What Is a Cram Down Round, and How Do You Avoid a Down Round?

In this video, you'll learn what a cram down round is and how to avoid one. When a court accepts a debtor's reorganization plan, provided it is fair and equitable, despite objections from creditors, the situation is known as a "cramdown."

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Additional Resources

   • What is Pay to Play in Venture Capita...  
   • Why VC’s Don’t Want to Lead Down Rounds  

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This is May, 2022 and there's been a correction in the NASDAQ which is filtering through to the startup ecosystem. And so if your company's not doing as well as projected, if the valuation's too high and you need more money, this is a risk if you're running a company and it's also a risk if you're a VC, like you put capital in these companies maybe a year ago or two years ago or six months ago. The last thing you want is for there to be a cram down round, and essentially what a cram down round does is it compresses all the ownership positions of previous investors, founders, angels, everybody and basically creates almost like a new cap table. And so there's a couple different components of this so I'm gonna go through this slowly. So, hopefully, everyone can track this.

The first thing you do is the new capital is going to demand probably some draconian terms like they are gonna ask for a much lower valuation on their capital. They might even ask for like enhanced liquidation preferences, check the video on that. But they're basically doing this 'cause they want a good deal. Oftentimes, a cram down round is done by insiders. And so there'll be one kind of VC firm that really believes still, and there'll be a couple firms that are in the company maybe who don't believe as much but they also don't wanna lose their position. And so typically a Pay-to-Play round is kicked off and that is designed for all the venture capitalists to kind of be forced into participating or they lose their ownership.

So that one VC firm that really believes puts forward a term sheet and says, "Other VC firms, if you don't participate and do your pro rata you are going to be crammed down." Right? And so what that means. So the term sheet comes together and say like one VC firm participates along with the lead and one decides not to. So right before the money comes in, there is a massive reverse stock split and all the owner... Like I'm talking like 1000 to one, or 10,000 to one, or 100,000 to one, so that the old ownership positions get condensed down into very small share counts. Right before the money comes in, they still kind of own the same amount of shares or same amount of the company as a percentage, but then the new money comes in and that, they get a lot of shares because again, they're taking a lot of ownership in the cram down.

And so what results is maybe the previous management team, founders, angels, and even the VC firms that did not participate in the Pay-to-Play end up with like one, two, 3% ownership, maybe like 5% ownership, maybe 10% ownership that's heavily negotiated but it's gonna be materially smaller than what everyone owned before. I'm saying, you know, 1, 2, 3, 5% ownership total across all those stakeholders. The new syndicate that came in, in my hypothetical had a lead VC, who's the insider and then one that really still believed are gonna own a huge portion of the company. And then the final ingredient is a new stock issuance to the management team that is staying. So sometimes when there's a cram down like the founders have to leave or the CEO gets fired, or the CFO and the COO get fired, whoever is staying with the company or coming into the company will typically get a pretty generous option grant.

Again, the common stock will get another like 10% of the company, maybe up to 15% of the company and those shares will go to the new people running the company and obviously the rank and file. And so you end up with this situation where the people put the new money in, who crammed everyone else down, own a big chunk of the company. There's a new option grant that incentivize management team, the people who are still there, big percent, you know, 15%, something like that. And then again, heavily negotiated but the previous investors, previous angels, previous founders, management team own a very small part of the company.