Cram Down – A Test of Character for VCs and Founders

This article previously appeared in TechCrunch.

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 a “pay-to-play” i.e. 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. Some even insisted that all prior preferred stock had to be converted to common stock. For the common shareholders (employees, advisors, and previous investors), a cram down is a big middle finger, as it comes with reverse split – meaning your common shares are now worth 1/10th, 1/100th or even 1/1000th of their previous value.

(A cram down is different than 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 raise another round. But now with the economic conditions changing, that’s no longer true. Startups that can’t find product/market fit and/or generate sufficient revenue and/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 my fiduciary responsibility (which is BS because venture capital is a power-law business, not a “salvage every penny business”) or “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, 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 advisors who trusted and bet on you get nothing, but you and a few key employees come out OK. All of a sudden the deal which 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 hostage 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.

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 advisors. There is nothing worse that guarantees you permanently ruin relationships (and your reputation) is for early investors and advisors to hear about your decision to take a cram down is when you ask them for signatures on a decision that’s already been made.

Being able to assess alternatives in a crisis is a life-long 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. 

Lessons Learned

  • Cram downs are done by VC bottom feeders
    • Taking an “unfair advantage” and contributing to the toxicity of the startup ecosystem
  • Founders often believe they need to take a cram down rationalizing “I’ll never have another good idea, I have so much time and effort sunk into this startups, I don’t have enough energy to do it again, etc.”
    • Founders rationalize it’s good for their employees
  • Take time to think about alternatives
  • Don’t get trapped in your own head thinking you need to solve this problem by yourself
  • You’re burning the very people who were your early supporters
  • Walk away
    • You can do another startup again with your head held high
  • P.S. if you’re prepared to walk away there are pretty good odds you’ll end up with a much better deal (if you want one)

Here’s What Happened When Deputy Secretary of Defense Dr. Kathleen Hicks visited Stanford’s Gordian Knot Center for National Security Innovation

It was an honor to host US Deputy Secretary of Defense Dr. Kathleen Hicks at Stanford’s Gordian Knot Center for National Security Innovation.  (Think of the Deputy Secretary of Defense as the Chief Operating Officer of a company – but in this case the company has 3 million employees (~1.4 million active duty, 750,000 civilians, ~800,000 in the National Guard and Reserves.)

She came to the Gordian Knot Center to discuss our unique approach to national security and innovation, and how our curriculum trains the next generation of innovators. The Deputy also heard from us how the Department can better partner with and leverage the U.S. innovation ecosystem to solve national security challenges.

Our goal for the Secretary’s visit was to give her a snapshot of how we’re supporting the Department of Defense priority of building an innovation workforce. We emphasized the critical distinction between a technical STEM-trained workforce (which we need) and an innovation workforce which we lack at scale.

Innovation incorporates lean methodologies (customer discovery, problem understanding, MVPs, Pivots), coupled with speed and urgency, and a culture where failure equals rapid learning. All of these are accomplished with minimal resources to deploy at scale products/services that are needed and wanted. We pointed out that Silicon Valley and Stanford have done this for 50 years. And China is outpacing us by adopting the very innovation methods we invented, integrating commercial technology with academic research, and delivering it to the Peoples Liberation Army.

Therein lies the focus of our Gordian Knot Center —connect STEM with policy education and leverage the synergies between the two to develop innovative leaders who understand technology and policy and can solve problems and deliver solutions at speed and scale.

 What We Presented
A key component of the Gordian Knot Center’s mission is to prepare and inspire future leaders to contribute meaningfully as part of the innovation work force. We combine the unique strengths of Stanford and its location in Silicon Valley to solve problems across the spectrum of activities that create and sustain national power. The range of resources and capabilities we bring to the fight from the center’s unique position include:

  • The insights and expertise of Stanford international and national security policy leaders
  • The technology insights and expertise of Stanford Engineering
  • Exceptional students willing to help the country win the Great Power Competition
  • Silicon Valley’s deep commercial technology ecosystem
  • Our experience in rapid problem understanding, rapid iteration and deployment of solutions with speed and urgency
  • Access to risk capital at scale

In the six months since we founded the Gordian Knot Center we have focused on six initiatives we wanted to share with Secretary Hicks. Rather than Joe Felter and I doing all of the talking, 25 of our students, scholars, mentors and alumni joined us to give the Secretary a 3-5 minute precis of their work, spanning across all six of the Gordian Knot initiatives.  Highlights of these presentations include:

  1. Hacking for Defense Teams – Vannevar Labs, FLIP, Disinformatix
  2. CONOPS Development
  3. National Security Education Technology, Innovation and Great Power Competition
  4. Defense Innovation Scholars Program – 25 students now, 50 by the end of the year
  5. Policy Impact and Outreach –ONR Hedge Strategy, NSC Quad Emerging Technology Track 1.5 Conference
  6. Internships and Professional Workforce Development – Innovation Workforce Vignettes

If you can’t see the slides click here

Throughout the over 90 minutes session, Dr. Hicks posed insightful questions for the students and told our gathering that one of her key priorities is to accelerate innovation adoption across DoD, including organizational structure, processes, culture, and people.

It was encouraging to hear the words.

However, from where we sit..

  1. Our national security is now inexorably intertwined with commercial technology and is hindered by our lack of an integrated strategy at the highest level.
  2. Our adversaries have exploited the boundaries and borders between our defense and commercial and economic interests.
  3. Our current approaches – both in the past and current administration – to innovation across the government are piecemeal, incremental, increasingly less relevant and insufficient.

Listening to the secretary’s conversations, I was further reminded of how much of a radical reinvention of our civil/military innovation relationship is necessary if we want to keep abreast of our adversaries. This would use DoD funding, private capital, dual-use startups, existing prime contractors and federal labs  in a new configuration. It would:

Create a new defense ecosystem encompassing startups, scaleups at the bleeding edge, prime contractors as integrators of advanced technology, federally funded R&D centers refocused on areas not covered by commercial tech (nuclear, hypersonics,…). Make it permanent by creating innovation doctrine/policy.

Create new national champions in dual-use commercial tech – AI/ML, Quantum, Space, drones, high performance computing, next gen networking, autonomy, biotech, underwater vehicles, shipyards, etc. who are not the traditional vendorsDo this by picking winners. Don’t give out door prizes. Contracts should be >$100M so high- quality venture-funded companies will play.  Until we have new vendors on the Major Defense Acquisition Program list, all we have in the DoD is innovation theater – not innovation.

Acquire at Speed. Today, the average DoD major acquisition program takes 9-26 years to get a weapon in the hands of a warfighter. We need a requirements, budgeting and acquisition process that operates at commercial speed (18 months or less) which is 10x faster than DoD procurement cycles. Instead of writing requirements, DoD should rapidly assess solutions and engage warfighters in assessing and prototyping commercial solutions.

Integrate and incent the Venture Capital/Private Equity ecosystem to invest at scale. Ask funders what it would take to invest at scale – e.g. create massive tax holidays and incentives to get investment dollars in technology areas of national interest.

Recruit and develop leaders across the Defense Department prepared to meet contempory threats and reorganize around this new innovation ecosystem. The DoD has world-class people and organization for a world that in many ways no longer exists. The threats, speed of change and technologies we face in this century will require radically different mindsets and approaches than those we faced in the 20th century. Today’s senior DoD leaders must think and act differently than their predecessors of a decade ago. Leaders at every level must now understand the commercial ecosystem and how to move with the speed and urgency that China is setting.

It was clear that Deputy Secretary Hicks understands the need for most of if not all these and more. Unfortunately, given the DoD budget is essentially fixed, creating new Primes and new national champions of the next generation of defense technologies becomes a zero-sum game. It’s a politically impossible problem for the Defense Department to solve alone. Changes at this scale will require Congressional action. Hard to imagine in the polarized political environment. But not impossible.

These are our challenges for not just the Gordian Knot Center for National Security Innovation but for our nation. We’ve taken them on, in the words of President John F. Kennedy,  “not because they are easy, but because they are hard. because that goal will serve to organize and measure the best of our energies and skills, because that challenge is one that we are willing to accept, one we are unwilling to postpone, and one which we intend to win.”