Still, keep in mind that the examples I was explicitly told about were for companies who were going to be acquired in less than 6 months (so there was no new round of investment), and that the recapitalization affected not only the ex-employees (which is terribly dirty and dishonest in itself), but also the existing non-key employees who happened to be there for a long time and got significant equity by joining early (which is a tragedy).
There are other things, though, like carve-outs.
If company A is being acquired by company B, and company B needs key people from company A to stay, and the employees do not have enough upside for company B to be assured they'd stay... you might set aside some acquisition proceeds for those people. This tends to hurt both investors and past employees.
It would be nice if someone maintained a list of all of these “tricks” and what to watch out for in your options agreements. I try to pay attention to this as a layperson, yet I am frequently learning of more lingo and new deal structures that introduce a lot more risk to both founders and employees.
A much more common carveout would be something like this:
- A $15M acquisition of a distressed company that may very well be insolvent if the deal is not completed
- $10M is owed to investors to repay liquidity preferences
- A founder is gone who would get $1.5M of the remaining
- Any reasonable escrow fund, etc, on the $3.5M that would go to the remaining shareholders is not enough for the acquirer to be sure they retain key talent.
This deal can't be reasonably done with $15M split according to the capitalization table.
So instead, the investors take $9M (10% haircut, since they're first in line for any fall-back plan); $4M goes to existing shareholders (20% haircut)-- including that missing founder who now gets $1.2M; $2M is held in an escrow for people that the acquirer needs to keep.
This isn't a breach of fiduciary duty, because it's mostly being dictated by the acquirer and because no shareholder class ends up worse off than they'd be in any likely alternative.
E.g. my last time around-- there was a deal that would have paid back investors and even paid a little to employees... but the acquirer would have required key technical staff to stick around.
The only way that deal would have gotten done would be if it was possible to carve out enough funds for those key technical staff. (It wasn't, so instead it was an asset sale that did not pay back investors).
- I have never been part of a recapitalization or carveout (though I did do diligence on a couple of companies that would have recapitalized as part of a fundraise if funded)-- other than the normal term of stepping up the incentive option pool as part of a capital raise.
- Even so I pretty strongly feel there are times they are necessary tools, and are mostly used in this way.
- Of course, anything can be abused by people with poor ethics.
If you have done multiple rounds of investment already, and need to raise more capital... and the cap sheet is "dirty"-- having non-involved investors, major blocks of shares for employees that are no longer there and were involved on past projects, etc... It can become difficult for a new investor to invest, particularly if the company is otherwise troubled.
After all, the investor wants to make sure there's enough upside for A) them, B) key executives, and C) new employees hired/the incentive option pool. They also do not want to be 6th in line, or whatever, for liquidity preferences. So they may demand that the capital structure of the company change.
Management / the board are generally obligated by fiduciary duty to not recapitalize if there's any reasonable option to protect existing shareholders. But if the only way you're getting a fundraise done is with a recap, it happens-- after all it is still looking out for existing common shareholders in getting them something instead of nothing.