Do Restarts Have A Negative Overhang?
Following is a question that I got from a reader of this blog on Friday. “I have wondered about the dynamics of a restart company and how it affects employees, options and the dynamics between existing money and new money. My company took about 30MM during the boom years, did not get anywhere, and there was a restart financing round for a new product/market. However, I feel a “bad” history has an overhang even in a company’s new life. “
Since Jack Bauer got a restart last night I thought I’d take on the question today. Restarts are a way of life in the world of VC-funded companies. An entrepreneur starts a business. A VC (or VCs) fund it. Time passes. The company gets fucked up and goes off the rails for a variety of reasons (the product doesn’t work, the market doesn’t develop, the executive team doesn’t gel, the entrepreneur gets kicked out of the company, the VCs push the company in a direction that makes no sense.) Suddenly, a bunch of money has been invested and – while there might be something there (most notably a product or some customers) – the business has clearly stalled. The board tries to find a new investor to lead a financing or a buyer for the entire company and comes up dry. While shutting down the company is one option, VC-backed companies often get a second (or third) life via a restart (it’s harder for most people to call the ball and declare failure then it is to put in a little more money in and keep trying.)
In a restart, some subset of the existing investors provide financing for the company. While this can be done in conjunction with a new lead investor, in this case I’m describing the dynamics of an internally led restart. Often this follows or is in conjunction with a change in the leadership team and a meaningful headcount and expense reduction. In the cleanest restarts, the company is recapitalized via the new investment, reducing (or eliminating) the previous liquidation preference overhang and well as the previous equity ownership. A “full recapitalization” (at a $0m pre-money valuation) will eliminate the value of all previous equity – this is the harshest case – typically the previous equity will receive some small share (5% – 10%) of common stock in the recapitalized entity. There is often extensive negotiation around this since not all of the existing investors are participating in the new financing and – even though they don’t want to put any more money in – want to figure out a way to preserve some economics in the off chance that the company is ultimately successful. This gets even more complex if the existing investors have been bridging the company with debt as some of the investors may not want to put any new money in, but want to get credit for their debt investment. Ultimately this resolves itself because if the existing investors can’t figure out a structure that works for everyone, the company usually disappears into dust.
As part of this recap, the employees that are staying with the company will receive new options in a “refreshed” option pool that is usually between 10% and 20% of the equity of the company. Since this is a restart, this equity also starts vesting again, although in some cases employees are given some vesting credit for previous service.
It’s kind of like Jack coming back from the dead. Some people will think this is bad; some people will think this is good; most people will be suspicious. While the company undeniably has an emotional overhang, a lot of companies address it by such simple things as changing their name and pretending the history doesn’t exist. If the recap is clean (e.g. no big liquidation overhang, employees treated fairly, non-participating investors acting like big boys and girls and taking their medicine), then there probably isn’t much overhang on the restart. If there’s a complex ownership structure with the non-participating investors and old executives hanging around trying to extract something out of their investment without continued participating, then the overhang will be meaningful.
Each restart is going to be different – as an employee, rather than default into “it’s good” or “it’s bad”, look under the hood and see if the company has a clean restart (financially and emotionally) or if it’s merely the same group of characters deceiving themselves that “a little more money will make us successful.”