Down Round

Down Rounds and Recaps Part 4: Navigating the Startup Recap

Welcome to part four of our series on down rounds and recaps:

Let’s get on our way.

Preferred stock. It’s the innovation that makes raising venture capital possible.

Your investors make a risky bet on you and your team. To offset some of that risk, you issue preferred stock with two essential features.

➡️ Liquidation preferences place preferred investors first in line for any distributions that come from a change of control.
➡️ Investor rights give your investors control over the most critical decisions you’ll face. When to raise. When to sell. When to recap, pivot to profitability, or wind down.

Economics and control. That’s what preferred stock is all about.

Preferred stock is a valuable tool when things are going well for your startup.

But when you’ve missed critical milestones, your valuation has fallen, and there is no clear path to raising fresh capital, those economic and control rights can be a roadblock to your startup’s survival.

What is a recap

A recapitalization (“recap”) is the restructuring of a startup’s debt and equity mix.

🗝️ The defining feature of a recap is that it dramatically reduces, or even outright eliminates, the economic value and rights of existing preferred stock.

The goal of a recap is to reset the startup’s cap table and position it for an infusion of fresh capital.

A recap generally takes place when:


💰 Your preference stack, the combined value of all of your liquidation preferences, is greater than the value of your startup.

🗳️ Investor rights are held by preferred investors who will no longer financially support your startup

💼 Investors are willing to provide fresh capital, but only if the preference stack is reset and investor rights are shifted to this new investor group

A common recap scenario

  • Through your Series B, you’ve raised $100 million in funding.
  • Every round of funding has been built on similar preferred stock terms, including a 1x liquidation preference.
  • The result is a $100 million preference stack. In a change of control, the first $100 million of cash goes to your preferred investors.

Here’s the problem. You’ve struggled to scale since you raised your series B. You’re burning cash faster than planned, and you’ve missed the milestones you need to raise your Series C.

Investors now value your startup at less than $50 million, far less than the total amount of venture capital you’ve raised so far.

Most of your current investors won’t invest more cash in your startup. You have less than six months of runway.

🙌 But all is not lost.

You’ve identified a combination of new and existing investors who will extend your runway for another 24 months. You’ll be able to execute a difficult pivot, rediscover and scale product-market fit, and get back on the path to an exit.

But these investors aren’t going to sit under your existing preference stack. And they won’t cede control to your current investors, who are no longer willing to support the company.

They are insisting on a recap comprised of three key components:

➡️ Convert all existing preferred stock to common stock, wiping out the liquidation preferences and investor rights.

➡️ Execute the conversion to common stock at a 10:1 ratio. For every 10 shares of preferred stock, the preferred stockholder will get only 1 share of common stock rather than the standard 1:1 ratio. This will dilute existing preferred shareholders, increasing the ownership of the new investment group.

➡️ The new preferred stock will have a 2x liquidation preference, anti-dilution provisions to protect them from future down rounds, and participation rights with no cap. All of these features will dramatically increase the size of the exit you’ll need for you and your team to see value while reducing the potential for earlier investors to see any return at all.

This is a very common framework for a recap.

For your existing preferred shareholders, it’s a tough pill to swallow.

You have a difficult choice. Wipe out the investors that backed you from day one.

Or run out of cash, wind down your startup, and move on to something new.

Executing a recap

If your current investors can block a recap, how do you get it done?

➡️ Build support through a transparent, thorough process to identify alternative solutions. Your startup’s struggles should not be a surprise. Keep your board and investors engaged, informed, and aligned as much as possible.

➡️ Understand the voting threshold for executing a recap. Not every investor will be supportive, even when it seems apparent that there is no alternative. Work closely with your corporate counsel on the process and build support investor by investor.

➡️ Be prepared to walk away. Divisions within your current investor base and overly aggressive terms from an outside investor can create an untenable situation. Don’t make a bad deal. Your willingness to wind down your startup and walk away is ultimately your strongest leverage.

In the end, the best investors will acknowledge when their support has waned, be quick to write down the value of their investment and shift their focus to higher potential startups in their portfolio. They won’t begrudge your desire to recap and keep trying.

Less sophisticated investors will fight you every step of the way, risking burning it all down in an effort to extract value that no longer exists.

Should you recap?

Given the impact a recap has on your existing investors, trying to execute a recap is not a decision you should take lightly.

Some view the recap as unfair. An abandonment of the investors that got you this far. I disagree.

So when should you recap?

You’ve exhausted every other reasonable option.
You tried to raise a bridge round. You tried to raise a down round without the recap. You ran a mini-sale process that generated no interest. You wouldn’t settle for a bad deal, but you tried to get something done on reasonable terms for everyone.

You can’t, or you won’t, pivot to profitability
Perhaps your product-market fit isn’t scaled enough to sustain a profitable business. Or you don’t want to run a smaller, profitable business with no clear path to an exit. Jumping off the venture track to run a small business isn’t for everyone.

You can deliver a target return to your new investors
Despite your prior missteps and setbacks, you have a viable path to scaling product-market fit to a level that will deliver a target return for your new investors. That target return can vary depending on the type of investor leading the recap.

The most important reason to recap

You still believe in your vision, and a recap is the only path to creating value for you and your team

You raised too much too fast. Your cap table is a mess, scaring away new investors.

It happens. Sprinting from fundraise to fundraise creates perverse incentives that distract us from what matters most.

But in the end, you’re still passionate about the problem you’re trying to solve. You still believe there is a venture-scale outcome ahead. You still want to put that dent in the universe.

Great. But building a venture-backed startup is not a purely altruistic pursuit. You’re also trying to build wealth for you and your team.

You aren’t obligated to put in years of hard work when your equity is worthless solely to try to generate a return for your investors.

The recap is critical to ensuring incentives are aligned for everyone. Most importantly, for you and your team.

And if, in the end, you can’t get that recap done, you just might have to wind your startup down.

This doesn’t mean you have to give up on your vision.

You can start again with a clean cap table, new investors aligned with your vision, and a wealth of experience from the mistakes of the past that will give you a greater chance of future success.

I know. Easier said than done.

Which is why a recap is a legitimate tool in the founder toolbox.

Note: The concepts of investor rights, the mechanics of preferred stock, and the technical aspects of executing a recap are complex. Remember to always consult with your legal counsel or other professional advisors before making any decisions or taking actions based on the content of this article.

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