Early-stage founders sometimes face a challenging dilemma:
The company must raise additional capital in order to survive.
Raising the additional capital at the projected valuation would dilute founders.
The extent of the dilution would eliminate meaningful equity incentives for the founders.
Without meaningful equity incentives for founders, investors won’t invest the further capital in the company.
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:
Capital Needs
Expected Valuation
Founder Dilution & Equity Incentives
From there, we outline some of the structures and mechanisms that can help realign stakeholders and allow the company to move forward.
Article Contents
Preface: How Do I Know If I’m In A Recap Scenario?
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 Model A 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 3: Downward Macroeconomic Trends
Core Drivers Of Recapitalizations
1 | Capital Needs
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:
What are the product and growth targets for the next 12-18 months?
What is the budget you expect will be needed to hit them?
Having defensible projections and a clear strategic plan lends credibility to any recap proposal.
2 | Expected Valuation
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).
3 | Founder Dilution & Equity Incentives
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.
Where Founder Dilution Comes From
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.
Capital 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.
Capital Needs And The Option Pool
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.
Magnitude Of Dilution
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.
Paths Forward
If dilution and realistic fundraising terms would leave founders with too little equity to be adequately incentivized, there are three high-level paths forward:
Wind down the company
Recapitalize (redefine company ownership structure)
Spin out a new company
1 | Wind Down The Company
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.
2 | Recapitalize (Redefine Company Ownership Structure)
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.
Determining A Target Founder Equity Level
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:
In the context of a recapitalization negotiation, founders have an incentive to maximize what they communicate as their BATNA (best alternative to a negotiated agreement).
Investors have some incentive to try and minimize the founder’s BATNA, but are also practically limited: if the investor doesn’t think they’ve invested in a great founder who has plenty of alternatives… they probably shouldn’t invest in any case!
And in both cases, the other party needs to be incentivized enough through equity to keep the company going.
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:
Founder Composition: How many core founders are there? More founders often means relatively smaller equity stakes for each.
Stage and Growth: What are the company’s revenue and growth attributes?
Company Market: Where are the company locations and markets?
Fundraising Conditions: What is the current state of the market? Macroeconomic trends may mean that founder ownership % is, on balance, going to be slightly less or more.
3 | Spin Out A New Company
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 original company becomes a holding company with an interest in the new company.
The original company dissolves and existing investors are issued new investment agreements to invest in the new company.
The variation best suited to your company typically depends on your relationships with investors and the company’s administrative resources.
Best Practices In The Context Of A Recapitalization
1 | Balancing Interests
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:
How many rounds of fundraising the company will require
How much capital in each round of fundraising the company will need
The company’s hiring targets
What a realistic exit scenario may look like
2 | Investor Communications
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.
Negotiating Before Or After Fundraising
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:
Getting a new investor to invest in your company
This is easier if you already have existing investors on board to reduce ownership levels they’re otherwise legally entitled to.
Getting existing investors to agree to modify the terms of their investments
This is easier if you have a new investor who is offering to invest much needed capital on the condition that existing investors agree to a haircut.
Bringing Key Investors Into The Process
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:
Inform major investors that the company is considering a recapitalization and discuss what you think are the 1-2 best paths forward.
Take their feedback, weigh it, and decide on a path forward.
Communicate the decision to all investors. Share the rationale behind it and what goals the recapitalization will help accomplish.
Execute the legal process.