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)

8 Responses

  1. Great post. Thank you.

  2. Hi Steve;…I lived through a cram down that also had pay to play for the VCs..The cram was about 400:1. We eventually gave options back to all the employees who stayed on. 7 years later we had a modest IPO lead by tier 1 Bank…5 years later the company hit a $3billion market cap & I took some off the table. At our peak around 50 employees had about $1Million in option value or more. In short taking the cram was the best thing I ever did for myself & the employees. One observation is that your thoughts alternatives may be warped by being in Silicon Valley where another start up is always around the corner. We were not in a hotbed so restarts were not that available. Si riding the horse you rode in on was a better option….Your thoughts??….Ron Rosenzweig

  3. This is such good advise from Mr. Blank. Founders should keep this post handy for the unfortunate time (hopefully never) they are faced with the decision. You have a choice.

  4. Nicely put. Many of these comments also apply to forced mergers, where a VC combines two or more of their loosely-related portfolio companies into a single new entity trying to make it look pretty for a new buyer.

  5. Extremely timely now that the punch bowl is being taken away. More importantly extremely valuable advice as usual.

  6. Yes, this is real, this this happened before, it’s happening again, and WALK AWAY is the power move.

    Would LOVE to read a discussion from Steve Blank about some of the negotiating points AFTER walking.

  7. This is a bit of a self-serving memo from your point of view. As an angel you lose it all. But the founder has more on the line, and loses less in this outcome.

    The Founder gets to reset and take a reset crack at the same problem.

    If you’re profounder why would you recommend they die just to prove their loyalty to you? I can see the benefit in “calling bluff” here as a way to prevent these nasty deals but …

    In a fair situation: This is basically a “reset” of the company. Company history is worth nothing, so you can either kill the company and go on to the new new thing, or reset NowCo and basically start again with the current band of pirates.

    In an exploitative situation – it’s different though.

    Unpopular opinion: I would hate to do it but, prefer to kill the investors than kill the baby.

    • @bob dobbs,

      Startups come into this situation from many directions. Two extremes:
      – They were pushed to acquire customers and market share in
      advance of profitability or even revenue, raising large sums and
      spending aggressively. These artificially fast-growth firms are at
      the most risk when the money dries up.

      – Bootstrapped startups, or those that raised funds more
      conservatively, may have a better understanding of their cash
      requirements with minimal outside funding.

      It will be interesting to see whether Sequoia sends another RIP Good Times prediction. https://articles.sequoiacap.com/rip-good-times

      Fun story: In 2001 during the dot-com crash, a startup CEO friend invited us to see his new offices. Thick rugs, lots of chrome and glass and expensive furniture, very high-end. He told us that when they moved in, the previous startup was still running, albeit without any staff: all the racks of servers and routers etc were still in operation. They didn’t have any login information to shut things down, so they just unplugged everything and sold it to a used equipment broker. Cisco later delivered two pallets of new routers intended for the previous tenant, and wouldn’t take them back. The Cisco rep literally told them, “We are writing off so much inventory this quarter it will never be missed. Keep it.” My friend was building a hardware business and had no use for Cisco routers, so those pallets went to the broker as well. They did keep all the fancy furniture; the anticipated call from a bankruptcy administrator never came.

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