tough deals, are to the benefit of the company by diluting the influence of passive investors and increasing the influence of the common stock and active investors. However, they are difficult to put in place as investors typically object to them unless they are out of options.
Other Forms of Recaps
Coming out of the last cycle, a lot of cap tables are very inefficiently used, which can lead to problems outlined in my post Company Killing Capitalization Problems.
The principle of efficient capitalization says that you only get 100 points of cap table and they should be used to maximum effect to incentivize value creation. Good cap table management means minimizing the portion of the cap table that is “dead weight,” meaning locked up and inoperative. Practically speaking, this means granting points to effective people and clawing them back from ineffective or departed people.
A common blunt instrument to recap a company is to do a large option pool top-up to be immediately granted to the executive team and key employees. It’s not unheard of to see a 25% pool created specifically for this purpose, meaning the rest of the shareholder (investor) base takes 25% additional dilution.
Why you can’t avoid this with “non-priced” convertible notes and SAFEs
At this point some of you will say “Who needs 200+ pages of priced preferred equity docs when you can avoid pricing a company with a convertible note or SAFE?” Indeed, the main benefit of convertible notes and SAFEs is they are faster and cheaper to put in place because they don’t have hundreds of pages of downside protection to be negotiated. However, using a convertible note or SAFE for the express purpose of avoiding a down round is fighting fire with gasoline.
The primary disadvantage in uncertain times is that a convertible note or SAFE has full ratchet anti-dilution, meaning it automatically reprices to at most the next round price - with no broad-based weighted-average mitigating mechanism. Nowhere in the docs is it written as “full ratchet anti-dilution” because it’s inherent in how it works.
To illustrate, a $5M SAFE at a $50M cap (10% dilution if converting at the cap) converting in a $25M valuation priced round automatically reprices to $5M at a $25M valuation (20% dilution). On the contrary, a standard priced preferred equity round of $5M at $50M post-money (10% dilution) would likely reprice to somewhere between 10% and 15% dilution depending on the amount raised at $25M valuation. Only the latter is a down round, but it’s the one you’d probably prefer as a founder. By the way, notice how there is a valuation “cap” but not a valuation “floor” on convertible notes and SAFEs?
Push the Reset Button
All else equal, it’s better to bite the bullet and do the down round sooner than later. It’s completely normal for a public company valuation to decrease, so founders shouldn’t think of a down round in the private markets as being abnormal.
When paired with certain necessary and advisable cram downs and other forms of recaps, the end result can actually be favorable for everyone. Ultimately it’s a chance to reset the company and cap table for the present reality, and to shed any baggage from a bygone era.
Those who get smart quickly and take decisive action will come out stronger and execute more confidently into a generational value creation opportunity ahead. On the other hand, those who kick the recap can down the road and cling to their paper valuation of the past may have a tough time finding their footing.
