in Angel Investors

Cram-downs and Co-investment

In today’s challenging times it is a strong possibility that companies/investors may be faced with a cram-down financing round. Depending on how well or not well this is handled can have a big bearing on the future success of the company and the investor’s potential for return. So what does this mean?

Here is how a typical scenario would go:

  • An early stage company is seeking funding to get their company to the next stage (i.e. get their initial prototype to market, achieve cash flow break even, expand to the US, etc).
  • They do pitches to investors and close out an investment round.
  • Everybody is happy and optimistic of future success.
  • According to management’s ‘conservative’ projections the funding will allow them to execute their plan to reach a milestone (say cash flow break even) in 8 months.
  • 7 months later, the investment group is told things have gone slower than expected and the company needs to raise more money to meet their original milestone.
  • The investors, having not been engaged, decline to put more money in.
  • The company finds another set of investors that is willing to put money in, but only under their terms.

Such terms can include:

Lower valuation – the new investors’ shares are priced cheaper than the previous round shares. This means the new investors will get a larger stake in the company based on the amount they put in compared to the previous investors. Previous shareholders have a smaller percentage of ownership and their holdings are worth less than when they closed their financing round.

Board seats – the new investors may require the current board to be dissolved and re-constituted with a composition that allows them to control the board.

Management – the new investors may require the current CEO to step down and be replaced with a CEO of their choice.

Liquidation preference – the new investor’s shares will receive liquidation preference. In other words, on sale or wind-up of the company, the new investor’s shares are paid out first (could be 1x, 2x, etc) then the remaining proceeds are pro-rata split (i.e. if things go south, the new investors will ensure they get their money out).

So you ask, what about the previous round’s term sheet that you collectively spent hours negotiating and thousands on legal bills? There could have been very well thought out anti-dilution and control mechanisms. However, the new investors will simply state their investment is depending on prior shareholders forfeiting their rights in the old term sheet. The existing shareholders can either refuse to sign and most likely the company will run out of money and go bankrupt or accept the conditions of the new investors.

At best case, the company closes the deal and lives on. However, the investors are not happy since their investment is not on favourable terms and the management, if they have not been replaced, are under control of the new investors.

The way to be more proactive is to:

a) Ensure there is a good investor management program in place where investors are kept apprised of the successes and failures of the company.

b) With an engaged investor base, start the ground work early to plan for potential future financing rounds. Ensure investors are kept up to date with the realistic future funding requirements the company is facing and get a feeling for current investors’ appetite for participating.

c) Leverage investor’s networks to tap into co-investment initiatives between angel groups.

Bryan Watson, executive director of the National Angel Capital Organization sums it up nicely:

“At the recent National Angel Summit the panel called Co-Investment – Taking It To The Next Level discussed this topic. This is a real concern for many Angel investors they often represent some of the first outside money invested into a company.

The panelists noted that operational failure is understandable in an investment. That is, even though best efforts were put in, the company failed because of the market, team, technology, etc. What is unacceptable, the panel noted, is financial failure where Angels are crammed down because they didn’t reserve enough capital to participate in future rounds.

Through co-investment, Angels are able to syndicate with more investors and, while still raising significantly sized rounds, ensure they retain enough capital in reserve to ensure that when the next round of funding comes along they have the capital to participate and avoid being crammed down.”

craig at