Liquidation Preferences are commonly misunderstood by first-time entrepreneurs. The problem is an investment may seem inexpensive up front, but devastatingly bad for the founders in the end.
Here’s why. Let’s say you are trying to raise $2MM in capital. You get two offers, and one values your company at $3MM, pre-money, and the other $6MM pre-money, and they give you $3MM That’s great, you think; offer #2 values my way company higher, so it’s the better deal; the investor must be smarter, and understand the business opportunity better. You’re probably right, they do. Everyone likes control, and the entrepreneur kept more of it. Of course, there’s a requirement to set aside 20% of the company for an ESOP, but that’s not an issue right yet, at least, not for the purposes of this article. In short, you set aside 20% of your shares for employees.
Offer #1 is for $2MM, with a 1x preference, but offer #2 had a 3x preference attached. While offer #2 is better up front, it will cost you a lot more on exit. Or any other liquidity event. The deal gets done, and options are distributed. The company capitalization table looks like this:
46% – Founders
33% – Investor
20% – Employees (ESOP)
Let’s say that two years on, the company is sold for $10 million. It’s done alright, but by no means is it a home run. Still, everyone should be walking away happy, correct? Maybe not. At first, you would think the processed get divided up like this: Founders 46% = $ 4.6MM; Investors $3.3MM; ESOP $2MM. Looks good for everyone, right? In two years the investor gained $1.3MM.
Unfortunately, that is not how it looks. The investor had a 3x preference. Now that becomes important.
If the investor (the preferred stockholder) had a 3X Liquidation Preference Participating Shares, they would receive 3X their investment, or $9MM before any Common Stock is paid in an acquisition. That leaves $1MM to divide up, instead of $10MM. Then, because their shares are participating, they would receive 33% of the remaining proceeds. This changes the picture considerably. Now, the investor would have a $9.33MM return, instead of the $3.33MM their ownership percentage entitled them to. The Employees get $200,000, and the founder walks away with $460,000, or 4.6%.
The deal doesn’t look so great in hindsight does it?
Normal Liquidation Preference Terms
The standard Liquidation Preference is 1X in most VC deals I’ve seen. When you are seeking funding, the investor holds the key; you need the money. They will argue it makes absolute sense, as investors expect to receive their investment dollars back before employees and founders are rewarded for creating value. On a first round of funding, we agree. Once the company is cash flow positive, or multiple parties are seeking to get in on a good thing, there’s no need to give anything up.
If the prior case, if the founders did the financing at the 1x, without participation rights, then the outcome would have been different. In this case the Investor would have received their 33% first, so $3.3MM, and that’s it. The founder and employees would divide up the rest, and everyone would walk away happy.
Very often, VC’s get a 1x preference with participation rights. In this case they would get $3.3MM for their preference, and then 33%, or $2.2MM of the remaining $6.6MM. They would get $5.5MM for a $2MM investment. The founder would get $2.85MM, and the employees would divide up $1.7MM.
That’s still a great return for the investor, and not many people would get mad about $2.85MM for two year’s work!
Why Investors Need Liquidation Preferences?
Almost every investor will value their cash over the entrepreneur’s sweat-equity investment. As an entrepreneur, I found this insulting sometimes. But, when you are building a business and need the cash, you have to deal with it. The investors look for a Liquidation Preference on their shares makes absolute sense when things go sideways. Using the scenario outlined above, let us presume the business didn’t grow, and a competitor is eating up market share. You’ve now got offers on the table for $4MM for your business, and everyone knows the business is the walking dead. You have to take the deal.
This is where the investor’s preference is so important. They get their investment back, so $3MM. You as the entrepreneur, and your team walk away with very little, but you get something. Think of the preference as insurance. The investor gets insurance in case things go sideways, and you as the entrepreneur only pay for it in arrears, when the company sells.
Preference Terms to Negotiate
A 1X preference is insurance in case things go wrong. Any institutional investor is representing a group of investors or Limited Partners, and part of their responsibility to those parties is to secure the investments as best possible. The stronger your opportunity though, the more varied your options. The investor may ask for a 2x preference; 3x; 4x and full participation rights. That’s sounds greedy, but some will ask to test the entrepreneur’s acumen.
A 1X preference with participation rights basically means the investor is protecting their investment, and participating in the gain. It’s pretty common. I have seen deals with all sorts of variances. As the entrepreneur who is convinced they are sitting on a gold mine, you may try to vary the terms: a 2x preference with no participation rights? This would mean the investor will double their money, but no more, if you are successful. It’s possible…
As an FYI, when a company is very successful and goes public, preferred shares convert to common shares, and lose their preference rights; You may be able to negotiate alternate scenarios under which this could happen. It’s all part of the deal the investor and entrepreneur strike.
Remember, the deal you make probably will never be re-negotiated, unless it is in both parties’ interest.