Cram downs are a character test for VCs and founders

Cram downs are back, and I’m keeping a list.

At the turn of the century after the dotcom crash, startup valuations plummeted, burn rates were unsustainable and startups were quickly running out of cash. Most existing investors (those still in business) hoarded their money and stopped doing follow-on rounds until the rubble had cleared.

Except, that is, for the bottom feeders of the venture capital business — investors who “cram down” their companies. They offered desperate founders more cash, but insisted on new terms, rewriting all the old stock agreements that previous investors and employees had.

For existing investors, sometimes it was “pay-to-play” — if you don’t participate in the new financing, you lose. Other times, it was simply a “take-it-or-leave-it, here are the new terms” deal. Some even insisted that all prior preferred stock had to be converted to common stock.

For common shareholders (employees, advisers and previous investors), a cram down is a big middle finger, as it comes with reverse split — meaning your common shares are now worth 1/10^th, 1/100^th or even 1/1,000^th of their previous value.

A cram down is different from a down round. A down round is when a company raises money at valuation that is lower than the company’s valuation in its prior financing round. But it doesn’t come with a massive reverse split or change in terms.

They’re back

While cram downs never went away, the flood of capital in the last decade meant that most companies could simply raise another round.

But now with the economic conditions changing, that’s no longer true. Startups that can’t find product-market fit, generate sufficient revenue or lacked patient capital are scrambling for dollars — and the bottom feeders are happy to help.

Why do VCs do this?

VCs will wave all kinds of reasons why — “it’s just good business” or “we’re opportunistic.” On one hand, they’re right. Venture capital, like most private equity, is an unregulated financial asset class — anything goes. But the simpler and more painful truth is that it’s abusive and usurious.

Many VCs have no moral center in what they invest in or what they’ll do to maximize their returns. On one hand, the same venture capital industry that gave us Apple, Intel, Tesla and SpaceX, also thinks addicting teens is a viable business model (Juul), or destroying democracy (Facebook) is a great investment.

And instead of society shunning them, we celebrate them and their returns. We let the VC narrative of “all VC investments are equally good” equal “all investments are equally good for society.”

Why would any founder agree to this?

No founder is prepared to watch their company crumble beneath them. There’s a growing sense of panic as you frantically work 100-hour weeks, knowing years of work are going to disappear unless you can find additional investment. You’re unable to sleep and trying not to fall into complete despair.

Along comes an investor (often one of your existing ones) with a proposal to keep the company afloat and out of sheer desperation, and you grab at it. You swallow hard when you hear the terms and realize it’s going to be a startup all over again. You rationalize that this is the only possible outcome, the only way to keep the company afloat.

But then there’s one more thing — to make it easier for you and a few key employees to swallow the cram down, they promise that you’ll get made whole again (by issuing you new stock) in the newly recapitalized company. Heck, all your prior investors, employees and advisers who trusted and bet on you get nothing, but you and a few key employees come out OK.

All of a sudden, the deal that seemed unpalatable is now sounding reasonable. You start rationalizing why this is good for everyone.

You just failed the ethical choice and forever ruined your reputation.

Cram downs wouldn’t exist without the founder’s agreement.

Stopping cram downs

In the 20th century, terrorists took hostages from many countries except from the Soviet Union. Why? Western countries would negotiate frantically with the terrorists and offer concessions, money, prisoner exchanges, etc. Seeing their success, hostage taking continued.

The Soviet Union? Terrorists took Russians hostages once. The Soviets sent condolences to the hostages’ families and never negotiated. Terrorists realized it was futile and focused on Western hostages.

VCs will stop playing this game when founders stop negotiating.

You have a choice

In the panic of finding money founders forget they have a choice.

Walk away. Shut the company down and start another one. Stop rationalizing how bad a choice that is and convincing yourself that you’re doing the right thing. You’re not.

The odds are that after your new funding, most of your employees will be left with little or nothing to show for their years of work. While a few cram downs have been turned around (though I can’t think of any), given you haven’t found enough customers by now, the odds are you’re never going to be a successful enterprise.

Your cram-down investors will likely sell your technology for piece parts and/or use your company to benefit their other portfolio companies.

You think of the offer of cram-down funding as a lifeline, but they’ve handed you a noose.

It’s time to think

With investors pressuring you and money running out, it’s easy to get so wound up thinking that this is the only and best way out. If there ever was a time to pause and take a deep breath, it’s now.

Realize you need time to put the current crisis in context and to visualize other alternatives. Take a day off and imagine what’s currently unimaginable — what would life be like after the company ends? What else have you always wanted to do? What other ideas do you have? Is now the time to reconnect with your spouse/family/others to decompress and get some of your own life back?

Don’t get trapped in your own head thinking you need to solve this problem by yourself. Get advice from friends, mentors and especially your early investors and advisers. There is nothing worse that guarantees you permanently ruin relationships (and your reputation) than for early investors and advisers to hear about your decision to take a cram down when you ask them for signatures on a decision that’s already been made.

Being able to assess alternatives in a crisis is a lifelong skill. Life is short. Knowing when to double down and knowing when to walk away is a critical skill.

In the long run, your employees and the venture ecosystem, would be better served if you used your experience and knowledge in a new venture and took another shot at the goal.

Winners leave the field with those they came with.