Seed Round Recapitalisation: Practices That Damage The Investment Community

Killing Angels by Justin Bysma on deviant art http://justinbysma.deviantart.com/art/Killing-Angels-136103296

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. 

Angel and seed investors take an early chance on startups, and hence should be rewarded, not screwed over. The reason why there are more seed and angel investors today is because the media has capitalised on VC celebrities such as Peter Thiel, Mark Cuban et al who have made original angel investments that have paid off quite well. If it becomes common practice for VC groups to recap seed rounds, there will be less of that wealth to go around in the long run due to a drastic decline of seed round funding in the next decade. This is a trend that should be weeded out before it becomes more widespread. There aren't any government laws against this sort of practice, and to be fair, I am against too many goverment regulations limiting what VC groups can and cannot do, because it doesn't solve the problem, merely masks it with legal loopholes. However, this is a practice that people should simply know is damaging to the entire venture capital community. There aren't laws either for spitting your gum out on the middle of the sidewalk (unless you are in Singapore) nor for defacing public works of art; people simply know that these sorts of actions have negative consequences for the entire community. When seed and angel investors are rewarded, then investments increase in magnitude and sets off a pattern of economic growth which creates a favourable climate for venture capital in the entire nation. 

Let's face it, entrepreneurs- if a prominent Silicon Valley VC firm offers you £500K, but wants to recap a seed round, chances are, there will be another VC firm who will match that investment. Don't buy into that poker game of psychological scare tactics- "You're not worth anything because you couldn't raise a Series A". Series A is inevitably harder to raise and longer to close because there will be due diligence, closer analysis of your financials, and more in depth questions to answer, such as LTV (long-term value) and CAC (customer acquisition cost) etc. One Founder of a FinTech startup here in London, told me that he walked away from a Series A funding round at the last minute because the VC group did not give him favourable terms for the founders and the seed round investors. He then went and found another VC group willing to agree to his terms and successfully got his Series A. 

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