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Early-stage founders sometimes face a challenging dilemma:
A recapitalization – a restructuring of the company’s ownership – is one way to solve this impasse.
In this article we unpack each of the core drivers of a recapitalization in the context of early-stage venture-backed companies:
From there, we outline some of the structures and mechanisms that can help realign stakeholders and allow the company to move forward.
As a founder, a good starting point is to ask yourself: if I raise at a realistic valuation, will I still own enough of the company to be motivated to keep going?
This is an exercise that’s generally done better with numbers than with words:
Template Recap ModelA simplified model you can use is provided here.
Below are a few examples to illustrate companies facing a recap scenario.
Company 1: Business Pivot
Company 1 launched in 2018 as a fintech tool. They raised a total of $5M via SAFEs with post-money valuation caps ranging from $10M-$40M.
In 2021, the company changed directions. They now build a platform to help teachers communicate with students virtually.
The company needs to raise more capital in the next six months, but is concerned because the company’s business stage no longer aligns with its fundraising stage: on paper, the company should be gearing up for its first priced equity round, but in reality it is a newly-fledged company due to the strategic change.
The company may need to recapitalize so that its financing terms reflect its business stage and founders still have enough equity to make the effort worthwhile.
Company 2: Volume Of Convertibles
Company 2 raised $10M on SAFEs over five financing events (from friends and family and several tranches of pre-seed and seed rounds). The SAFEs raised at each financing event have different, extremely low valuation caps.
Upon the company’s first priced equity round, these SAFE investments will convert into equity. The amount of money raised via SAFEs converting to equity makes it likely that founders will be left with such a small % of the company’s equity that they won’t be able to attract new investors.
The company may need to recapitalize to balance the ownership percentages across founders/employees, early investors, and new investors.
Company 3: Downward Macroeconomic Trends
Company 3 raised capital at a post-money valuation of $30M nearly two years ago. The company is looking to fundraise again soon.
Recently, market and industry trends suggest that it will be difficult for the company to raise at a pre-money valuation higher than $30M. In fact, the founders believe they won’t be able to raise at a valuation above $15M.
The company may choose to recapitalize in order to incentivize and retain employees whose equity packages will lose substantial paper value at the new company valuation.
A core assumption underlying a recapitalization scenario is how much money the company needs to raise.
The inputs should generally flow out of your company’s strategic plan. Some questions to consider include:
Having defensible projections and a clear strategic plan lends credibility to any recap proposal.
The second core assumption underlying a recapitalization is the valuation the company expects it can raise new funds at.
A fundraising valuation is generally a function of macroeconomic conditions, the company’s traction, the size of the market, and the company’s projected financial performance. Brex and Y Combinator have some useful articles discussing how to value a startup.
Valuing a company is an inexact science. This is especially true for early-stage companies. As a result, a recapitalization proposal will generally be more credible if it assumes a range of likely valuation outcomes.
In a situation where a recapitalization would significantly (and unfavorably) alter the investment terms of existing investors, it’s especially helpful to be realistic and transparent about the range of expected fundraising valuations.
Speaking with potential investors and getting their feedback on valuation range can often provide a valuable and more objective anchoring point (even if the investors themselves aren’t investing in the round).
All founders have options for how they spend their time and focus – no founder is legally obligated to continue working for their company!
Of course, the company owns its assets, including intellectual property such as trade secrets, customer lists, and patents.
However, the assets that allow great founders to create value – especially at the earlier stages – are often within them: their personal drive, know-how, connections, intelligence, vision, charisma, and resilience. And a founder can take these assets with them at any time.
A major reason many founders dedicate these assets and outsized effort to their companies is the potential for outsized rewards from their equity interests.
It’s this practical reality that creates the soil for a recapitalization to occur.
Founder dilution is inevitable when accepting external financing – you exchange ownership in the company for capital.
There are common fact patterns that lead to levels of dilution that tend to inhibit further growth; generally these are tied to the amount of capital raised on certain terms.
Several sets of terms can be problematic for early-stage venture-backed companies when things don’t go as planned:
Conversion at valuation cap or discount
Many venture-backed companies initially raise capital via convertible instruments (convertible notes or SAFEs). Upon a “triggering event” (typically the company’s first priced financing round), the investments convert into company equity. Most convertible instruments convert at either a cap or a discount.
A valuation cap is the maximum valuation to calculate the share price when the convertible holder’s money converts to equity.
A discount is the percentage discount to the share price paid by new investors that the convertible holder receives when their money converts to equity.
Conversion at a Most Favoured Nations Clause (MFN)
MFN clauses are sometimes used in early-stage convertible investments to ensure that investors receive conversion terms that are no worse than other investors. For example, the form of YC SAFE that comes with an MFN clause ensures that the investor receives the most favourable economic terms that the company agrees to with other investors between the issuance and termination of the SAFE.
Conversion to fixed %’s
Some convertible investments stipulate a conversion into a fixed percentage ownership of the company. The most widely-known example of this is Y Combinator’s standard deal where $125k of their $500k investment converts into a fixed 7% upon the company’s next priced equity round.
A company’s hiring needs will (or at least, probably should) dictate the size of its option pool. An option pool is the equity reserved to incentivize and reward employees through stock options.
The larger the option pool, the less equity available for founders and investors.
Generally, companies that require large teams of senior or specialized employees will set aside larger option pools.
In most of the cases above, the magnitude of dilution experienced by founders is driven by (1) the dilution from the terms; and (2) how much was raised on those terms.
For example, if you raised $1M converting at a post-money valuation of $10M then you might end up with a fine cap table.
But if you previously raised $9M on a post-money valuation of $10M then it almost certainly won’t work: the converting security holders will own too much of the company.
If dilution and realistic fundraising terms would leave founders with too little equity to be adequately incentivized, there are three high-level paths forward:
In some cases, the best outcome for all stakeholders is actually to let the company wind down and realize any value that’s left in it.
For example, in a case where the founders want to pivot substantially and existing investors are not interested in further backing the founders in the pivot, the value to investors may be greater by winding down the company and selling its assets.
A key variable here is what liquidation value is left in the company. If a company has millions of dollars in cash it can distribute to investors, this might make for a sensible option. If the company doesn’t expect to return any proceeds (for example, because all of the company’s value is intangible and hard to sell), then winding down the company may be less attractive then figuring out a path to keep the founding team engaged.
A second option is resetting the company’s ownership structure in order to provide key founders and employees with adequate equity incentives to be able to raise a round and stay motivated.
The mechanisms to best do this depend on what the target founder equity level is, where the dilution is coming from, and the practical ability to mitigate it.
This is more art than science and is complicated by the fact that there is both a dimension of alignment and misalignment between existing investors and founders:
A simple if imperfect way to bridge this gap is to look at what the market for comparable founder teams is in terms of their equity ownership at similar stages.
Several good data sources exist to help benchmark this:
Data sources generally suggest that median founder dilution hovers around or just below 20% for each round through Series B.
When using these benchmarks as a founder, it’s usually best if you can compare the data points to your company’s particulars:
For companies that have substantially pivoted business strategies and have many existing investors, spinning out a new company may be a workable solution.
There are two variations to spinning out a new company:
The variation best suited to your company typically depends on your relationships with investors and the company’s administrative resources.
As a founder, it is your responsibility to balance the interests of all company stakeholders. The best path forward for the company finds the most sustainable level of alignment between the interests of founders, employees, and existing and new investors.
While easier in theory than in practice, planning the next few years of the company’s growth will help give a clearer sense of the shared needs and goals of stakeholders.
Consider factors such as:
By definition, a recapitalization entails changes to the company’s capital structure - therefore impacting investors. Beyond meeting the baseline notice and consent requirements outlined in investor agreements, clearly communicating to investors the goals and rationale behind the recapitalization can preserve your relationships.
Every investor has their own set of incentives, but a fundamental goal is almost always to maximize the value of their investment. As a founder, you’ll increase your probability of successfully navigating a recapitalization scenario by conveying to investors how the company’s restructuring will match their interests and time horizons.
A critical event is the actual raising of the next equity round.
This begs the question: should you try and negotiate recapitalization terms before or after beginning fundraising efforts?
The answer mainly involves a tradeoff between the two jobs you’ll need to do as a founder:
It often can be helpful to explain the recapitalization strategy to investors before trying to execute it. Major investors in particular may prefer to be consulted ahead of the final decision.
If your company has only a handful of investors, consider explaining the situation to each one personally either through email or a live conversation. For companies with many investors, a more realistic approach may include personal explanations to major investors and an emailed update to the remainder.
Below is a sample order of operations for communicating a recapitalization strategy: