Ask A VC: How to Protect Early Investors from Recaps, aka "Pay to Play" with Dave McClure
Pocket Sun

Recaps happen when new investors come in and think the valuation is too high relative to the company's progress. We had a discussion within an investor group and hereby share some helpful lessons learned.

If you're an early stage investor, what can you do to protect yourself from the "pay to play" game?

Dave: New investors typically either (1) reset the valuation lower and wipe out earlier investors, or push them from preferred to common stocks & dilute them, and/or (2) require all existing investors to "pay" into the new round in order to defend / prop up their previous ownership, otherwise at risk of (1).

Typically existing investors are given a ratio of something between 1:1 to 1:5, which means they have to put in a new $1 to defend their previous $1-5 of equity ownership.

For example, previous investors put in $2M for 40% of $5M post-money valuation. Later, the company raises $5M on $20M post for another 25%. Then later, new money comes in, saying "this company is only worth $10M. I'll put in more money but existing investors get kicked to common, unless they put in $1 new money for every previous $3.5 of old money, otherwise they get wiped out."

The company previously has 50% of shares with old investors, but unless they put in another $2M, they will be wiped out on a pro-rata basis by new investors. Thus, if they don't "pay" they don't get to "play".

Founders and current employees typically get a new option pool, so they aren't diluted as much. Investors who don't "pay" in the new round and former employees get diluted or washed out, and the cap table is now freed up for the current team and new investors.

If previous investors dont like these terms they can of course always offer their own new terms to the founders and if they have board control, they may even be able to block the new investors recapping However it looks bad for existing investors to block a new deal - even if it's a recap - without offering *some* kind of alternatives.

Note that recaps don't happen that often, since when investors lose faith in a company, usually others will too, and nobody wants to lead. But if there *IS* still value in the business or the team, some investors may simply want to re-price the deal. If old investors don't want to put more money in or defend the recap, then usually founders will go along with new investors to wash out old ones since it's their only choice.

Thanks Dave. When this happens, does 500 Startups tend to double down if there's potential value, or call it a wash and rather put that capital on a new horse?

Dave: Usually we don't participate in recaps unless we really believe in the company. We've done it a few times, but it rarely works out very well. Often times we just end up throwing more good money after bad. Occasionally if the ratio isn't too bad, we might participate.

On a few occasions, I've actually used the *threat* of a recap to get earlier investors to participate in a new round. Particularly when previous investors have a big chunk of the cap table relative to founders, and the early valuations might be unfair, or the last round valuation was too high, then we might try to push for a recap. But usually we aren't a big enough investor in the company or round to pull this off, and usually if the company was over-priced or mis-priced in an equity round, it's very difficult to correct.

This is why I disagree with all the articles pushing for pricing the rounds of early-stage companies when it's not clear if he investors have reputation or experience to do an accurate pricing. An over-priced convertible note is survivable, but often an over-priced equity round can often kill a company if no new investors want to deal with the hassle of a recap or pay-to-play deal.

Other answers from the group:

  • We had a similar situation recently with a company that relocated to Silicon Valley. As part of the pivot, they also recapped the company. We opted out because frankly, if the founder is not protecting your interest, it's best for an early stage investor to walk away in this situation.

  • If the company needs a recap, it means things have not gone well to begin with and chances of a successful outcome have been reduced.

Featuring Dave McClure, "Founder & Troublemaker" @500Startups