Cram downs are a character test for VCs and founders

Steve Blank Contributor

Steve Blank is a founding faculty at the Gordian Knot Center for National Security Innovation at Stanford University, an adjunct professor at Stanford and a senior fellow for innovation at Columbia University.

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Cram downs are back, and I’m keeping a list.

At the turn of the century after the dotcom crash, startup valuations plummeted, burn rates were unsustainable and startups were quickly running out of cash. Most existing investors (those still in business) hoarded their money and stopped doing follow-on rounds until the rubble had cleared.

Except, that is, for the bottom feeders of the venture capital business — investors who “cram down” their companies. They offered desperate founders more cash, but insisted on new terms, rewriting all the old stock agreements that previous investors and employees had.

For existing investors, sometimes it was “pay-to-play” — if you don’t participate in the new financing, you lose. Other times, it was simply a “take-it-or-leave-it, here are the new terms” deal. Some even insisted that all prior preferred stock had to be converted to common stock.

For common shareholders (employees, advisers and previous investors), a cram down is a big middle finger, as it comes with reverse split — meaning your common shares are now worth 1/10^th, 1/100^th or even 1/1,000^th of their previous value.

A cram down is different from a down round. A down round is when a company raises money at valuation that is lower than the company’s valuation in its prior financing round. But it doesn’t come with a massive reverse split or change in terms.

They’re back

While cram downs never went away, the flood of capital in the last decade meant that most companies could simply raise another round.

But now with the economic conditions changing, that’s no longer true. Startups that can’t find product-market fit, generate sufficient revenue or lacked patient capital are scrambling for dollars — and the bottom feeders are happy to help.

Why do VCs do this?

VCs will wave all kinds of reasons why — “it’s just good business” or “we’re opportunistic.” On one hand, they’re right. Venture capital, like most private equity, is an unregulated financial asset class — anything goes. But the simpler and more painful truth is that it’s abusive and usurious.