Recapping a round??

imagesBrad Feld and I had a quick email over the weekend about recapping a round.  He had heard that I agreed to do it with a company and he was surprised that I said yes.  I told him that I am beyond pissed, annoyed and angry over the entire thing but once I took a deep breath I did it because I wanted to do right by the entrepreneur.  I was pretty much the first dollar into the company at a very low valuation.  I have been there ever since from more capital to many conversations.  Probably not enough questions from their end because maybe this would not have played out as it did.

Since the company started there has been a few rounds done on one note.  I loathe that.  It is messy for everyone involved and the original investors get screwed because they really have zero idea what they own until everything converts.  The company also evolved into what it is today.  I give the entrepreneur huge kudos for figuring it out.  Then along comes a firm (which does many deals a year and will remain unnamed) and says the only way that this company can get money from them is to recap the original investors deal.  The entrepreneur owns too little of the company at this point. Due to several iterations of capital on the same note to figure out the companies direction the entrepreneur got seriously diluted.   That is why I wish more questions were asked over the many times we talked.  Perhaps I could have been of help here but too late.

How do I feel about this?  I am furious.  I feel like I got hosed.  I took a big risk by putting money in early on and now a VC with power behind them comes in and says here is the deal or we won’t let you in to our fold.  What should have the investors done?  Revolt?  What is the point of that?  Then we all lose.  So I did what I believe in first and foremost and that is supporting the entrepreneur.  The one caveat I made with the entrepreneur (which is purely blowing air) is that if this VC doesn’t secure a killer Series A for you then I will personally come out to SF and make this all public and have a showdown.  If you are going to screw me and all the investors who came in around me then you better make it something we can all feel good about in the long run because right now I am just holding my nose.

I just do not see this ending well for the entire industry.  From the SAFE and KISS documents that are like writing an agreement on a napkin to being a bully and screwing early investors is just not pretty.  Having a document to live up to (aka maturity dates and interest payments) and figuring out how to close on one note and create equity before adding another is part of the journey.  It makes the entrepreneur a better business person.  The VC that did this is shooting darts.  I am not a dart shooter.  Every thesis is different.  I think about each investment, I want to help each investment and I want to everyone to move forward with zero interest in screwing my investment colleagues.

Enough said.  I wrote on Brad’s post yesterday that I would take this conversation to my blog instead of ranting on his discussion thread.  Here is Brad’s post below.  As always a worthy read from Brad.   He calls it silly.  I agree but it is worse than silly, but I just can’t come up with the right word without being too dismissive but this VC is certainly taking advantage.

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 $100, essentially making the convertible debt worthless. The new money comes in at a pre-money valuation of $100, 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.