VC Insights: The re-up

Managers in a scale-up business need to be incentivised by having a meaningful stake in the company they run. Often they don’t. This is a big problem which may well be a serious long-term valuation drag. But it can be fixed…

A recurring theme in our series is that founders and other managers in a scale-up business need to be major shareholders. Financially, their focus should be capital gain – not salary, perks, or prestige. More importantly, the scale-up will succeed best if they have a strong emotional sense of ownership.

Often, the founder team and subsequently hired management end-up just a small percentage of the share capital. This is a problem that needs fixing to make a business investable.

So, in this post, we’ll look at ways to re-enfranchise management – the re-up.

How did management end up here?

By the time the venture investor gets involved, most scale-ups are already showing signs of battle-damage. There are various ways in which newly-minted start-ups (like our dear old SaaSco: them again) lose their shine and that directly impact management’s shareholding, such as:

  • Getting into revenues took longer and cost more (nearly always) so SaaSco’s management got diluted by follow-on rounds, possibly at a reduced price per share;
  • SaaSco’s happy band of founders fell out. One left. There were no leaver provisions in the Articles. The leaver kept their shares. That equity is essentially wasted. The replacement manager currently has no shares and is less than happy. The same problem arises with staff options that vest quickly; or
  • SaaSco went through a bad incubator or accelerator programme that didn’t add a huge amount of value but did take a big chunk of the equity.

Also, some scale-ups start life with inherent structural flaws, examples being:

  • SaaSco was founded by a corporate financier who put in limited finance to hire a management team aiming to raise external equity to do the heavy lifting. For a scale-up business particularly, this model just doesn’t work;
  • SaaSco came off the production line of a start-up factory (basically a variation on the previous point); or
  • The business started as a university or corporate spinout where the founders were weak or poorly advised in negotiations, and SaaSco’s cap table was too heavily skewed in favour of the mother ship.

Why is this a problem?

The new investor should see the shares held by the initial promoter, incubator, academic institution or old parent as dead equity – share capital held by someone who once upon a time contributed but who now has nothing else to add.

Contrast management: a good manager adds value massively more than their salary every day they turn up to work. They do that because of their shareholding – either for financial reasons, or due to the emotion they feel from really being part of something.

But don’t expect a manager to miss out on months of family life, cancel their holiday, or code through Christmas, solely because of a half per cent share in a start-up.

More dead equity in a business means less management incentivisation. The lower management’s morale, the lower the valuation should be. Which dilutes management even further. There needs to be a circuit-breaker.

Fixing the problem – the people bit

We’ll look at the mechanics of fixing the cap table in the next section. First off, though, is getting agreement that there is a problem, and getting the buy-in from all the stakeholders.

  1. Management

Oddly enough, management themselves can be the problem. Sometimes they profess that they’re more than happy with their small-but-perfectly-formed two per cent shareholdings.


So we invest.

And then, further down the line, still on meagre salaries, SaaSco’s management make it clear that they’re totally fed up. They’re maybe four years into a really tough tour of duty. They can see a good exit becoming a possibility – so they finally do the maths. They realise that the people who are going to do well are the venture investors and, most of all, those folks who were around at the beginning that somehow got themselves half the company. (We should have a name for them – SmugCo, perhaps. Then again, let’s be professional – no point raising the temperature. There’s a deal to be negotiated.) Let’s just call them MotherShip and SpentUpAngel.

Our problem is that, once we (as new investors) have invested, to give more equity to management means all shareholders chipping in – that costs us. It might cost us a lot. But this problem was evident at the start: even before we invested. It should have been MotherShip’s and SpentUpAngel’s problem, not ours. We should have made it their problem when we invested.

The answer? In the first place, as a condition of investment, we must insist that management receives equity from the current investors. And we as investors need to be prepared to walk if they don’t.

We could, of course, decide that management with so little financial drive aren’t our kind of people. But be careful: we meet founders who are otherwise entirely commercial, and happy to negotiate hard with us, but are highly respectful of their alma mater, or former bosses, or friends. Time, distance and proximity to the money will diminish that respect. Our role is to fast-forward the tape[1].

  1. MotherShip and SpentUpAngel

At this point, let’s assume that investors and management agree. Next up: we need to take the argument to SaaSco’s existing external shareholders.

The proposal isn’t immediately attractive. Firstly, MotherShip and SpentUpAngel are going to get diluted to raise new monies. They may not agree with the valuation. They may not even agree that the company needs to raise again. Then we tell them that, in addition to being diluted through the round, they need to give up some of their current shareholding in favour of key managers. A real one-two punch…

The arguments in favour of accepting the proposal are varied depending on circumstances, but essentially boil down to this: “If you, the existing shareholders, give up some equity for management then we will invest; and then two good things will happen:

  • SaaSco will not die (or, less dramatically, SaaSco can hire some new people and grow at 3x its current plans); and
  • Management will be happy bunnies and work without rest until SaaSco becomes a happy-bunny-led unicorn.”

This is an easier argument to run when everyone can see that SaaSco has been quietly starving to death or is simply running out of cash. The argument is more nuanced when additional money from a new investor will take an okay situation and make it better. In that case, MotherShip and SpentUpAngel may just say no, or might just take their time. They will want to trawl the investment market one last time to try find an investor with terms that better suit them. Perhaps MotherShip or SpentUpAngel might be able to find some cash down the back of the sofa.

We’re in no hurry. We set a quarterly reminder.

  1. Fairness

We think the re-up can be fair to all parties. After all, the reason we are even negotiating with SaaSco is that our proposal is, presumably, market-rate: the best deal that SaaSco could get.

But it’s also important that both the shareholders and management perceive the proposal as fair. We need to work with them because an aggrieved incumbent will mean an uncomfortable relationship as fellow shareholders. If they appear to feel that we are holding them over a barrel, then we would hesitate to invest.

In discussing fairness and perceptions, it’s worth noting that a re-up proposal can be used disingenuously. If SaaSco were performing spectacularly with external investors holding just a tiny minority, then as a new investor we shouldn’t low-ball the valuation while offering to protect management with a re-up. MotherShip and SpentUpAngel would find another investing partner. We would have zero credibility with management. It wouldn’t make sense to even try.

Of course, the dead equity issue applies to each generation of investors. Once invested, we face our own challenge. We must move the business forward, grow its value and demonstrate how we as investors make an ongoing contribution to the business. The alternative is that we may need to raise capital on poor terms that could heavily dilute management. Then it’s our turn to be the dead equity.

And at that point we too are fair game.

Anatomy of a re-up

At this point, we’ve got buy-in to the principles of an investment into SaaSco, combined with a re-up. How would the mechanics work for SaaSco?

Firstly, just to note that the re-up can create a bunch of tax issues. That’s not our bag, so we would simply recommend getting some sensible, practical, and cost-effective tax advice about which process to follow.

The purpose of the re-up is to increase management’s fully diluted shareholding, inevitably at the same time decreasing the shareholding of the external investors. This can be done in two ways:

  • Shrink the number of shares held by external investors; and / or
  • Increase the number held by management.

In each case, the re-up could be achieved by either a transfer between investors and management, or alternatively by a share buy-in or issue by SaaSco – eliminating or creating share capital.

So, simplistically, these are the tools at hand:

  • Management buy shares from the investors;
  • SaaSco buys in some of the investors’ shares;
  • SaaSco issues new shares to management.

In each case, the consideration for the shares results in a transfer of value, unless SaaSco was being re-built and demonstrably was worth near-zero. That’s one of the issues for the tax advisers.

An alternative to issuing or transferring actual shares is to use share options. The choice of whether to issue or transfer actual shares versus options is likely to come down to tax treatment and the costs of establishing an option scheme. There’s also an emotional angle: somehow, options just don’t feel as real as shares.

There are plenty of alternative mechanisms that could be used – different classes of shares, or ratchets that increase their effective share of the booty at different exit values are two examples. We like simplicity, so unless there’s a pressing need (tax problems, say) then we like to keep the cap table simple. That way everyone is shoulder to shoulder and the legal costs are less. That way, follow-on rounds are easier to negotiate.


Right, back to SaaSco.

Let’s say we value SaaSco at £4m pre-money and propose to invest £1m in ordinary shares. External investors already hold 60% of the company. The two founders, Adam and Eve, hold the balance.

What’s the effect on the founders?

SaaSco cap table without re-up

Hmmm. Adam and Eve matter a lot but, if we do this deal, then they’re already down to 19% each. And with a series A and subsequent rounds, and maybe a bunny-hop round in between, and dilution from an option pool… Well, soon they aren’t going to have a reason to turn up to work at SaaSco anymore.

So, let’s use the share buy-in mechanism to re-up the founders, and maybe we decide after long consideration that we want them to have the same stake after this round as before. Being lazy, let’s use Excel’s goal-seek to work out how much to buy-in: turns out we need to buy-in and cancel about 42% of the shares held by MotherShip and SpentUpAngel.

This is the result:

SaaSco cap table with re-up

For us, the new investor, there’s no direct advantage – we still end up with 20% of SaaSco. The founders are better off that the last scenario – they have raised £1m without dilution. The indirect advantage for us the new investor is that they still have a meaningful stake.

As for MotherShip and SpentUpAngel?

Well, that depends. Simplistically they traded a combined 52% of a nominally £4m pre-money valuation for a 32% stake in a £5m post-money company. That’s £2.1m reduced to £1.6m. A bad deal.

Of course, this assumes that the £4m pre-money valuation is a hard figure. In practice, it represents the potential of SaaSco assuming it gets financed, and assuming that management are pointing in the right direction. So, the real comparison might be against half of nothing.

In practice, whether MotherShip and SpentUpAngel agree to the terms depends on their assessment of the do-nothing option (say, is SaaSco running out of cash?), whether they accept that management’s stake is looking a bit skinny, and whether they have other offers with a better deal for them.

Exceptions to the rule

The re-up isn’t the right tool for every job. We already covered the cases where it gets used disingenuously just as a pricing argument. It’s worth also bearing in mind that the founder team maybe deserve to be diluted down to a small stake. Possibly they’re just not terribly competent. In that case, the investment is probably not going to work unless new management are being grafted on. To make that a success, room needs to be made in the cap table for the next generation of fearless leaders.


Management teams matter.

In early-stage businesses, equity is the primary incentivisation tool – so management need to feature large in the cap table. If they don’t it is a serious value drag, so the intelligent investor should hold on to their cash until management have been re-upped. And incumbent investors should be cognisant of the damage this can inflict on the value of a company – investment is about maximising returns, not maximising percentages.


David Smith

Partner, DSW Ventures

[1] For those born since 1995, this is a reference to analogue devices which used a magnetic-coated polymer film as media for recording and playing-back data, audio, and/or video. They were quaint and fun to use. There was a particular satisfaction in winding up spilled tape using a pencil.