The Rise of Cram Downs in Venture Capital
As economic conditions shift, startup financing has become more challenging to obtain. In desperate times, some venture capitalists use “cram downs” as a way to inject cash into struggling startups. This article delves into what cram downs are, why venture capitalists do it, and how founders can stop it.
What are Cram Downs?
During the dotcom crash in the early 2000s, startup valuations plummeted, making it difficult for most startups to secure financing. Cram downs occur when bottom feeder venture capitalists offer struggling startups more cash but insist on new terms. They rewrite all the old stock agreements that previous investors and employees had, which can include converting preferred stock to common stock and issuing new terms. Common shareholders like employees, advisors, and previous investors feel the financial pain from a reverse split.
Why Do Venture Capitalists Use Cram Downs?
Some venture capitalists will justify cram downs as their fiduciary responsibility or claim that they are opportunistic. Venture capital is a power-law business, so investing to get every penny back is not necessary. In reality, cram downs are abusive and usurious. Many venture capitalists lack a moral center, and instead of investing in companies that offer a positive impact on society, they support harmful business practices.
Why Would Founders Agree to Cram Downs?
Founders in search of additional investment can become desperate, leading them to grab any offer to keep the company afloat. Existing investors may offer desperate founders financing, but it means the company will start over with new terms. In some cases, investors promise that founders and a few key employees will get made whole again in the newly recapitalized company. But previous investors, employees, and advisors get nothing. Founders may rationalize this deal as the only way to keep the company alive. However, they fail to make an ethical choice and ruin their reputation.
Stopping Cram Downs
Venture capitalists will continue using cram downs as long as founders accept it. Founders should attempt to walk away or shut the company down. Instead of rationalizing that the deal is good for everyone, take a pause and think about alternatives. Life is short, knowing when to double down and when to walk away is a critical skill. In the long run, the venture ecosystem, and employees will be better served by founders who use their experience and knowledge in a new venture.
Lessons Learned
Cram downs are done by VC bottom feeders who take an unfair advantage, contributing to the toxicity of the startup ecosystem. Founders often believe they have to take a cram down, rationalizing that they will never have another good idea or that they have so much time and effort sunk into the startup. Founders also rationalize that it’s good for their employees. To stop cram downs, take time to think about alternatives and don’t get trapped in your head thinking you need to solve the problem alone.
Final Thoughts
Cram downs are a problematic practice in venture capital. They benefit bottom-feeding investors and harm common shareholders, including employees, advisors, and previous investors. Founders have a choice to walk away or shut the company down. They should consider alternatives, including starting a new venture with their experience and knowledge. Cram downs need to stop, and founders can lead the way in changing the game.
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