I was reading an article the other day in VentureWire which made me laugh out loud. The article described the recent acquisition of optical networking company Picolight by JDS Uniphase for $115 million.
A little background… Picolight had raised a total of $125M in venture capital since it’s inception in 1996, and it doesn’t take a rocket scientist to determine that if $125M went in and $115M came out years later that somebody lost money here. The vast majority of funding (>$80M) was raised prior to a recapitalization completed in 2003. Recapitalization can imply different outcomes based on the context (i.e. emergence from bankruptcy, buyout of existing shareholders, etc) but in the VC world, typically it means a new equity round is closed at a significantly lower valuation than the previous round(s). In the process, prior classes of stock (both preferred and common) are “crammed down” into a comparatively small percentage of the overall company ownership and are typically converted to common stock.
While this obviously isn’t terribly pleasant for existing investors and founders, recap rounds do enable promising companies to continue growing on a new trajectory despite a challenging history. They might have raised “too much” capital or had prior management that spent profligately or simply commercialized their product before the market was ready. Investors in the recap (either new investors or existing ones who “play” in the round) typically have the potential for reasonable returns upon exit based on the lower valuation. Depending on the terms, those that invested at the recap round might have made several times their money on their Picolight investment. Current employees are usually “re-upped” through a reconstituted option pool, so they too remain incented.
What was so amusing about the Picolight story was a quote from one of the VCs who lost a non-trivial amount of his prior investment, yet releflected on the bright side of the tidy return on participation in the recap round. “The $80 million that went in during the bubble died and went to money heaven,” said Rory O’Driscoll, managing director at Scale Venture Partners. “We reinvested and it looked pretty dark, but we added a few investors and did very nicely on the new money. If I’d just done the last two rounds I would be extremely happy.” I love the personification of capital that many of us in the VC biz engage in, from “putting money to work” to “flushing” money lost in write-downs and write-offs. But I have to say that recapped investment dying and going to “money heaven” is my favorite, and I have respect for him seeing the glass half full.
Humor aside, recaps have been something I’ve been thinking about over the last year or so. There have been a number of companies recapped in the last 2-3 years, many of them initially started or funded prior to 2001 when large sums of VC dollars were invested often at significant valuations. Undoubedly, there will always be otherwise promising companies that are recapped but I believe that we may be in the latter stages of working through this “pre-crash” corpus of startups. Once the last of this group has run its course, either through successful recap and eventual exit or by simply folding tent, I suspect we’ll see fewer VC recaps overall.