Recapping of seed rounds is still a practice that is not widely practiced, but which threatens to damage the entire venture capital community. Joanne Wilson (Gotham Gal) blogged about it a couple of days ago here.
Imagine this: A startup has angel investors who put in £2 million of convertible debt into their fledging company, and then, not successfully raising their Series A, they fall back for another £500K angel round- except that this particular VC group wants to recap the original £2 million investment, so that those shares are now worth 0.1% of the company, whilst the new £500K round gets 60%. Hence, successfully screwing over the original angel investors who put in £2 million.
Not only is this kind of practice unsavoury and uncouth, but it destroys the tacit honour code that investors have with their entrepreneurs. The reason why the venture capital community is booming today is because there are more angel and seed investors than there were 30 years ago. If this sort of seed round recap becomes common practice, then a chain of events will inevitably follow, in which there will be a drastic decline in seed capital funding- which directly correlates into less capital being available for later rounds because those startups originally funded by angels would simply not exist.
So why do some VC groups insist on these kinds of damaging tactics such as seed round recap? Most likely, they have underperforming portfolios and are desperate to make their investment go as far as possible. According to this Kauffman Foundation study in 2012, venture capital groups in Silicon Valley have delivered poor returns for more than a decade, and since 1997, less cash has been returned to investors than has been invested in VC. Only 20 out of 100 venture funds generated returns that beat the public market by an equivalent of more than 3 percent annually, and out of 88 venture funds, the vast majority- 66, had failed to deliver returns. [Note: Since this study was from 3 years ago, and utilised the outlier "successes" of Groupon and Zynga (two previously high-profile unicorn companies), I extrapolate that this trend really hasn't changed much.]
When you (as a Founder) take money from an investor, you are building a relationship with that investor as well. If a VC group wants to screw over your original investors, chances are, they will also screw you over at later rounds. Trust is a tenuous thing- hard to build and easy to break, and most business relationships are built on trust alone. Without trust, you're better off taking money from a loan shark than a VC group that wants to destroy the very foundation of what your startup was built on.
Honour thy seed investors, entrepreneurs.
By Sierra Choi, Director of Marketing