The Silliness Of Recapping Seed Rounds

Here’s the scenario. A company raises $2m of seed money from angels in a convertible note with a $6m cap. Assuming equity is raised at or above that cap, the total dilution, before the new money, is 33% (equivalent to an equity financing of $2m at a $6m post money valuation.

The company spends the $2m building and launching their first product. The first release is underwhelming, but they iterate aggressively, with feedback and support from some of their angel investors. The product gets a lot better. They go out to raise a Series A, but there are no takers. The feedback is “come back when you’ve made more progress with customers.” They are running out of money.

One of their angel investors, who happens to be a VC firm, decides to invest another $500,000 in the company. But instead of adding it on to the note or doing an equity round with a price, which could still be an early stage price but below the cap, they make the argument that since the company couldn’t raise a round, the company is worthless.

So they recapitalize the company. The term sheet converts all the convertible debt into a post-money valuation of $100k, essentially making the convertible debt worthless. The new money comes in at a pre-money valuation of $100k, but includes a complete refresh of founder equity to 40% of the company. So the new investment gets 60%, the founders get 39.9%, and the $2m of seed money gets 0.1%.

As part of this, all of the seed investors get a chance to participate in the round prorata to preserve their ownership percentage. But this equity round is going to be controlled completely by the VC who just did the recap.

Yup – this just happened to us in an FG Angels deal. It blew my mind. We signed the paperwork, wrote our investment off, and walked away. We have no interest in re-investing alongside a VC firm that doesn’t respect a $2m investment by seed / angel investors. While we understand the pressure the founder was likely under, we don’t accept the notion of the bribe where the founders get 39.9% and the investors, who put up $2m in a convertible note, get 0.1%.

Sure – it happens. It usually happens in a later round, when the company is in fact worth much less than the liquidation preference overhang and insiders use a pay-to-play and a low valuation to reset the preferences and the cap table. The founders usually get wiped out completely, but existing management usually ends up with new options for between 10% and 20% of the company. It’s not pretty, but it happens.

But in this cycle, I hadn’t seen it in a seed round.

When I made 40 seed investments between 1994 and 1996, I had a philosophy that I’d double down on a seed investment. If I put $25k into a company, it made progress, but couldn’t get to the next level where it could raise a round, I’d offer up another $25k at the same price. If I was leading a gang of friends (that’s what I called it before the word syndicate started to be used), and that gang had put in $200k alongside my $25k, I’d encourage my gang to do the same, and they often did. In some cases this turned into nothing, but in a few cases it had magnificent outcomes for me and my gang, along with the entrepreneurs. And, everyone, in either case, felt good about how things played out.

We are big boys and are fine walking away from investments that aren’t working. But it galls us when we make bad people decisions, which happens sometimes, but not that often anymore. In this case, we misread the respect – or lack thereof – that a co-investor and an entrepreneur would have for the other seed investors and the seed capital that helped them get a product built and into customer hands.

While I wish them well as a company, the individuals are no longer part of our gang. And the VC is a firm we have no interest in ever working with again. The entrepreneur and the VC may not care at all, and that’s fine with us, but we’ll remember the behavior for a long time.

In a single turn game, this might be rational behavior. But in a multi-turn game that lasts for a very long time, across multiple contexts, this is a bad strategy. And developing a reputation for recapping seed rounds is, in my book, silly.

Calling All Entrepreneurs: Give Back To Your Community

At Foundry Group, we have a deeply held belief that we benefit from our local community (Boulder, in our case) and that we have a responsibility, as we have success, to give back to our local community.

My partner Seth Levine just had an excellent OpEd in the Boulder Daily Camera explaining this. It’s titled Entrepreneurs can give back, by giving early to EFCO. In it he explains more about Entrepreneurs Foundation of Colorado (EFCO) and Pledge 1%, two organizations we have helped create.

Seth also describes our recent gift of $300,000, via EFCO, to Boulder-based non-profits, to fill a gap in funding from Foothills United Way that happened recently.

“The Community Foundation Serving Boulder County announced last week it will grant an additional $300,000 to local Boulder County nonprofits this summer in response to a 62 percent cut in funding from Foothills United Way. The grants will be funded by Foundry through our membership in the Entrepreneurs Foundation of Colorado (EFCO).”

While many people view Boulder as a wealthy town, we have our share of people struggling to make ends meet. In fact, as Seth highlights in his OpEd:

“We hope this money will impact the thousands of local families and individuals who struggle to make ends meet in what is viewed by many as a wealthy, prosperous community. In fact, Boulder County has higher poverty rates than Colorado as a whole, and more than 9,000 children in our community live below the poverty level (defined as just over $24,000 per year for a family of four.)”

Amy and I contribute personally to several of the non-profits that this funding will go to. But, with EFCO, many more people can help. This gift is from Foundry Group and involved all the people (11 of them) who work for Foundry Group, not just the four partners. And, when you go to the EFCO page and see the list of the other 70+ or so companies that are members, you start to get a sense as to the power of the startup community in giving back to the broader community.

To date, Boulder-based startups such as Rally Software, Gnip, Revolv, Mocavo, DocPopcorn, Techstars, and Filtrbox have joined Foundry Group in distributing more than $3.5 million to Colorado community nonprofits since 2007 at the point of exit — when companies are either acquired or go public.

If you are a founder of a company and subscribe to the #GiveFirst motto that is so central to the Boulder startup community, give me a shout if you want to get plugged into EFCO (if you are in Colorado) or Pledge 1% (if you are anywhere else in the world).

The Foundry Group Detroit House

In an effort to buy real estate in burgeoning startup communities around the United States while more deeply engaging in the startup community, my partners and I have bought a house in the Cass Corridor neighborhood in Detroit. Jason Mendelson grew up in Detroit so this is a nice homecoming for him.

If you’ve followed my efforts with my Kansas City Fiber House, you’ll know where we are going with this. This time the four of us bought the house together (personally, not with our fund) and are providing it to Techstars teams in the Techstars Mobility program which is based in Detroit.

The house is a four bedroom Victoria house built in the 1920s on a cute cobblestone street near midtown. It’s around the corner from the Shinola store and several new brew pubs. It’s within walking distance of a Whole Foods.

We are converting the basement into a big work space so it’s a comfortable live/work house. Turnstone is once again helping out with the furniture. Jason is threatening to create a basement bedroom for us (Foundry partners) to stay at when we come to Detroit. Since I stay in my guest bedroom at the Kansas City house when I’m there, I’m a fan of this.

Ted Serbinski and the team at Techstars in Detroit has been amazingly helpful on all fronts with this, just like Lesa Mitchell, Ben Barreth, and the KCSV folks have been in Kansas City.

Now that we have two houses, I wonder where the third one will be.

A Week of Intellectual Dissonance

I’ve been heads down this week on a handful of transactions. As a result, I haven’t been paying much attention to the world around me, but it’s inevitable that some stuff leaks through in random conversations, emails that I get and skim to respond to later, or stuff I notice, even though I’m not looking.

While I was just in the shower, I had a handful of random things roll through my head that I realized were creating intellectual dissonance for me. They are the kind of thing that I like to dissect and chew on, and expect I’ll blog deeper about some of them. Whenever I feel intellectual dissonance, it’s usually a leading indicator of something. It’s not necessarily “something bad”, but it’s almost always “something different.”

But for now, I thought I’d share the list just to get it out of my head and on virtual paper somewhere.

1. I saw two situations where angels are being pitched on secondary purchases of late stage companies. While the secondary activity has been going on for a while, I separate for “people trying to buy late stage stock” from “angels investors.”

2. Several people, who I view as generally stable and rational, had unexpected negative emotional responses that I felt were overwrought and inappropriate to the situation. In each case it felt like something else was going on, but when confronted the individual actually dug in on their emotional, non-rational position.

3. I pay little attention to the macro, especially global stock market indicies, but somehow I noticed that the Shanghai Composite was down over 30% in the last month and then up 5% yesterday.

4. I encountered a huge retrade on a deal from someone who doesn’t have a reputation of retrading deals. It’s not something I’m involved in but I noticed it.

5. I saw two situations of what I would consider very bad / disingenuous early stage investor behavior in the context of companies that had previously raised modest amounts of angel money. Each were things that regularly happened in the early 2000s, but I have seen very little of in this cycle. Suddenly, I noticed two different situations in the same week.

6. I thought Stan Wawrinka had a shot at Wimbledon, or at least was going to be in the finals (I love Stan). He was on the receiving end of an 11-9 loss in the fifth set.

7. The NYSE and United both had massive, independent computer outages at the same time. But, it appears not to be cyberterrorism.

I generally define intellectual dissonance as stuff going on in my head about factual / experiential things that seem interesting or different to me in the moment, or things I rarely think about or notice showing up in the thought stream.  While it could just be my brain doing it’s normal garbage collection, it felt worth pondering.

Live In My Kansas City Fiber House For Free For A Year

I’m running another competition for a startup to live for a year for free in my Kansas City FiberHouse.

When I bought my house in Kansas City in 2013, I announced my intentions clearly.

“I’m not going to be living in it. Instead, I’m going to let entrepreneurs live / work in it. Rent free. As part of helping create the Kansas City startup community. And to learn about the dynamics of Google Fiber. And to have some fun.”

So far we’ve had two different companies live/work in the FiberHouse. HandPrint spend the first year in the house and LeapIt spent the second year.

The third year could be you! Apply today.