Recaps, Downrounds and Cap Table Engineering: What Really Happens When Your Growth Plan Fails with Steven Finn

28:04So if you have a mega fund series B investor who shows up with 100 million, owns 40 % of your company, and then vanishes off the face of the earth, they are dead equity. They are not helping, right? So they are not helping because they own too much and because they create way too much of a liquidation preference overhang. So the way to deal with that is to basically get them to accept that this is a loser and that there's a path to partial recovery, eliminate their liquidation preference and bounce them down into common stock, and then dilute them by expanding the option pool for those who are showing up every day.

28:40Now you have maybe, but it's key if you need their signature, which you almost always do, to be presenting a story that can get them to partial or complete recovery at 1x, right? And if you can tell that story, you can really wiggle around the rest of it. How do you tell an investor that they're debt equity? You ask them to put up more money, and when they say no, you tell them they're debt equity. You convince someone that they're debt equity by convincing them that in the absence of a round, they are at a zero and that they are standing in the way of a round. So you have to basically work on the psychology that gets them to believe that 0.2x is better than zero, and here is a path to 0.2x that actually genuinely make sense got it right you prove to them that the thing they created is unfundable right right right and also and also i mean with also being unfundable they actually also refused to to keep funding it yeah sorry it's cutting os olsen and that's that's a huge problem with the megafunds right it's it feels great when andreason cuts you a big check it feels really shitty when you have a bunch of conversations about why they're not following on with potentially net new money.

29:52Right. Right. That's the double-edged sword. Do you think as well we're also in a period where there's, obviously there's always pressure on companies. I'm not saying that there isn't, especially ones that are venture-backed in terms of growth. But do you think there's a new pressure also because venture's going through a little bit of a liquidity crisis, if that's fair to say, with LPs not really getting returns, a lot of private companies, right, that on paper are quite big, but at the same time, you know, haven't gone public, you haven't gotten these exits or haven't gotten these acquisitions.

30:31Some of the acquisitions have been blocked. How does this kind of relate into, does this relate at all in terms of liquidity when it comes to either restructuring or losing confidence in a company and you want and and wanting to get your money out yes um the way i described to rlps in our most recent update letter how we have to operate now is we have to operate from a place of financing risk first right and we have to do that differently than we ever have before because we're now in a market where even the best performing companies don't necessarily get that next round lined up, right? It's kind of that bad, right?

31:17So if that's the case, that means that we probably need to have more concentrated portfolios because we need to be willing to put more money up for things that are working in the absence of it from the outside world, right? We just need to be able to do that. But it also means that we're generally, and I hate to say it's sad but true, right? But we need to be looking for things that are taking smaller swings, right? That have less of a cash need to get over a smaller hump because we don't believe that the money's out there. All of that is driven by what you're saying, right, which is institutional LPs are now a couple of years behind on getting the returns they've been promised, even if they're still there on paper.

31:59Often they're not. Funds are having a hard time raising their next fund. So I think VC is taking it a little slower to both try to have their companies perform better in their current funds, but also to try to buy some time into what might be a better market. Right. And that leaves us in a place where there's just less cash available. So what do you say? Finance risk first. I was just taking notes. Yeah. You mean concentrated portfolios. So you're not investing in as many companies and you're investing in less companies, but but but having but having more but also at the same time, having more ownership in those companies.

32:41Yeah. But I would say that the first question that we need to answer for ourselves in any net new investment now is how many dollars does this company need before it does not need dollars anymore? And where do we expect those to come from? Right. That is not a conversation that we had anywhere near as specifically in 2019 when we were in a world where the great performers were going to be able to raise the next round from the outside world and we didn't have to worry about them. Do you, so, and also, so, by interest first, you obviously have contrary portfolios, you have more share in these companies, but it's the less amount of, but it's, but you aren't investing in as many companies.

33:20The return profile, let's say more looks like a growth equity PE return profile rather than a typical VC profile, if that's fair to say, and that it's less risky. You don't have maybe have as many outliers or the outliers aren't nearly as, you know, big. We're not targeting 100x in any deal, right? If you were targeting 100x in consumer food, you'd be nuts. We need to do investments that mostly work and we're kind of gunning for triples. Makes sense. Yeah, no, totally. And so and in terms of and in terms of I know that one of the questions that you just said that you ask is how much more money would this company need after a round?

34:03Is the goal that you be? Well, when you invest, are you thinking, can this be the last equity round this company raises? The trade-off is that when you are the last equity round the company raises, you're likely to get a lower return multiple, right? Because those future raises after you can accelerate valuation, can allow the thing to grow bigger, right? So it's not, is this the last equity round? I led a series B in a company a year and a half ago, right? And it was like a 25-ish million dollar series B. and we looked around the existing cap table at a bunch of very excited faces who were happily joining us in this round and many were reserving money for future rounds as we did as well right so this was not the last round there will be one or two more rounds in this company but we have a like around the table was almost enough money to get the whole thing across the line to profitability and then you take it from there.

35:06If we said, we're raising$25 million now and the company needs$30 million more over the course of the next few years to get to profitable and then take it from there, maybe we looked around the cap table and saw that 22 of the 30 were already there, that this guy's holding that much and that guy's holding that much and we're holding another four or five or whatever. We saw a very clear path without needing to go find the magical series C lead to getting the company all the way through where it needs to get. Not that that was the last money in. That makes sense. That makes sense. Back to, I guess, on the restructuring side too, where, first of all, how do you communicate restructuring to the board and investors?

35:47But typically, who kind of starts the conversation of restructuring that, hey, things aren't going? I try to. You try to. Okay. So it's typically coming from the investor side. Has it ever come from the actual founder or operators that are part of the board? Yes. The closer you get to cash out date, the more everybody gets creative. I pride myself on trying to see it far enough away that you can figure out while there's still enough cash in the bank to get a deal done. In terms of far enough cash in the bank, what's typically your timeline or how do you evaluate that? I mean, we're seeing companies have a very hard time raising money with six or even nine months of runway in the bank.

36:35So if you don't have real line of sight into where the next round's coming from, if it's not coming from insiders with six months left, it's time to start talking about how to compel your insiders to be your next round or it may just all explode. Do you, I mean, I'm sure you also get situations where an insider might say, okay, we can maybe do a recap. We'll put a little bit of money in, but maybe it's not meaningful. But we want to just put money in just to make sure externally it shows we haven't lost confidence. We can say, you know, maybe it's 100K, maybe it's 50K. Maybe it's just, you know, not that much money.

37:10Does that, has that worked? Does that ever work? We've been that guy. It works when somebody's holding the bag, right? So if nobody's holding the bag and burns 200K a month and the last lead says, I'm going to put in 100K, it does not work. But if some confident insider has put up an inside term sheet or something or put up enough money that we've now bought past a year of runway and the noteworthy members of the cap table kick in a couple of bucks for positive signaling, it buys some time. It's usually pretty transparent. Got it. But to get someone externally then to come in, has that, when the insiders are only putting up a little bit of money, not maybe meaningful enough, does that typically work?

37:51Or the optic's just so bad that it probably won't? It depends on, like back to my comments earlier about runway. Outside investors, we have a rule at Citi that, of course, we violate all the time, but we really try not to, that we do not add a net new company to our portfolio without it having 18 months of runway. at least. We don't want to add something that has six months of runway and then in two months be worrying about where the next check's going to come from. The company needs to have some time to spread its wings and figure out its thing and execute its plan. So that's our perspective as outsiders.

38:25I think others share that perspective. So we do not, if we have enough cash to invest in this company three months of runway, we would like those to be months 17 through 19, not months one through four. So if insiders can put enough money together such that we can come in from the outside and be that impactful runway extension, it's great. If they're kicking in three days runway expecting us to buy a couple months, it never works out. Got it. That's, yeah, that makes sense. That makes sense. Are down rounds still considered a scarlet letter or is that changing? I never view them as a scarlet letter.

39:04It depends on how they're executed, right? So like A shitty recap would be the thing I described earlier. Companies raised$100 million. I'm just going to come in$1 million pre without adjusting for the past, and now I still need$102 million exit to 2x. It's not a scarlet letter. It's just a bad deal. But I think we've all now lived through such a ridiculous boom bust, maybe boom, but mostly bust cycle that everybody understands that the world looked different three, four years ago. And if you can kind of elegantly craft a deal that is lower price, but logical for today's situation without bringing the baggage of the past into it, I have no problem with that.

39:50And I like to write this. has your, has how you invest, has that changed in terms of how you were investing three or four years ago? Because obviously the market overall was very different and changing. And so I'm kind of, was, was just very different towards, towards now in terms of the market was at a, an all time high when it comes to valuations, right? If that's fair to say. Yeah. And now of course, except of course, maybe if you're AI, but if you're not an AI. In our world, if GLP is, if your GLP is. Yes. Oh, that's fair. That's fair. That's fair. Yeah. Yeah. No, that makes sense. Totally.

40:23So how has has your process or how you think about valuations, has that changed at all when it comes to three or four years ago to now? Less in considering valuations and more in considering long term fundraising plans for individual companies. Right. It's we just really can't bank on the next guy being there. And that changes how we think about everything. Right. If you look at early deals we did in, for example, cultivated meat, we did those alongside very, very deep pockets who came in with very little conviction and looking for option value, as you said earlier. Right. So now when they don't materialize and, you know, not to make Andreessen my punching bag, but Andreessen leads a series A in a cultivated meat company and puts in 25 or 30 million and is maybe has access to all the money that the company would ever need to get to the finish line.

41:20That's less exciting than it's ever been today and was super exciting in 2021 because we've seen how it plays out when things don't beat expectations. So I guess, Ed, this makes sense. It seems like you're constantly having to also look over your shoulder or at least look over your shoulder a little bit in terms of, okay, what are the Series B, Series C players kind of doing? And what kind of metrics do they need in order to get comfortable? And how much maybe runway a company needs that, okay, when we actually look at companies now to invest in, we need to make sure that they're going to obviously have plenty of runway.

41:58because it's not going to kind of pull together. That's actually a really bad signal if they're running out of cash really quick. Yeah, and they also just need to be businesses more than they ever have before, right? Margin is runway. Every margin dollar you have is an equity dollar you don't have to raise, right? And that is a bigger focus than it's ever been. I mean, we've always been pretty gross margin obsessed. It's really what is the difference between a business and not a business, in my opinion. and it's just now more impossible than it's ever been to scale into margins. So things that don't have good margins out of the gate and need to raise money to scale into them are going to have a hard time ever doing that.

42:42What about EBITDA? When do you think that a company in consumer should be your close to breakeven or EBITDA positive? And you can even, if you want to break it down by different categories, for example, that's that's fine as well yeah it definitely depends and it's like we'd like to see really solid gross margins i'd say depending on category that could range anywhere from kind of 40 to 80 90 net gross margins um we probably spend less time in the categories that are closer to 40 right when i say that our blurry line in the sand is product market fit that is later in a cold chain beverage that it is in a high margin d2c friendly powder business right because you have fewer options for distribution uh and it's super expensive to do that distribution you're shipping heavy things cold right there's lots of extra expenses around it um profitability I mean, if you're doing 100 plus million and you're not doing it profitably, there's probably some problem there with likely your margin.

43:56And maybe you are in the wrong places and grew too fast and, you know, prematurely scaled. But, yeah, it's really very different by category. I think it's some we've seen businesses profitable at a million in sales. we've seen businesses unprofitable at 300 million in sales it's uh yeah it's it's one answer how how also when you let's say you have a distressed asset a company isn't you know doing so well and how do you bring how do you think if there might be an opportunity to still sell this asset right and and how do you go about maybe this is more like an investment banker uh uh question. But how do you kind of bring that company to market to see, okay, let's figure out if there actually is a suitable company that might be interested in buying this?

44:52And how do you actually even market or promote the value that the company have in order to kind of bring together these two parties? I think the first step is probably not to go out with something like That is to take the step back and try to adjust it into something that looks less distressed. So kind of first do like a recap, for example. Yeah. When we see companies that are either recapping or selling and they're not quite sure yet, I tell you right now, they're not selling. Okay. Okay. That's helpful. Yeah. So getting that recap in place, getting whether it's a right size team or right size product portfolio and really building a company that's capable of doubling down on what works instead of just constantly shooting for the moon.

45:39That's what makes it attractive. Bankers are good to bounce thoughts off of and figure out, you know, are there potential acquirers? What does this market look like now? What do comps look like now? but frankly at the end of the day they're all going to tell you they can sell their your thing and then some can and most can't at least in our experience everyone is very positively inclined on the way in and then it turns out it's a tough market so it's really if you know who your perspective universe of acquirers are you should go talk to them if you don't you probably have a problem in and of itself.

46:23So yeah, I think bankers are a very useful resource in understanding if there's a market for something, but take their yes with a little bit of a great result, if that makes sense. Yes, it does. It does. But also I think the insight at least here is firstly a recap, first actually structure the business where it becomes, where then you know that what evaluation they kind of give in terms of, or what that acquisition price is, which I know is negotiation, but whatever that ballpark is, that you're able to actually fulfill that in that you have a much more clean cap cap. Yeah, I think that's right for everyone involved, right?

47:03Why would a founder push to sell something for 80 million with a$100 million prep stack? What do they get out of that? Nothing, right? You have a serious misalignment problem if you try to sell the distressed thing with the weird cap table while it's distressed and with a weird cap table, right? Because you need the same signatures that you need to do the recap to do the exit, except now there's no hope. Yeah. Do you have any favorite in terms of selling distressed assets, a distressed asset in consumer and they're actually able to pull it around and turn it into an incredible brand? I haven't seen much of it.

47:51There's a couple of roll-ups that will take in distressed brands and roll shared services over them. I think that's a conceptually good model. I think that can work. I think it's always hard to know when you're trying to catch a falling knife if it's fallen too far. And I've seen very little of those roll-ups being able to successfully raise the money they need to actually leverage the shared services. So they need to raise money too because they're bolting on unprofitable assets. Right. And it's not, that's a tough sell. we've passed on a couple of them. Yeah, I can imagine. I also feel like with roll-ups, yes, you can maybe stream on operations better and obviously get margins a lot tighter for a lot of your companies.

48:48Maybe you're switching suppliers, so you're all using the same supplier, and then you're actually able to get scale from that way or whatnot. At the same time, you still have to obviously sell and marketing, and that costs money to do so, and that's all still individual, right? It's not like you can really spread or share those costs where you have some type of economies of scale in that way. There are in the back end, there are in operations, there are in accounting, right? There's plenty of synergies and plenty of reasons why it should work, but you're 100 % right. That's not where the bulk of the cash to grow is going.

49:23And without that cash to grow, you're where you are. Totally. What are some smart ways founders... What are... Are there smart ways for founders to protect themselves early so they aren't wiped out in a restructure?

49:43Yeah, I mean, don't raise stupid rounds is a good one. Right? Don't raise aspirational rounds because you think it's the finish line and you get to post all over your LinkedIn, right? That's the number one thing founders do to shoot themselves in the foot is accept stupid terms and stupid rounds. So I think back to what I said earlier, raise the money you need for the timeline that makes sense and really focus on raising the money that allows you to pour fuel on the fire that exists and not go hire everyone in the world and go to every door and all that. So that's all important. trying to keep control of the board with the common is helpful it's not that helpful because at the end of the day typically we see preferred board members getting outsized control and there's all kinds of you know even if there's a board that's six common seats and one preferred there's plenty of important decisions that need a preferred director's approval right so that's just like it's a start but it doesn't get you all the way um it's really be super important to the company right the founders that are not super important to the company or screw it up or piss off investors are easy to get rid of from like in a recap situation right and it happens all the time where we're gonna bring in cash and we're gonna bring in the new guns to to run with the cash if you think that's you be more important but i mean if you are the founder who is completely indispensable you will always have the negotiating leverage no that's that's fair because of course then you're irreplaceable and so um yeah that makes an irreplaceable right that means that any recap whether or not your signature is actually required you should be thought of as a required signature right and those whose signatures are required to get something done get their pound of flesh every time or nothing gets done yeah that makes got it um how how do you know when someone is still coachable like a founder is coachable even when their original plan has collapse oh you know when you see it it's a that's a tough one um but i mean it's from a fundraising perspective i am usually screaming early and often that we need to know where the next dollar is coming from and if there's three to six months left in the bank and we still don't know and don't have good insight into where because the founder thinks it's going to be no problem I've probably lost hope in that founder's ability like the number one rule of CEO in a startup is don't die right like don't run out of cats it's your job to not die right so if you can't look that in the face you're not coachable enough for me and that is what it is but yeah I think that that's that's a big one for me on the fundraising side in terms of execution that that einstein quote of insanity is the definition of insanity is uh doing the same thing over again and expecting different results right you know who's who uh then it it's usually obvious pretty early how i mean because i'd imagine that some of the reason why retail businesses raise big rounds is let's say they're doing really well in a region or maybe they're the natural channel and then and then one of the big conventional um retailers comes and says we're gonna put you out of every store blah blah how do you and maybe this might be more of a question to melissa but how how do you all and then of course it's really tempting right because you have a natural retailer that is interested in you wants to go national so you then and then of course you're you're pitching that to investors investors get very excited and so you were able to kind of close this big round.

53:44And then even though you have the money and maybe you actually did support the natural relapse, the product didn't work in that sort for whatever reason. Maybe your prices were too high. Maybe it just didn't make sense. In that example, the big conventional retailer who wants to take you in, I would look at their set for your thing. And if it doesn't exist, you're a question mark. And if it exists at a way lower price, you're a question mark. They don't know how it's going to go. I think that that's just important to note. Yeah, no, for sure. For sure. I would say, how do you think about when you do have those companies, and maybe it's kind of that example of they raise a Series A with you, and then maybe they raise a massive Series B, and that's the reason why they raise a massive Series B.

54:33How do you think about what the growth journey maybe should look like for a retail business that will be successful in terms of growing slower? Is there a certain amount, for example, of number of stores that they should be in that, again, gives you an idea of, okay, now we should kind of, and Velocity is looking good, now we should expand, but we shouldn't expand too rapidly. How do you think about it from, for example? It's more about the types of stores that they work in than the number of stores, right? And the demographics around it and what kind of marketing they're doing around actually driving traffic to those stores to get it.

55:10You know, we have one of our best performing companies is a company called Circle, right? They have a water bottle with a pod that is the flavor pod. And it maybe behaves differently at different kinds of retailers because in some place you need to buy the bottle to get into the ecosystem. And some retailers have massive water bottle businesses up against Stanley and Obala and other kinds of normal looking water bottles. And some retailers don't sell any water bottles. Right. So that's what they have to then figure out is where should they be? Right. Should it be in the places that sell the water bottles?

55:53Should they be the only water bottle in the place that doesn't sell the water bottles? Or should they only be a replenishment thing in those? Right. So that's when you're something like that, it's a complicated undertaking. Right. But for most kind of normal grocery products, it's just about where do you sit in your set and does your set move? And if your set moves around your prices, you should seek to be in those doors. But, yeah, different for every kind of category. That's great. That's great. What's my final question is what's one book that's inspired you personally and one book that's inspired you professionally?

56:37I would say the lean startup back in the day inspired me personally just to like be a hacker and try shit and see where it goes and, you know, not put all eggs in one basket. in terms of professionally, this essentialism, I forgot who wrote it. Greg something new. Yeah, that really, we have an incredibly erratic business, right? We have deal flow that falls from the sky. We have companies that we need to deal with on a regular basis. And just even the picture on the cover of a circle with a bunch of arrows coming out of it, instead of exerting all that effort to actually move the circle. That one was huge for me in terms of just really focusing on what matters.

57:29It's very, very easy to be distracted in our line of work. Yes, I can only imagine because, of course, you have your LPs. You have, of course, obviously the founders that you're serving. You have new prospects, new prospective businesses that are coming to you looking for investment that you're doing analysis for. You also might have companies that actually might need recap or help in that regard. So there's a lot of things that you're kind of juggling on all of it. And the time sucks or not always where the time should go. Some of our best performers are the ones that we've put the least time into because they know how to do it.

58:12Right. And some of the places where we put the most time, it winds up all being for nothing. Right. And then that's that's my my one kind of call out curse that I have is I see a situation and I try to figure out the deal I'd still do in that situation. Many of those scenarios I should just let die. Well, that's a great point in that you spend a lot of time with recaps, thinking about recaps and obviously how to do it. Does it even make sense to kind of spend time with those companies doing that instead of focusing and giving more time to the companies that actually are growing and winning? it's gotta be a balance i don't think it's that different than doing a company the first time right many possibly even most will fail but when it works it was all worth it great answer great answer steven thank you so much for your time this is a lot of fun yeah thank you anytime thank you and there you have it it was awesome having steven on the show thank you so much for listening and please subscribe on whichever platform you're listening on So you are kept in the loop of the latest episodes.

59:25And check out the newsletter at theconsumervc.com. Thank you, Glymphs, for sponsoring this episode. And thanks for listening.