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.

  • Our founding team made the decision a long time ago that our integrity was never a bargaining chip to keep our company afloat. Running out of money can mean the death of a company, but running out of integrity to keep the money coming in is the death of a founder’s reputation – something far too important to put up for sale.

    • Well said. I strongly agree.

      • I have spent far too many nights worrying about how to raise the investment we needed to secure for our startup, but I’d much rather be awake worrying about that than losing sleep over the way I treated investors. While I know that sometimes difficult decisions have to be made, and founders have to be pragmatic, it shouldn’t include choosing to accept an offer that is quite lucrative for the founding team but rides rough shod over angels who helped the team get that far. Our founding team walked away from an offer that would have done this very thing to the original investors, and it is one of the many reasons I have so much confidence in them.

    • Bingo. +1000000000000. By the way, even if you fail keeping your integrity you will get a chance again. I made that decision when I was trading for myself. I could have cheated or skirted the edges and been retired right now. I didn’t. But, I can look in the mirror. There was a poem about that called The Man in The Glass:

    • DavidMelamed

      It’s interesting because my immediate reaction was to blame the investors…but there is a very clear lack of integrity on the founders part as well.

      There are more important things in this world than making money or building a successful startup.

      Without knowing anything else, I would bet this startup fails at some point of time in the future…As the Ronco Principle states, “In a sufficiently connected and unpredictable world, you can’t seem
      good without being good.” –

  • They’ve just put a big banner above their heads that says, “If you want friends, get a dog; we’re greedy and are only in it for the money”.

  • Sadly these founders have sold their soul to the devil. This VC will likely treat them as shabbily as they treated the co-investors next time there is a bump in the road.

  • I could go on a rant here. Instead I am going to take Brads post and continue the convo with a post of my own tomorrow. Thanks to Brad for writing about this.

  • I read the first couple of paragraphs thinking “Well done Founders for finding a way to save your company – even at a hefty personal reputation hit”, but then I agree with comments below, and Brad’s point that the longer road will catch back up with them.

  • pasmith13

    Brad, you are a better man then I am. You didn’t call out the VC by name and you wished the company well. I would not want to co-invest with the VC … nor would I want to be an LP for the VC. In the long run, this type of behavior is just bad business.
    To the founders … you better not have another bump because you know what’s coming (unlike the seed players). The VC has just told you exactly the type of firm with which you are dealing.

  • I have very little money in a few of the FG Angel companies. I’d be interested in knowing if any of the five I’m in are this company. Maybe backchannel me somehow? Thanks.

    • You aren’t in this one.

  • Thanks for sharing your insight on how deals get made and broken. In the long run, they made a big mistake.

  • As the GP of a fund that was at end-of-life in 2008, I faced a similar issue in that an VC fund sumbitted a term sheet to our portfolio company for a series B raise that essentailly converted our entire stake to common and reduced our fairly healthy % of ownership to small single digits. “Non-participants should be crammed to zero, we are doing them a favovor” the partner said. The company needed the financing, but essentially told them to f-off. We received funding from a another group that kept our series A in place, junior of course to the B, but respected our 8 years of hard work helping the company achieve 35% yoy growth. Years earlier after extending our sereis A round to the point where our invested capital subject to a 1x liq pref exceeded the value of the company, I re-upped the two founders to a 40% interest pari passu to our preferred…that’s right, 40%. We sold the company last July, the founders made money, and my old LPs got a note-worthy recovery…..Respect works both ways!!

  • I went through a similar situation. Ironically, the new CEO of the firm said, “I don’t want to treat my prior investors like that, and I don’t want to treat the previous founders like that”. I thought that showed good character on his part and made me feel like I am backing a good person. We had a long talk about crushing the original investment down, but really didn’t want to do that. Other VC’s asked us to do that to be part of the deal, but we didn’t want to do that. Can talk about it off line, but I’d love to have FG Angels in the syndicate. I might lose money on this one, but at least I feel good. I find that when I don’t do things that I feel comfortable doing, I don’t execute as well and all kinds of emotions get in the way. If I am true to myself, things go a lot better.

  • Everyone knows that VC is a reputation business and a long haul business but people don’t think about entrepreneurship that way as often. The truth is though that most founders will start half a dozen companies over their entrepreneurial career. Tanking your reputation early on in that cycle is a terrible career move.

  • I would guess they would say they didn’t have a choice, but we always have choices — even when you feel your back against a wall. We’re entrepreneurs, for Pete’s sake! See a brick wall? Figure out a way over, around or thru it! Sometimes it really hurts, but taking the high road always works out for the best. At the very least, you can look back and not cringe – which I imagine they will be doing. I am so profoundly, eternally grateful to
    my investors and have been told I am protective of them to a fault. That’s one fault I am happy to live with.

  • Kip Heuertz

    Exceptional article Brad. Reputation is key. With companies like this one where they received seed money from the gang of friends, is there a concept of a lead investor to help guide the company through some of these decisions and to coach them on maintaining their reputation?

  • Great read… would also question the ethics of the attorney’s that helped to structure the deal… i get that they are just being paid to do the work but at some point i’d hope they say to themselves why would we want to be involved in this.

  • I cannot imagine the upside of doing this??? Why not just approach the investors, discuss the issue, shut down the company when you ran out, and start a new one? Your investors, if you were good to them, would probably understand and be good allies to you too!

  • Oussama Ammar

    I know the lawsuit and things but knowing the name of the VC will help lot of founders out there. . .

    • Matt Kruza

      I agree. I think very highly of brad, but honestly he is one of the few people who could name a name here with little risk. He is already immensely respected (that will not change, in fact calling it out would enhance it) and there are no legal issues at ALL, 99% certain (I doubt there is any sort of nda on talking about this… welcome to be challenged, but I doubt that). And defamation (libel in this case) does not apply if brad was factual. No VC would sue him or the company, as that would unleash the streissand effect in large. I challenged Joanne Wilson when she made a similar post 6 months or so ago to name names. I engage with her and brad a lot her on their sites and respect them, but do us all a favor and NAME NAMES. Why it is important is that it will also put the fear of god into other VCs in future negotiations. Please Brad!

    • where I miss “the funded” most of all was this type of info, sad to see Adeo let it go down..

    • JamesHRH

      If you really care you can go to AngelList, go thru the FG Angel deals and figure this out for yourself.

      Asking Brad to publicly shame someone b/c you are either unimaginative or lazy is, well, ………..

      • Matt Kruza

        Care to tell us which it is then? Spent about 30 minutes going through angellist and crunchbase and think I MAY know the company (hard to tell), but even the one I think it is has 3-4 other VCs involved. And probably has not filed its reg d filing yet, so hard to know which company / firm it was. This is partly like not outing a bad cop / bad teacher / bad employee within a company. I feel a little potentially for the founders, but they could have easily still had 25% which would have been HUGE by average re-caps (it appeas most agree with that) and the investor (any VC firm) has such an information and prestige advantage but all but maybe a handful of entrepreneurs that to not out feels like a cop out. Mad respect for Brad, and disappointed that he chose not to share. But it does not make any of us “lazy” to not find out…

        • JamesHRH

          Would you do a deal with Brad if he made it a habit to publicly shame other investors when he dislikes their behaviour? come on.

          • Matt Kruza

            Yes if it is as bad as he alludes in this case. And this isn’t a habit. And he is one of a handleful of investors that could actually do this properly. Read my comment below to reference how this would serve as a meaningful “shot across the bow” for bull shit like this. It’s either “not that unusual or big of a deal”, or it should be called out. Will he, most likely not. Doesn’t mean its right.

          • Today’s post will be about why I don’t publicly call out people in situations like this.

          • Matt Kruza

            Ok. Look forward to hearing. I come in with a heavy skepticism of such an approach but will definitely listen and give your post due thought and see the rationale

          • Christian Thurston

            Glad to hear it. I scratch my head when people expect you to publicly name and shame. Obviously integrity is a great reason not to do that but a lot of people find “integrity” too nuanced to grasp so I’ll switch to game theory.

            Naming and shaming reduces options and serves no benefit to the person who has the choice to name and shame. So it’s sum negative. Bad actors also have a tendency to lie and throw mud back. Most people won’t read the detail, they’ll see the cat fight and write both sides off and move on with their lives. So what rational reason is there to name and shame?

            The only reason is irrational – revenge. And as the old saying goes: never throw a punch in anger.

  • Rick

    Just be thankful you have something to do. No having anything to do sounds like fun at first but it sucks!

  • DavidMelamed

    I wish I read this a decade ago. I was recruited into a startup that went through a similar recapitalization right before hiring me. We failed a year later when the investor decided to pull back his investment and refused to make good on his commitment. I didn’t get screwed too bad… but in retrospect, I should have seem this coming. After all, I was working with an investor that forced a recapitalization of a friends and family round…and an entrepreneur that chose a second shot at success over his integrity with his own family and friends. (not that true integrity would differentiate between family and strangers) but someone without integrity and without loyalty to those closest to them…is as good of a warning sign as ever.

  • Hugely shortsighted of them, which I find is sadly pretty common in the “party round” note situations.

    When I think of the longer term possibilities of doing great things with people over a long period of time (e.g. decades), this type of behavior is pretty hard to fathom.

    Also, yet another reason to dislike notes, capped or not, Founder or VC.

  • Pierre Powell

    As a member of the syndicate, I decided to join you in the boycott. I joined the syndicate to learn these lessons without a huge financial risk. Would love to get an inside-baseball perspective (as a syndicate member) on why FG Angels did not chose to continue their investment or at least use their incredible credibility to influence the start-up and their VC conspirators…

    • Since pro-rata was being offered to each member of the syndicate on a case-by-case basis, we decided not to interfere with the deal. We thought about the different approaches and this seemed like the cleanest, easiest, and most supportive for everyone (both the angels in the syndicate and the entrepreneur) especially since our FG Angels investment strategy is well-articulated (e.g. we are only writing the first / angel check.)

      We could have spent a lot of time on this, but decided it wasn’t a good use of our time. We expected the entrepreneur would have pushed back on the investor and/or constructed a deal that was less advantageous to him, and more respectful of his early investors, but that clearly wasn’t the case.

      So we decided to vote with our feet by disengaging, signing the paperwork, and moving on. Since individual members of the syndicate could participate if they wanted, we didn’t feel like we disadvantaged anyone by not fighting for a better deal.

      I’m not a fan of fighting with co-investors, especially at the seed / angel level. I’m much more collaborative and it’s served me well over the past 20 years.

  • Rupert Edwards

    Brad thanks for this post. It is a great reminder that the core of our ventures is who we are. This is a good alternative to the normal startup-blog-tsunami where good business is almost always synonymous with ‘smart business.’ We all need to be reminded that good business is first of all ‘good’ before it is ‘smart.’ Under pressure its not always easy to remember. So keep sharing these stories.

  • That behavior is truly appalling.

  • Prabhaav Bhardwaj

    Why was there no anti-dilution measures or have they been ignored?

    • Anti-dilution doesn’t apply to convertible notes. They get priced on the equity round, which in this case was done at a $100 post-money valuation.

      • My goodness. How many posts are you going to have to do where convertible notes muddy the waters before entrepreneurs figure out they should not take convertible notes ever? For God’s sake, if your an investor, have some balls. Either give em a straight up loan or have the chutzpah to take a straight up equity position. Stop with this convertible hedgingness.

  • Richard Ginsberg

    Was this just a non-standard term sheet? How did the founders end up with 39.9% of the recapped company without buy-in from convert investors? Yes, your back is against the wall and you feel you are so close; 10-15% should be sufficient with annual options to claw back ownership. The VC sounds like a douche reminds me of Dick Fuld from Lehman Bros. people don’t forget.

    • We were told by the CEO this was the deal or the company was shutting down. There wasn’t a discussion or a negotiation – just the ultimatum. We decided life was too short to fight about it.

      • Richard Ginsberg

        The CEO better hope this is the one. Even if he does succeed, follow-on investors will give him tough terms to protect themselves in light of his current actions. I passed on a deal a couple months ago after the founder admitted recapping previous investors of $12m, he was raising at a $4m cap on the same entity!

  • Chris McDemus

    That is completely nuts. Who does a recap at a seed stage? I’ve never seen that and I’ve being doing VC work since ’95 and fought through the ’01 and ’08 crashes. Maybe you’d see this in a later stage deal in certain market conditions; certainly it’s a PE technique which can be used very strategically to help the company out but that’s PE not VC. It’s opportunistic to the point of being reputational for the fund. The debt holders clearly did not marshal themselves. They were creditors of the company and could have leveraged that into something larger than 0.1%. Usually in scenarios like this, it’s management that ends up with 10% or less of the company, with the outside investors (including the converting note holders) holding the overwhelming majority and you end up having management pushing for an equity carve-out or exit price carve-out so that they are still incentivized to build the business despite being nearly washed out. Crazy. Just crazy.

  • simon R.

    it sounds like the existing investors were unwilling to put in any additional money (in this case, not willing to put in a quarter to preserve a dollar’s worth of liq pref — using the $500K / $2M #s but there might be nuances). thus, a recap would be “fair game” unless:
    a) the founders had alternative financing sources but acted in self-interest at the expense of existing investors (ie took a deal that was better for founders, but worse for prior investors)
    b) the recap was done in a way that wasn’t fair to all investors (ie. two step cramdown, etc)

    couldn’t tell from the article if either of these was applicable here, but thought i’d throw in my 2c. if the choice, for a founder, is between shutting down (and laying off their employees), or taking a recap, i think it’s incumbent on the founder to take the recap assuming there is no other choice and they’ve done everything they can to try to make things work w/o “washing out” prior investors.

    • Recaps are always fair game. But there are significant reputational affects, especially if you care about the long game. That’s my fundamental point.

      It’s especially important for angels, who often only write one check at the beginning, to understand.

      And, I’ve been in many similar situations where there wasn’t a recap – but more money put it by some of the existing investors at a modest, but appropriate valuation for the stage of the company (vs. effectively $0).

      • Simon R

        definitely agree. an extremely punitive recap should be a last resort.

  • A potential seed investor recently advised me strongly to proactively push for this as founder/ceo, after a shift in product strategy (not a pivot). Made it sound like ‘this is how things are done in the valley’. Luckily, my first angels include close friends and family so there was no way I could even consider it. Glad to hear some other folk play the long game.

    • Glad you have good advisors and you respected them.

  • James M.

    Give me a break Brad.. You’re an INVESTOR! You made a bet that didn’t materialize. The company ran out of cash, the existing investors weren’t willing to pony up more money, so you got crammed down and now you want to cry about it. The founders don’t owe you anything, the VC doesn’t owe you anything. This is the problem with early stage investors and your clubby bull shit networks. Welcome to the private equity world.. Risk / reward. Put on your big boy pants and don’t cry about a one off deal in your blog..

    • I think he said a VC did this, not a PE firm.

      • It was someone who is promoting themselves as a highly regarded VC firm.

        • Christian Thurston

          Unlike the VCs who don’t claim to be highly regarded ;).

      • Rick

        Hi William. How are you?

        • Rick, you’re back! All good & wishing you the same.

          • Rick

            Nice to see you still here and on AVC. Your contributions are valuable.

    • I think the point he was making was that even though this was an entirely legal procedure, it was short sighted, especially on the part of the VC, to treat the convertible debt in this manner.

      I for one would be interested to hear how he would have preferred to proceed: shut down the company, raise finding on different terms, etc.

      Sounds like a tough situation all around, and it is possible that the fact the VC was dealing with a syndicate changed their behavior.

    • It was cut throat, perfectly legal but cut throat.

      • Yup – and I’m not complaining about the legality of it. We signed the consent and agreed to the deal because fundamentally we want to support the entrepreneur and if this is what he wanted to do, so be it.

        • Christian Thurston

          Think we’ll start seeing minimum valuations creep into convertible debt?

    • Hmmm – I guess you didn’t read the tone of my post very carefully.

      For example: “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.”

      I agree that the founders don’t owe me anything and the VC doesn’t owe me anything. They just shouldn’t expect me to ever return a phone call or an email from them again. Which may be just fine with them – and that’s ok.

      More importantly, I’m not complaining about a one-off deal. I expect this is a pattern that is starting to crop up. It’s fair warning to angels jumping into the pool.

      • Rick

        “to ever return a phone call”
        I don’t even use email but still can’t get you to call me!

        • Yeah – well – metaphor …

  • Ian Vincent

    What happened to the “debt” part of the “convertible debt”? How did the company make the debt go away?

    • It converted into equity in the round, but at a $100 POST-money valuation (basically zero / worthless). There are lots of edge case issues around the debt part of it, and there’s an argument that could be made around how the debt is handled. But the threat is “if we don’t do things this way the company is worthless and we are all just walking away unless you consent to this deal” so that doesn’t really matter.

      • Ian Vincent

        Thanks for responding. Points noted. If not zero value, what value did you think the company had?

        • No idea. But there were plenty of ways to configure the deal so that the existing notes didn’t own $0 of the company.

          • Christian Thurston

            That makes sense. So something like Angel = 20%, Founders = 20% and VC = 60%. Or would you worry the founders were too diluted?

  • Sajid Rahman

    Excellent blogpost. The problem with some of the PE guys coming at seed round is they also bring in the garbage with them and do not understand how the game is played in the long terms.

    • Or they don’t care about the long term.

  • Is there anything in the original Seed Terms that could have prevented this, like wouldn’t anti-dilution clauses cover that typically?

    • Not really. It was a convertible note. Anti-dilution doesn’t apply since the note gets priced at whatever the round is.

      • Got it. thanks.

        • Saul_Lieberman

          Ultimately, this is not about the seed round having been a convertible note. The new investors say: do it our way or we walk. That can happen even if the seed investors hold preferred shares.

  • Jonathon Storer

    Then what’s the play for the company that needs that’s run out of money?

    • I don’t understand the question.

      • Christian Thurston

        Hi Brad, I think what Jonathon is asking is what should a company do when they run out of money and their cap table is making it hard to raise any further money.

        Perhaps you’ve written about this scenario before somewhere else on the site and if you have you might consider a linking to it at the bottom of the post or adding a “Here’s what the founders could have done instead if you find yourself in this situation”.

        I for one would be keen to know your thoughts on the better path here. Just to be clear though, I totally agree with you on it being poor form to not protect your angels.

        • I don’t think the problem was the cap table. Remember they only had convertible debt, so there was a configuration where the existing notes would get something (more than 0.1% of the company).

  • Jordan Thaeler

    I think it’s more interesting to look at a common scenario: founders raise $ at a valuation of X, company must exit at a value of X/2, founders walk away with $0. VC wins again.

    • VCs definitely don’t win in that scenario. I define a win is defined as “at least a 3x return.” Getting some of your money back on an investment is definitely a loss. Doing it gracefully and trying again is what it’s all about in my book.

      • Jordan Thaeler

        I thought most of the LP structures mirror that in classical PE: 2 and 20%. VCs still get that fat 2% on, nowadays, billion dollar funds. Founders don’t get that guaranteed 2%. Further VCs get the life of a fund to earn that return. Since VCs are investing later and later in “startup” lifecycles, they can put in money, gauge trajectory, and force a sale in 3 years if needed, leaving another 7 years to put that money back to work, no?

  • Rick

    If the company was running out of money and was going to shut down and investors were going to lose everything anyway. Then shouldn’t the company do what they did with the hope of providing an investment opportunity for the original investors at a later time that might allow them to recoup both the original investment and the later investment?
    If I were in your shoes I would not like what happened in this case. But I just wonder if it’s ever good to shut down a company when there is an option, even an undesirable one, for keeping the business open?
    This feels like a tough one.

    • Christian Thurston

      I think the point is that it’s not actually an all or nothing proposition for the founder. The founders got 39.9%. Some of that could have gone to the angels instead. It’s not that Brad doesn’t understand that things don’t always work out well. The point is that it appears the founders weren’t interested in doing anything at all to take care of their early investors.

  • Mike Marcantonio

    Did the note have a change in control provision?

    • I don’t remember. I’m not sure that would matter – you could argue it would apply but then the existing investor that drove the recap would just say “ok then I’m not going to do this…”

      • Saul_Lieberman

        so it’s not really about a seed round or convertible notes. the recapping investor can always say “ok then I’m not going to do this…” even if the seed round held preferred stock.

        • Matt Kruza

          Yeah we are aligned here Saul I think on the direct issue / technically. However, both with Brad, Joanne Wilson, and mark suster talking about this much (maybe talking their book a little.. but they all seem very straight shooters), they seem to be implying that there is a culture / precedent that setting a price sets. And I may agree with that argument. I mean another thing in this case is a $2m note on a $6M cap seems super high. Best Case (for the entrepreneur) they give up 33%, and if the next round is at a $4M pre (for the new money), the note gets 50%. I think a note should be more for a 5-20% stake in the business, otherwise you should cross the valuation threshold.

  • Naming names is taboo, and I get why you won’t do it. But still. Ugh.

    Celebrities can do something as silly as wear a bad outfit, and get hung out to dry in the media. These entrepreneurs and investors have done far worse, and they deserve to be exposed and to suffer the same treatment — if not worse.

  • To me this just sounds like yet another argument against convertible notes. Although a floor would have protected you here (am I wrong?), having a note with a cap and a floor just ends up being a priced round. So why not just require all your investments to be priced rounds? 2M on a note seems like a lot anyways :-/

    Sorry you got ripped off, regardless of whether they are technically right or not, you are spot on that this is just a crappy way to treat people who supported you with time and money. Biting the proverbial hand that feeds.

    • Saul_Lieberman

      priced, even preferred round doesn’t help if the new money says do it my way or i walk.

      • I’m not sure thats true. Being an actual shareholder would make it harder and give the original investors more influence, plus then there is the whole “fiduciary duty of an officer to the shareholders” which can get ugly in courts.

        My 2 cents, I think a priced round puts founders and investors on equal footing. Throw in some board seats and the investors can actually block this type of shenanigans.

    • I’m not sure it mattered whether this was equity or a convertible note. In the equity case, the investor could have proposed the same recap.

  • dionlisle

    Brad, thanks for sharing and having the patience to answer the questions in the comments, those that make sense and those that don’t. I am on the CVC side and painfully aware we are often seen as dumb money, so try hard to think beyond today’s deal to the next and the next after that.

    I find it hard to believe (i do believe you) that anyone would be so short-sighted, the “VC” involved, the CEO or anyone that wants to “work in this town” again.

    You are far too classy to name names, but eventually everyone will know who these classless parties are and they will struggle to get anyone to return a call or an email.

    Thanks for sharing, I am always looking to learn from others BEFORE I make an irrevocable mistake.

    • When I was starting out making investments in the mid-1990s, I often heard corporate VCs called dumb money. Then, as the private equity guys showed up in the late 1990s, they were the dumb money. Then the hedge fund guys that showed up in 2000 were the dumb money.

      In 2001, I found out, very painfully, that I was the dumb money. Actually, most everyone in the ecosystem had been dumb money based on the completely suspension of disbelief.

      Once again we are hearing the phrases “dumb money” and “hot money” being thrown around. In addition to being incredibly disrespectful, it’ll falls into the program of viewing everyone in the category as the same. They aren’t – each investor is different – and that’s an important distinction.

      Over the last 20 years, I’ve found a number of CVCs who I have deep respect for an like working with a lot. And they are far smarter money than a lot of other VCs.

      So – keep asking those questions …

  • martinsnyder

    There is a price to dynamism, which is sloppiness. Everyone an amateur Rockefeller, with lots and lots of speculation involved. Probably many more amateur Buffets out there, but you don’t hear so much about ’em…

    If you look at the Krupps or some other dynastic stories, from time to time there is a gestation of decades or even generations before breakout. That’s long-term investing….

  • Scott Kosch

    I am a syndicate investor in this company and have been trying to get my head around this situation as well. A total cram down after just a seed round is highly unusual. I tend to limit blame to the investor who proposed this. The entrepreneur’s back is against the wall, and in order to keep the lights on and resume paying the team, he will agree to almost anything. There has to be enough stock in it for the team to remain incentivized, so the only people to take it from are the prior investors. To be clear, I was offered the opportunity to participate and the entrepreneur has been generous with his time to answer my questions; however, the severity of the recap valuation really troubles me.

    At this stage of the company, I believe that not respecting $2M in seed investment is a clear indication of vulture capital, not venture capital. This is not to say that past investors who don’t participate shouldn’t get diluted. But getting wiped out if they don’t participate is dirty pool. I expect this sort of behavior in other asset classes, but successful venture capital investing doesn’t work when you completely burn bridges just because you have the leverage to do so. I’m certain that the lead VC made the assumption that many of the angel investors wouldn’t participate, so the deal structure would help them to consolidate a larger position.

    I wish the entrepreneur and his team well as they fight to continue the pursuit of their vision. I worry that they won’t see the fruits of their labor.

  • Jonathan Lyons

    Let me add some cross-industry experience to support Brad’s key point.

    In my early career, before I moved out to Silicon Valley, I worked on political campaigns in Washington, DC. Politics can be an intensely completive space (like startups and finance) – and winning an election or a policy fight is
    a huge deal.

    I learned a valuable lesson by watching people advance quickly, but then just as quickly flame out.

    Lesson: Being long-term greedy and doing the right thing are usually the same thing.

    This is why Brad’s post resonated with me. If you focus on the long game, think about the entirety of your career and all the people you could possibly help along the way, then you’ll do very well in life – essentially, maximizing your own economic self-interest. But, if you play the short game, cut corners, break laws, etc – then you’ll get ahead quickly and maybe do the next deal on good terms, but at the cost of your reputation. Over time, your reservoir of “luck” – aka community good will – dries out.

    Surprisingly – to me, given the high stakes in politics – most people in DC actually understood how this works. (A few didn’t – and their careers have since stalled. I won’t be naming names, either… .)

    So, that’s the mantra I tend to live by: when faced with an overwhelmingly difficult decision (like choosing a funding partner or negotiating a deal), doing the right thing is almost certainly long-term greedy. It works out most of the time. And even if it doesn’t, you sleep a hell of a lot better at night.

    Thanks Brad for publishing on this important topic.

    • Great political / DC analogy. IHMO the long game is the only interesting one to play.

  • Wow, I didn’t know this could be done with raising on a convertible note. I better understand why some investors are against convertible notes and only invest in priced seed rounds.

    Whoever invests in the seed round should be rewarded for that risk. Period. Whether raising the A round was “easy” or “hard” shouldn’t matter.

    I really like the tone and wording you used in this blog post. You are setting such a great example for investors and entrepreneurs alike.

  • Wow…not cool. It is arguable that, since they decided to follow-on with another infusion, there is value. Isn’t valuation at this stage more about what a company needs to reach milestones and the corresponding ownership needs? Is there a way this scenario on a down round at seed stage could be avoided?

    • Valuation at this stage is highly variable depending on a lot of different factors, including the dynamics between all the parties. Ultimately a lot of it is driven by how the investor putting in new money approaches and treats the situation.

  • Mike Porath

    I’ve been talking to a lot of other founders recently and they seem to focus on one of two questions: What is best for me? What is best for the company? Ironically, it feels like those who answer the latter are more likely to be the ones who come out on top. I’m guessing this founder-VC match won’t end well.

    • I have deep, deep respect for founders who ask first, “what is best for the company” and then follow it with “what is best for my existing investors.” What is best for “me” and what is best for “my new investors” is important, but there are different ways to sequence the priorities, as you correctly point out.

  • David Waxman

    Brad: First of all, that is reprehensible behavior. I look forward to reading your piece on why you don’t want to name this VC. I’d certainly like to know who it is so I can avoid.

    Off main topic: do you see a lot of post-money caps? I would interpret $2M on a $6M capped note as representing 25% dilution at conversion (prior to new money), not 33%. (p.s., yet another reason to dislike convertible notes…)

    • Post on why I don’t name names in situations like this is up –

      Re: caps being post vs. pre – it’s very often ambiguous. I know some lawyers who write it that way to theoretically give more leverage in the equity round to the entrepreneur, but it really just makes things more confusing and often ends up in a negotiating train wreck between three parties – new investor, entrepreneur, and note holders – resulting in the entrepreneur being squeezed and at least one of the new investor or the note holders being unhappy and feeling like they weren’t treated correctly.

      I usually am explicit about it now when I lead an equity round and wrote a post about what happened recently when I was sloppy.

  • mike

    Based on what i can find on FG Angel on angellist, it appears that the deal is Adsnative considering it’s FG Angel’s only $2m seed round that included Kosch as a co-investor. The other 2 VC’s in the deal were Onset and Interwest. Which one is it??

    • mike

      I guess it could be kbs + ventures … whoever that is

      • mike

        based on the below retweet by Keval Desai, a Partner from Interwest, I presume he’s the guilty party ….

        Satish Polisetti [email protected]_p Jul 14
        .@AdsNative live on

    • sat_p

      Nopes, not us.

  • Here’s the deal – the startup + VC firm have (almost certainly) been outed in the comments. I came to the same conclusion after doing abt 10 mins of research on angellist, but chose not to mention the name here out of respect for Brad’s desire to “…not start a food fight”.

    In any case – smart founders, arm yourself w/ as much 1st, 2nd + 3rd degree info you can on potential investors. This is one way.

  • kevrmoore

    Testify, Brad! I was recently recapped on a note taking a 50% haircut, and our investor group was pissed. Can’t imagine getting crammed to 0%. Mine was by a major seed ecosystem influencer in SV, so I support your suggestion that this behavior is increasing. Thank you for speaking out. Seed investors beware, you are now a commodity in this bull startup cycle.

    • “Seed investors beware, you are now a commodity in this bull startup cycle.” – this is a powerful punch line.

  • Brad, you did not mention the sum of the new investment, but it seems that the equity allocation restructure implies a tax event for the founders.

    • The investor put in about $500k and my understanding is that another $500k – $1m is now coming in from new angels, and a few of the existing angels.

      There are ways to structure around the taxable event for the founder, especially given the basis value. But I’m not paying attention to that – hopefully they are.

      • Thanks Brad. Your openness inspires me to share my experience too.

        Being an angel investor before it had such a fancy name (1997), I’ve been “fortunate” to experience several “pay to play” events in the past.

        I focus on early seed. I always did. I either do it alone or with people I know very well.

        As long as we (the startup) have resources, I fight for success. But this is a venture business, and most of the time things don’t work as we plan.

        Unfortunately, we can’t click ‘undo’ on time. Life is short and I honestly believe we should all try and do things we like, with people we love and products that delight their users.
        So once we run on fumes, I look at the mirror and ask myself if this journey is worthwhile continuing.

        I always keep a buffer to follow up – both for the few success stories and for circumstances where we are convinced that the tipping point is just around the corner.

        When I do think that we should discontinue – I share it with the founders. If they want to go on and I’m no longer a partner to this journey, I simply sell my entire shares (I never do convertible) to the founders for $1.
        The sales agreement usually includes an ‘upside miracle’ clause implying that if the founders pay me 10% of their future proceeds (upto a max of my original investment).

        This way, we can all move on in life. Founders are free to find new partners with a clean Cap table, I write down the investment in the venture and we say good bye as friends.

        • Yours is a good proactive approach. Have you ever had a founder unwilling to sign up for the upside miracle (since it would come out of their stock?)

          • All cases I had founders were grateful and thought this was noble. I guess it takes a real potz not to…

  • Shawn T

    Great post — sorry you had to write it. The founders should have done whatever was necessary in negations with the VC firm to insure the angels would get a real stake, even if it wasn’t great, and not let them get crammed down to nothing. (By the way, just finished “Venture Deals” and learned a ton — thank you and Jason for writing it.)

    • Thx – glad you liked Venture Deals!

      • re: Venture Deals, the tagline “Be Smarter than your lawyer and VC” (or investors) does happen. It also saves a young company a shload of money in legal costs.

        Disclaimer: our current attorney is great, and the board member and observer from our lead investor are great, but that’s not necessarily the case with everyone. Knowledge is power, and power keeps one from ending up like the firm in the article above…

  • As one of your early, and regular, FG Angels investors who also got burned in this deal the team and VC are not folks I’d do business with again. I was also rudely surprised at the outcome.

    So not only did they lose you Brad, and FG, but given it was also an AngelList deal the extended investor network will have a collectively long and far-reaching memory as well.

    • Ditto, Vineet. I think the posted letters from the founders left me with a bad taste in my mouth too. As investors (and as syndicate members we are) we are also bound by confidentiality wrappers that prevent us from outing the company name and details. It is a shame, indeed.

  • Ben Wild

    Great post. I’m not very experienced in these matters but it seems that there should be some legal protection for convertible note holders which would prevent recapitalization without their approval?

    • Sure, but the thread of the existing investor who was providing funding is “if you don’t take this deal the company goes out of business and you have nothing.” So legal protection doesn’t really matter in this circumstance.

      • Ben Wild

        Shocking that there are such dumb investors out there that would say that.

        • I don’t know if “dumb” is the right word, but “opportunistic” or “vulture” might be just as good. 🙂

      • WorruB

        Would it have been preferable if the team had just wanted to start over? I guess they were still relying on IP owned by the original entity?

        Where is the ethical line in your mind between starting something new (which would presumably have a new cap table where existing investors got nothing) which I think would be ethical and what happened here?

        Just in case the tone gets mis-read I’m not trying to just play devils advocate, I’m wondering when / where / if this line exists.

  • Yariv

    “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”

    So, it’s okay for the founders to get wiped out completely. But we should really wept a tear when you get wiped out?
    Welcome to eat-what-you-just-cooked.

    • Read the post carefully. I don’t think I’ve wept a tear.

  • Jakob Sorensen

    Oh, how “The Mighty” have fallen. Such a terrible example of a founder ruining the trust of their generous early investors.

  • aledalgrande

    I wonder why you didn’t mention who this people are. They should be known in the industry for who and what they are. Just facts.

  • Brian Zuercher

    This is a serious issue and I think I can make the case that it might be worse in Tier 2 markets (Chicago, Cincy, Detroit, Columbus, Indy, KC, etc.). There is often a gap in Series A in these markets, thus the angels are more often facing this situation.

    Does laying out a more likely longer-term capital plan up front help everyone involved keep funding top of mind?

    My main concern is the loss of confidence in newer angel investors. This can also raise concerns to issues around crowdfunding and a lower level of sophistication leading to more predatory.

    Not sure how to combat this, but appreciate the education provided here.

  • Daniel Chalef

    Brad, how would you have liked the founder to behave in this situation? I ask as it sounds like the founder was backed into a corner.

  • David Mohler

    Once I saw a similar situation in one of my angel investments. The investing angels transformed from being a great group of cheerleaders for the company to wanting it, and the VC firm, to fail. As the entity continued in a sector I knew well, “burned” angels who were well known and well-regarded gave highly negative (but accurate) comments on the company to all due diligence inquiries that subsequently came their way. Predatory VC’s need to understand there may shareholder value in a professional angel where incentives are aligned. Pissed off angels can be real devils!

  • Maurice Grasso

    Yariv – you’ve missed the point – if there is a “haircut” to be taken then this should be shared amongst all the Investors up till that point, including the Founder stake. Once you move into the areas of “preferential” treatment then you are really opening up a can of worms and sending out the message as Brad has said, that the Founder can’t be trusted to uphold any governance let alone good governance and the VC firm should have known better. These are the sorts of situations that need to be addressed by a robust Shareholder Agreement as generally the investors require protection from this sort of situation, with at least veto rights over this sort of thing happening. Given that we had a convertible note maybe the terms should have been around a discount on the next subsequent round which would have wiped out the Founder altogether if he had agreed to this sorry state of affairs and removed the incentive for him and the VC to behave this way.

  • J Patel


    1. $2M seed would have had at least 33% of the company had things gone OK.
    2. Things went badly, as happens..
    3. New investor wants 60% of the company for $500K.
    4. New investor and founder invite the old investors to participate. For $275K in additional money they could have gotten 33% of the newly capitalized company, The old investors refused. In essence, the old investors could have preserved their 1/3 ownership with just an additional $275K. True?
    5. The founder should absolutely have fought for and included a miracle clause that would make ALL investors whole if the company succeeds in returning some multiple to the new money.

    Perhaps all seed investments should allocate/preserve 15% of their initial investment for such a recap scenario. I am afraid these types of discussions will scare away the last investor who may believe in a turn around potential and is willing to back the founder. At least if the old investors had been offered hope of being made whole, this restructuring would have been more palatable.

    In the end, there are no happy people when things go wrong. It also seems wrong to scare away the last hope for a rebound.

    • Several important nuances but your miracle clause notion is directionally correct.

      1. The new investor is actually an existing investor.
      2. The investment was from angels in notes. Many angels don’t expect to invest again beyond their first investment. This is a normal tenor of the angel dynamic and as someone who has personally made > 200 angel investments separate from my VC investments, it’s something I’m respectful of.
      3. It wouldn’t be that surprising for the notes to have a haircut from what they would have had based on the funding dynamics, but to be haircut to almost 0% is unpalatable, especially given the investor / founder ownership dynamics post financing.

      I don’t think a fixed miracle clause is necessary nor do I think it’s a miracle clause. It’s simply an allocation of economics based on the $3m that had generated value, just not enough to get a new outside investor, which appears to be what the existing investor who drove the recap wanted. When it didn’t happen, the company was completely recapped.

  • Tim Eviston

    Brad thanks for sharing this. I think sharing these kind of tales really help entrepreneurs like myself learn the fallout of bad decisions. Although the entrepreneur was in a bad situation i feel as a leader it is their responsabilities to look out for all parties. The first investors especially. It is better to be a team player entrepreneur who looks after all interests than a succesful one who sells out his/her backers. I personally would rather have the company go down with my reputation as a good leader in place than as a winner who harmed my friends and colleagues. The loss of a company is a terrible thing and you have a responsibility as a founder to persevere and fight for your company. But not at the cost of your reputation and that of your stakeholders without including them in the decision making process. My 2 c.

  • wow. if this becomes a trend (I haven’t seen it yet, but presumably some of my early seed investments will be faced with it, I’m done angel investing.

    the entrepreneur is ultimately responsible for taking the deal (or not) here, but that’s cheap behavior by someone with a disproportionate amount of power. #bottomfeeders

  • Ross Klenoff

    Would there have been value in leveraging your position as creditor to either take the assets, code, contracts, etc. and have a talented team in the ecosystem continue to run with it (i.e., with you keeping a substantial portion of the equity)? If practicable, I wonder if this would have left you with more upside and helped telegraph to other companies that this type of inequitable offer is not likely to be rewarded. I don’t think you take a repetitional hit there.

    • Nah – it’s not the way I play.

  • You said it Brad. Proud that Subtraction Capital is a co-investor with FG Angel. And glad the tech world is small with most players here for the long run and pushing together with founders.

  • Joe Welu

    Great post Brad!

  • Angela Jackson

    Great post. Sad lesson but could happen to any of us. Naming names may be a good innoculant against future bad actors.

  • money is useless if you have no customers

  • dave

    how did they come up with the 0.1% stake for the convertible investors?

    • No idea, but that’s likely the smallest number the lawyers could do on their calculators.

      • Nice. 🙂

      • dave

        in this sort of downround scenario, when the convertible amount (ie. $2M) is greater than the new downround valuation (ie. $100K post-money), i get that the convertible debt is essentially worthless but functionally what is the usual way the convertible investors are allocated in the cap table? (ie how do you figure out their final stake?) as in your reply, is it just set randomly by the lawyers?