Founders – Use Your Down Round To Clean Up Your Cap Table

Mark Suster wrote a great post yesterday titled The Resetting of the Startup Industry. Go read it now – I’ll wait.

Once again, as we find ourselves in the middle of a significant public market correction, especially around technology stocks, there’s an enormous amount of noise in the system, as there always is. Much of it is very short term focused and, like a giant tractor beam, draws the conversation into a very short time horizon (as in days or weeks). And, rather than rational and helpful thoughts for entrepreneurs, it often brings out the schadenfreude in even the most talented people.

Mark’s post is one of the first in this cycle that I’ve seen from a VC giving clear, actionable advice . One of my favorite lines in buried in the middle:

“I’ve heard enough companies say “we simply can’t cut costs or it will hurt the long-term potential of the business” to get a wry smile. We entrepreneurs have been spinning that line for decades in every boom cycle. It’s simply not true. Pragmatic cost cuts are always possible and often productive.”

Many companies have hired ahead of their growth rate because they had the cash to do so. In our portfolio, we generally don’t have this problem because we aren’t big fans of either (a) overfunding companies or (b) escalating burn rates based on headcount. But, occasionally we find ourselves in the position on the board of a company where, as you look forward, you realize you are burning more than you should be for the stage you are at. As Mark suggests, this is a moment when you can proactively make pragmatic cuts. It will suck for a few days but feel a lot better in the long term.

But, more importantly, is another point Mark buries later on, which includes an awesome post of his from 2010.

“If you need to clean up your own cap table first – while very hard to do – it will make outside funding easier”

Again, go read the post now – I’ll wait. It’s so nice there are other great VC bloggers who write this stuff so I can just point at it.

I learned this lesson 127 times between 2000 and 2005. I started investing in 1994 and while there was some bumpiness in 1997 and again in 1999, the real pain happened between 2000 and 2005. I watched, participated, and suffered through every type of creative financing as companies were struggling to raise capital in this time frame. I’ve seen every imaginable type of liquidation preference structure, pay-to-play dynamic, preferred return, ratchet, share/option bonus, option repricing, and carveout. I suffered through the next financing after implementing a complex structure, or a sale of the company, or a liquidation. I’ve spent way too much time with lawyers, rights offerings, liquidation waterfalls, and angry/frustrated people who are calculating share ownership by class to see if they can exert pressure on an outcome that they really can’t impact anyway, and certainly haven’t been constructively contributing to.

I have two simple rules for founders in my head from this experience. First, make sure you know where the capital is going to come from to fully fund your business. You might have it in the bank already. Your existing investors might be willing to provide it. Or you might need to raise it. Until you are consistently generating positive cash flow, you depend on someone else for financing. And, in this kind of environment, that can be very painful, especially if you need to go find someone who isn’t already an investor in your company (e.g. your insiders require there to be an outside lead, or you need to raise much more capital than your insiders can provide.)

Second, keep your capital structure simple. There are three things that will mess you up in the long run:

  1. Too much liquidation preference: My simple rule of thumb is that if you’ve raised more than $25m and your liquidation preference is greater than 50% of your post money valuation, you have too much liquidation preference. This is a little tricky in early rounds and with modest up-round financings, as you’ll often have a liquidation preference that is high relative to your overall valuation. But, as you raise more money at higher valuations, this will normalize. Then, if you end up doing a down round, it suddenly matters a lot. Don’t worry about this too much, until you do a down round. Then use the down round to clean up your preference overhang.
  2. Complex liquidation preference: In an effort to keep from doing a down round, or too much of a down round, there will be tension between your old investors and your new investors (if you have them) around your new liquidation preferences. Often, there will be asymmetry between them with your new liquidation preferences having a multiple on them where they participate for a while up to a cap. Or participate forever. If you don’t know what this means, welcome to the world of terms other than price suddenly mattering, which Jason and I talk about extensively in our book Venture Deals. Deal with reality as a founder as well as an investor group and avoid this complexity – just clean up your cap table instead.
  3. Carveouts: After spending hours working through yet another messed up carveout that I inherited from an old bubble-era deal, I realized I hated carveouts. They are almost always written in a way that doesn’t really hold up, creates misalignment, or is a negotiating anchor in an acquisition situation. When I see a carveout being proposed these days, I know there’s a liquidation preference problem.

Mark’s post has good solutions for each of these, but the best is – as a founding team – to work with your investors to make sure that everyone is aligned for the upside case, rather than focused on protecting their capital in the downside case. For this, like so many other things in life, means “simple is better.” Most importantly, don’t be afraid to talk about it early, well before you have to go through another financing round.

  • Serious Question: At what point should a company be re-capped with fresh pools / equity being created and realigned?

    • I don’t think there is any magic moment, but whenever there is a flat or down round, it’s the right time to consider it.

  • “the real pain happened between 2000 and 2005”

    Indeed. Mine was compressed into the Apr – Nov 2000 period. Everything that cld go wrong did, nearly entirely as a result of exogenous events in the capital markets.

    That said, I may have been able to ride it out had my burn been lower. We were at $118k per month when our A round blew up. There was no plan B + it sucked in ways that haunted me for a looong time.

    Lesson? Every Plan A requires a plan B which requires a plan C which requires a plan D. If you get to plan E, run like your life depends upon it, because it prob does.

    • Great advice, the one thing that always mystifies me even at big companies is that people don’t write out a Plan B. Literally it the thought is if we write it out then it will come true….when the shit hits the fan you need a Plan B in place to start from.

      • Lots of humans don’t ever have a Plan B …

  • JC Landry

    I agree, creating a sustainable business model in these economic times should be a top priority, even looking at how the company may be able to self finance some of its near term growth can be a winner. We have found success in taking a laser like approach at targeting and growing very specific verticals such as pharmaceuticals and financials where with each new sale the next ones happen faster and cheaper, rather than a shot gun approach at mass marketing & sales. This allows the company to dominate a specific vertical quickly and efficiently while planning a measured attack for the next industry before rolling out.

  • Where I have seen the most anger and frustration is where people have structured really complex draconian liquidation preferences. Usually it is their first cycle in the game, and they got somebody that said I just need this money more than anything else.

    They expect that they will enforce these to the letter. When the shit hits the fan and it’s time to renegotiate the key’s (figuratively) get thrown on the table, and they realize they can have 100% of nothing or a much smaller percentage of something. Oh, the anger.

    That is where you and Mark are right clean this up first (although it’s not always possible) because no new investor wants to see that chaos.

    • Yup! Experience counts here.

  • RBC

    OT Champ jumping in – @bfeld:disqus it seems like the search function isn’t working properly on your site. I was looking up one of your blogs on email and it was only showing stuff circa 2010/12. On google I can search for your most recent stuff, so it isn’t down to the tagging of the articles.

    • Thanks. I’ll look into what is going on.