Recapitalizations Explained for Founders

Zack Shapiro is the founder and Managing Partner at Rains, a modern law firm for startups, with specific expertise in digital assets and financing deals, including venture rounds and M&A. Zack graduated with a JD from Yale Law School, and started his career clerking for federal judges in the Southern District of New York and the Second Circuit, and as an associate at Davis Polk, where he worked on regulatory matters for crypto companies during the ICO boom of the late 2010s. He later transitioned to startup law, co-founding an e-commerce startup, where he was both and operational cofounder and general counsel for the company. In 2020, Zack decided to strike out on his own to start a boutique law firm specializing in startups to represent founders across the full lifecycle from incorporation to fundraising, contracts, regulations, employment law, and eventually liquidation, mergers, and acquisitions.

I sat down with Zack in December of 2023 to ask him about the most relevant questions founders should be asking themselves about how to prepare for a recapitalization event or acquisition, and what he’s seen in his years of helping founders navigate this process.

Market Shifts and Impact on Startups

We started out talking about the days of the zero interest rate policy (ZIRP).

Give us a bit of history - how did the ZIRP affect startups, and how has that changed in the last 4 years?

In the period from 2020 to 2021, it was complete madness. Valuations were extremely high, and the mantra was to build and scale as fast as possible, without worrying about profitability. The dynamics in the venture market, I hate to say, were almost like a Ponzi scheme, where the plan for future profitability didn't matter. As long as you could secure the next venture round, founders and investors could offload equity at a higher valuation. This eventually led to dumping on the public market, which was ready for high valuations in the tech sector. It was all about increasing growth metrics with the end goal of bigger numbers, engagement, and ultimately a bigger exit, without considering the realities. This phenomenon was definitely a result of the zero interest rate environment at its core.

Since then, interest rates have risen, public tech valuations have declined, and the venture market has been greatly affected. The initial impact was felt primarily in later-stage venture and growth private rounds, where companies were hoping to go public within the next year. However, they faced significant challenges and had to adjust their business plans. Over the course of 2022, these effects began to trickle down to earlier rounds. The only area that was relatively less affected was the pre-seed stage, where we saw many raises at low valuations during the tech bear market. Even priced seed rounds have only recently started to recover.

The environment has shifted from a focus on growing at all costs to one of sustainability, what VCs often call "default alive". This is good news for very early-stage founders who have the flexibility to build a business with this new mandate in mind, rather than the previous mindset of prioritizing growth at all costs. However, it presents challenges for founders who had been building and structuring their companies based on the assumptions of the zero interest rate environment. They may have overhired or raised significant capital based on growth rather than sustainability.

Why is raising a large war chest potentially a bad thing for startups?

In early 2022, it seemed wise to raise a lot of capital while the market was favorable, allowing founders to weather the bear market. However, since then, many founders have realized that raising a large amount of money at a high valuation has its drawbacks. There are two main issues: valuation and the nominal amount of money raised.

On the valuation side, if you raise a Series A round at nine-figure valuations, as was happening at the peak of the market, it becomes challenging to raise a Series B round. You have set incredibly high hurdles for yourself in terms of maintaining momentum in the venture ladder and may even be positioned for a down round. The valuation itself can become a problem.

In terms of the nominal amount of money raised, many founders have realized that they have a significant preference stack. When considering an exit, they question whether their business is actually worth the amount of money they have raised. This issue was particularly problematic for later-stage venture companies that raised billions of dollars in venture capital and had preferred shares with a liquidation preference. This means that investors were entitled to a certain amount of money before founders would see any returns, sometimes in the billions of dollars. However, their business may not have been worth that much. The valuation that led to the preference stack was more a result of zero interest rates and market hysteria than the actual value of the business. This creates a challenging situation for founders. This is the market we have been seeing more recently in 2023, and it is likely to continue into 2024.

What are you seeing now in the market going into 2024?

We are seeing lower valuations and VCs are looking for sustainable growth rather than growth at any cost. For businesses that have already raised funds, we are seeing various types of liquidity events and financing, including more mergers and acquisitions and private equity-like activity in the startup world, which differs from traditional venture financings. In terms of growth, we are witnessing down rounds and the need to adjust assumptions for businesses that were established in a different environment to align with the current market conditions.

Recapitalization Explained

Recapitalization, a crucial process for startups, involves restructuring the company's equity or debt to align with current needs. Zack talked about the legal and financial implications, highlighting its importance in ensuring founders can adapt to changing market conditions.

What does it mean for a company to recapitalize?

Technically, recapitalization is the restructuring of a business's debt or equity structure to meet ongoing needs, particularly for later-stage or public companies to avoid bankruptcy. However, in the startup space, recapitalization typically refers to changing assumptions about ownership from earlier to later funding rounds.

When raising money for a startup, particularly at the early stages such as pre-seed or seed, it is common to use a convertible equity agreement like a SAFE or convertible note. These agreements determine the control terms and valuation terms for future rounds. As the startup progresses to earlier stage price rounds, the industry standard is to use the documents provided by the National Venture Capital Association (NVCA) for fundraising. These documents give preferred shareholders, typically venture capitalists (VCs), certain control rights over the business. This often includes a board seat with veto power over various company actions.

Recapitalization for startups typically involves bringing in an acquirer or lead investor who can help the founder negotiate the existing contracts based on new assumptions. This involves changing the terms in the bylaws, shareholder agreements, and voting agreements. Waivers from all investors are obtained to modify their rights, resulting in a new capitalization table and ownership structure that aligns with the founder's plans in the current business environment. While the legal work involves changing the paperwork, the challenging part is often the negotiation with former stakeholders, particularly the VCs who made optimistic early stage investments. The goal is to help them realize that strict enforcement of their rights could lead to business failure and a loss of their investment. Collaboration between the founder, lawyer, and new investor or acquirer, high-level terms are negotiated to protect the investment and keep the business alive. This may involve adjustments to ownership, anti-dilution rights, or liquidation preferences. In our experience, VCs are generally receptive to these discussions, understanding the current business environment and the need to find a practical solution. However, for founders considering recapitalization options, the most significant effort lies in managing investor relations and negotiating with former investors to release certain legal rights that may no longer be suitable given the company's future direction.

If I think my startup would benefit from being recapitalized, what are my options?

If you're running a startup that might need to recapitalize, the first step is to assess what is working and what's not, and determine a realistic trajectory for the business given the current environment. If you've raised too much capital and hired excessively, it's important to make necessary cuts and focus on achieving profitability. This should be prioritized before considering additional funding or an exit strategy. Once you've done that, you can explore various options.

If it makes sense, selling the business to a willing buyer might be a suitable choice, especially if the business isn't on the trajectory you initially anticipated due to different assumptions or unfavorable market conditions.

Another option is to transition the business from a venture trajectory to a private equity trajectory. This doesn't necessarily mean exiting the business entirely, but rather taking an equity check for a minority stake and focusing on profitability. Over time, the business can become sustainable, generate cash flow, and eventually pay dividends to the owners. At that point, you may be able to transition out of the business or consider selling your stake.

A third option is to take a different approach and raise funds at a lower valuation if the original growth projections no longer align with reality. Although this can be challenging for founders who initially planned for exponential growth, it may be the right choice. It's important to note that regardless of the chosen trajectory, there will likely be legal paperwork and the need for renegotiation and recapitalization of the business.

Navigating Investor Relations When Recapitalizing

As Zack said, the most challenging part of a recapitalization often lies in managing investor relations and negotiating with former investors to release certain legal rights that may no longer be suitable given the company's future direction.

Where can the interests of founders and investors diverge during a recap?

One area of potential conflict between founders and investors is the ability to block a sale of the company. During early stage venture rounds, founders should negotiate to exclude this provision. Even when things are going well, a founder might have the opportunity to sell the company for a substantial personal gain, but the VC may not consider the return significant enough. It is important for founders to have the ability to make decisions that can change their lives. However, when things go poorly, VCs have significant control due to their financing arrangements. They also have a liquidation preference, meaning they can withdraw a certain amount of money from the business before other shareholders receive any returns. This can limit the upside for founders in less optimistic outcomes that may arise. Additionally, specific sign-off from investors or minority shareholders may be required for certain actions.

How complex is the process of getting investors onboard with a recap if you have a board versus if you don't? Is that even the right distinction to make?

Unfortunately, I think it's more granular and complicated than that. You can generalize and say it's a more difficult exercise if you've raised a priced round and have a preferred director, who can unilaterally block a deal because of the terms negotiated in the priced round. In that case, there's not much you can do other than to explain that this is the way the business will survive and how things have to be going forward. Perhaps both sides can make concessions under those circumstances.

If you've only raised funds through SAFEs or convertible notes, the situation is clearer. Usually, there's a section called waiver and amendment at the bottom of a SAFE, which states that you can waive any term in the SAFE except for the purchase amount. This means that if a majority in interest of investors who have invested in SAFEs on the same terms agree, you can drag along the minority SAFE holders. In practice, this often ends up being the same as having one big priced round with one board member from the major investor, where you only need permission from that VC to recapitalize the company. It's similar if you raise funds through SAFEs, where your biggest investor will unilaterally represent a majority in interest in the SAFEs. However, there are cases where this is not true, even with SAFEs, and multiple parties need to sign off. Additionally, once you've had a priced round, depending on the negotiated terms with your investors and which investors qualify as major investors with special rights, it can be necessary for each investor to individually sign off on certain changes. These tend to be the more complex scenarios.

Does that mean if I only raised on SAFEs, I can decide to recapitalize or sell the company without getting approval from my investors?

You will still need to get your SAFE investors on board with a sale, unless you're okay with the terms that the SAFE has for the liquidation of the company. Since SAFE holders have priority in getting their money out, if you're a founder and you want to make money from your exit and your preferred stock, you'll need to go through this exercise.

Now, this doesn't apply if you're doing another venture round. I mean, technically, if you've only raised on SAFEs, you're not going to have a down round because safes don't technically value the company. The two economic terms in a SAFE are the valuation cap, which represents the maximum valuation that investors will pay in an optimistic scenario, and a discount to what investors in a price round will pay. There's no promise about what the price round price will be. So, in a less optimistic scenario, if you've only raised on SAFEs, it's like not having investors in terms of being able to raise a lower valuation than the valuation cap that the safes are at. As a founder, you can do that unilaterally without needing your investors' sign-off. It means you'll be diluted more from the safes than you had hoped, but that instance is very different.

However, when it comes to an actual liquidation, you really do need to be careful unless you're willing to go with the default terms from a liquidation SAFE. This only makes sense if you're going to liquidate the company for a higher amount than the liquidation preference that the safes collectively hold. In order to recapitalize, you'll need to have your investors on board.

What are some tips for founders who are getting ready to have difficult conversations with their investors about recapitalizing or selling the business?

In terms of getting this done, there are two important tools for founders to utilize. One is storytelling. Explain where you thought you were, where you actually are, and how you will protect shareholder value by abrogating some rights. Convincing people of this can be tricky, but founders often have to be storytellers, painting a vision of how the proposed path forward, even if it deviates from the initial fundraising documents, is the right one to sign off on.

The other crucial tool, which cannot be overstated, is leveraging the new money coming in. Whether it's the acquirer in the case of M&A or the lead investor in the case of a down venture round or growth round, their involvement can apply pressure on other investors.

These two tools are often linked. The acquirer or lead investor's leverage is the answer to how the recapitalization will preserve shareholder value. They can say that without making these changes, the new money won't be invested. This tends to have a strong impact on former investors, showing them why it's in their interest to sign the documents.

If you're a founder, it's important to consider who can be on board to help resolve the previous situation. How much can they assist in communicating with your old investors? And how can you ensure that the necessary investors come to the table to legally change the documents? These are matters to discuss with your lawyer. How can you effectively communicate the story of why it makes sense for them to sign the recapitalization documents?

Are founders always the ones to lead these conversations? Can lawyers like yourself help negotiate terms with investors?

The role of the founder in investor conversations can vary depending on the situation. While it is often the founder who takes the lead in these negotiations, there are instances where other parties, such as M&A advisors or lawyers, may be involved.

In most cases, the founder is responsible for leading these conversations. After all, it is the founder who chose to accept investment from these investors, and it is the founder who is charting the company's course forward. Additionally, the founder needs to obtain top-level approval from investors to recapitalize the company.

However, it is essential for founders to have thorough discussions with their lawyers before engaging in these conversations. These discussions should clarify the objectives and necessary sign-offs required to achieve desired outcomes. It is crucial to understand the legal landscape, the content of relevant documents, and the changes that need to be made before entering into negotiations. This knowledge will determine the leverage available, the narrative being presented, and the ease or difficulty of the conversations.

Lawyers often play a significant role in negotiating specific aspects of recapitalization. For instance, discussions surrounding a decrease in investor valuation or amendments to transfer rights, rights of first refusal, board mechanics, or legal protections typically occur between the founder's lawyers and the investor's lawyers.

Founders should prioritize having conversations with their lawyers to ensure that their interests are being advocated for effectively. It is essential to align with your lawyer on the key matters that are important to you, rather than wasting time and money on issues that are not critical or relevant to your goals. Similarly, founders should communicate with their investors to understand their priorities and concerns. By doing so, founders can address any misalignment between their investor's intentions and the actions of their lawyers.

As a founder, it is crucial to ask questions and seek clear explanations from your lawyer. A good lawyer should be able to communicate in plain language, avoiding jargon and legalese. If your lawyer is using complex language, it may be a sign of them withholding information. The negotiation process should primarily involve the principles (the founder and the investor) rather than becoming an exchange solely between the lawyers. When negotiations become lawyer-centric, progress can become hindered.

In situations where contentious issues arise or during a sale, direct involvement of new investors or acquirers may be necessary. While the founder and their lawyer may want to be present during these discussions, direct communication between the new investor or acquirer and the existing investors can help overcome roadblocks in negotiations.

Overall, effective communication, understanding the key points of negotiation, and engaging in a collaborative manner are essential for successful founder-investor conversations.

Where to learn more

Zack’s plug

If you're seeking legal services for recapitalization, down rounds, or sales, which involve complex negotiations, it's crucial to have a lawyer with a strong business sense. When interviewing lawyers, this should be one of the top criteria to consider. The mechanics of closing these deals may be a bit complicated, but for those with experience in the venture space, it's not that difficult. Many law firms can draft the necessary documents and handle the paperwork. The difference lies in finding a lawyer who can guide you through the process in a way that makes sense to you, enabling you to make informed decisions and negotiate effectively on your behalf. It's essential to have someone who understands both the legal and business aspects of a recapitalization, whether it's in preparation for M&A, private equity, or a down round.

My website is rains.law. I'm also on Twitter as Zack B. Shapiro (@ZackBShapiro). Additionally, many of our clients in the digital assets space use Telegram, where I can be reached as @coinlawyer.

Dealwise’s plug

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