The Dark Side of VC Recycling

There’s a worrying trend I’ve seen recently. A dark side of VC recycling that has emerged as investors try to recover from the hangover of 2021. A practice that represents the worst in VC and reflects a desperation amongst a handful of large funds to undo some of their investments.

What is Recycling?

When a startup in a VC’s portfolio has an exit, the firm can either distribute the money to its investors (the LPs) or it can “recycle it” and invest it in new and existing companies in the fund. The process of recycling is generally regarded as supporting long-term alignment between VCs and their investors, while also benefiting founders (as the VC has more capital to invest). In theory, it’s a win-win-win.

Here’s a great post about recycling by Brad Feld (Foundry Group) and another from Fred Wilson (USV).

In general, VC’s are allowed to recycle during each fund’s initial investment period (typically the first 3 or 4 years of the fund). After that, all returns go to LPs.

What’s the Problem?

Historically, recycling has been seen as positive for everyone involved: VCs, their LPs and startups. The only downside typically mentioned is that recycling delays the time until investors start to receive cash distributions from the fund (“delaying DPI” in VC parlance).

Recently, a worrisome trend has emerged amongst a handful of multi-stage funds that reflects a dark side of VC recycling: funds attempting to force startups to shut down or sell so that they can recapture and redeploy their investment dollars within their recycling period.

While it’s not uncommon for investors to nudge founders towards an exit if it becomes clear that the company is no longer growing, that’s not what I’m referring to here.

I’m talking about VCs trying to force companies with plenty of runway and whose founders have done everything right to sell or shut down.

Wait…what?!?

Let’s start with some background…

By late-2021 / early-2022 (the peak of the Frothy Times™), a number of large, multi-stage VC firms were deploying significant amounts of capital into companies that were far earlier in their trajectories than those firms would typically invest in. It wasn’t uncommon to see $20M, $50M or even $100M going into companies that hadn’t yet achieved product-market fit.

Contrary to popular narrative, these firms weren’t skipping diligence. Rather, they were intentionally investing in fast-growing companies ahead of the curve. The rationale for these investments was generally based on expectations that the companies would continue to rapidly grow, such that they would soon be able to secure leadership position in their markets and drive substantial follow-on rounds (and, thus, mark-ups for the funds).

By mid-2022, the warning lights of a recession were blinking brightly and VCs around the world were advising their portfolio companies to batten down the hatches. In the board room and across the interwebs, investors were proclaiming the need to cut burn and extend runway.

To their credit, most founders listened.

In fact, many startups extended their runway far beyond what investors could have expected. Many companies that raised in late-2021 / early-2022 found themselves proudly sitting on 3, 5 or even 8 years or runway. You literally could not have asked a founder to do anything more.

Unless you’re a big multi-stage VC.

The Risk of Runway

For firms who invested “ahead of the curve” (aka way earlier than they normally would), extended runways present a challenge. On the one hand, they ensure that the company has enough runway to weather the economic downturn, achieve product-market fit and ultimately become successful. On the other hand, by cutting burn and slowing growth, the expected time horizon for that to happen may be years longer.

That alone isn’t such a big deal (after all, VCs have the ability to extend their fund life with the approval of their investors…and they do so all the time).

What we’re seeing here is a handful of VCs who have serious buyers’ remorse. They are now staring at hundreds of millions (and in some cases, billions) of dollars “trapped” inside what are effectively very risky Pre-Seed and Seed stage companies. Investments that they should never have made to begin with. And they want a do-over.

How do they accomplish that? Recycling.

Are You Serious?

In the past several months, I’ve spoken with multiple founders who took investments from large multi-stage funds in 2021 or 2022 and whose investors have approached them about selling or shutting down the company.

All of these startups have years of runway and are growing and progressing at a solid pace (albeit slower than they were last year).

The founders have done everything they were “supposed to”. They hit their milestones, raised over-subscribed rounds, took preemptive capital when it was “on the table” and now they’re being punished for it by the very investors who pushed them to raise more.

It’s disgusting.

In pushing founders to unnecessarily sell or shut down their companies, these investors are putting on full display their utter contempt for entrepreneurs and their journeys. The arguments they’re making – and the degree of gaslighting they’re employing – is nauseating.

“You can always start another company.”

“Your reputation will be fine.”

“You could use the time off.”

“We’ll make it worth your while.”

The last argument is how they pull it off. In order to convince founders to preemptively sell or shut down their companies, these investors will offer them life-changing money.

All they need to do is give up their entrepreneurial aspirations, screw over their employees, customers and early investors, and potentially ruin their reputations.

And you wonder why people don’t like VCs?

This Can’t be Real…

Unfortunately, it is.

To be clear though, this behavior reflects only a very small minority of VCs. The vast majority of investors at all stages continue to be fiercely supportive of their portfolio companies and champions of their founders.

But those with the misfortune of having investors with buyers’ remorse face a tough road ahead. If you are one of those founders, know that you are not alone. Reach out to your angel investors, founder friends and early-stage investors for support. In most cases, a single VC cannot force you to sell the company, but they can make your life hell. Seek out a support network as you navigate the challenge.

Don’t be afraid to reach out cold to other founders in the VC’s portfolio. There is strength in numbers.

Also know that there are other solutions. If an investor wants their money back badly enough, then that might trump their need to save face (which is very much what they’re trying to do in forcing a sale or shutdown vs. unwinding their investment). Don’t be afraid to ask them a single, direct question:

“What would it take to get you off my cap table?”

If they want it badly enough, they have a price.

The entrepreneurial journey is difficult enough for founders. As investors, we have a duty to make it easier, not harder.