Startup 125: Term Sheet – Liquidation Preferences
May 27, 2009 by Joseph Ansanelli
Filed under Execution, Recent, Startups, Term Sheet
This is the second post in a series attempting to demystify venture capital term sheets. If you have not read the first post about Valuation, you can find it here.
Talking Stock
As mentioned in the previous post, a venture capital term sheet is a letter of intent that outlines a potential investment in a startup. The first and usually most debated item is the valuation as it has the largest effect on the dilution or amount of ownership you give up in order to receive funding. Once you agree on valuation (while keeping in mind the option pool twist), it’s important to understand what you have actually sold.
As in the public stock markets, you are basically selling shares of ownership. In the case of a traditional venture capital investment, each “round” or time you raise venture funding is typically referred to as a “series” and labeled alphabetically. A first round is typically referred to as a Series A, and subsequent rounds as B, C, D and so on.
Additionally, the shares sold to investors are “preferred stock” as compared to what is called “common stock”. Common stock is what founders and employees receive. Preferred stock is given to investors as a result of providing large sums of capital and they therefore receive various preferences over the common stock holders. These preferences include liquidation, dividends, unique voting rights, veto rights, and various other protections that will be discussed in future posts.
In exchange for the additional preferences, the price per share of preferred stock is typically greater than that of common stock. This lower price is why founders and employees can typically purchase shares in an early stage company for pennies per share. The price differential is changing somewhat with new accounting rules but more on that in a future post.
This post will review Liquidation Preferences, which are potentially the most dilutive preference to the common shareholders after the valuation and option pool size.
Liquidation Preferences – What’s the big idea?
Liquidation Preferences sound like a preference for who has the right to drink from the water cooler first. And metaphorically, that is correct. Liquidation preferences provide that upon a sale of the company, the preferred shareholders are paid before the common shareholders are paid anything. In other words, they drink first from the proceeds from a sale of the company.
The simplest and most desirable liquidation preference for founders and startup CEOs is an amount equal to the amount invested, also know as a “1X Liquidation Preference”. This preference basically says that the investors get their money back before anyone else. That is of course assuming there are no creditors.
Let’s go back to the example from the first post on Valuation. In that example, Series A preferred shareholders paid $4 million to invest in the company. In the case of a 1X liquidation preference, the preferred shareholders would receive their $4 million before any of the common shareholders receive any payment for their ownership.
If for example, the company is sold for $5 million, the preferred shareholders would receive $4 million first and the remaining $1 million would be split across the common shareholders – even though the common shareholders may own a greater percentage of the company.
Let’s look at an example of what would happen if the same company is sold for $50 million. An additional right of preferred shareholders is that they can convert their stock to common stock at any time. In this example, it is more beneficial to convert their preferred shares to common. Instead of simply being paid back their $4 million, they would convert their shares to common stock and instead receive their 40% ownership portion of $50 million for a total of $20 million (assuming all the option pool shares have been issued).
What’s the twist?
This seems and is actually a pretty reasonable right. The investors put up the money, which was presumably used to pay out salaries to the team, and therefore the investors should at least get their money back first. And generally, a straight 1X Liquidation preference is what I advise founders or startup CEOs to accept.
However, there are two Liquidation Preference twists for which to watch. The first is a multiple greater than 1X and the second is called “participating preferred”.
First Twist
Sometimes investors will ask for a multiple greater than 1, for example a 3X Liquidation preference. In our example, this means, that investors would get $12 million of any company sale before any of the common shareholders. Therefore, this is dilutive to the common shareholders for any sale of the company for less than $30 million as that is when it is beneficial for the preferred shareholders to convert their stock to common and participate based on their ownership. The basic math being 40% of $30 million equaling $12 million, which is 3 times, the amount invested in the series A.
Often times this will be used in the case that investors want to ensure that the founders and startup CEOs are incented to focus on long term value creation versus “flipping the company” for a smaller amount earlier. It is also commonly used in later rounds of financing where the valuation has increased significantly and the investors in those rounds want to ensure some level of return.
In general, it is beneficial to have all the preferred shareholders use the same 1X liquidation preference especially since investors typically have preferred voting and veto rights for a potential company sale that will be discussed in a later post.
Second Twist
The second twist for liquidity preferences is called “participating preferred”. This right allows that investors not only get paid their liquidation preference multiple but then can also participate in the payout of what’s left as if they had converted to common stock. That’s right, they get their liquidation preference multiple such as a 1 or 2X liquidation preference and then also participate on an “as converted basis”.
This is referred to as double dipping since they participate as preferred shares and also as if they converted to common stock. This is very dilutive since it means that effectively the preferred investors get a share much greater than their actual ownership. If investors insist on this, it is common that there is a price for the sale of the company at which this right goes away, for example a sale of the company for $100 million or more. Yet I strongly encourage that participating preferred should be negotiated out and avoided whenever possible.
Keeping It Simple
One of the reasons many term sheets today are 1X liquidation preferences with no participating preferred is because investors in early rounds of funding, are often not the primary investors in future rounds. And as a result, if a Series A investor gets aggressive liquidation preferences, then future investors will ask for the same if not even more aggressive terms which may ultimately hurt the early stage investors in addition to the common shareholders.
Therefore it’s best to keep it simple and have all preferred shareholders with a 1X liquidation preference and to be treated equally regardless of when they invested. The concept that all preferred shareholders have the same right is a legal term referred to as pari passu. If you can negotiate a 1X Liquidation Preference, with NO participating preferred and treat every Series on a pari passu basis, you are getting very reasonable terms. And as mentioned in the last post, the way to ensure reasonable terms is to have multiple potential options for investment. The more bidders you have, the more clean your term sheet will be. Stay tuned for the next post on Anti Dilution Provisions and Dividends.
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UPDATE: Continue reading the next post Startup 126 – Term Sheet Anti-Dilution
Other links and references
Startup 124: The Term Sheet – Valuation and Dilution
Download sample Term Sheet from National Venture Capital Association
Drop In Dime Photo by Chaval Brasil
Great post, keep ‘em coming
Glad you like and thanks. More to come…
Very helpful. As you continue this thread I’d also love to hear your thoughts on founder and employee option pools – e.g. ranges for key positions.
In general, the size of the option pool is best decided by putting together a budget for the next 12-24 months (roughly until you think you will need another round of funding) with all the people you need to hire and estimates for each person’s options.
Send me a note if you have a specific question about a position and I can do my best to give some guidance.
What type of language would we see in the term sheet or LLC agreement if the first and second twist was being proposed? Would it actually say “participating preferred” and “3x liquidation preference? Or, would they use other more subtle language we may not know, recognize or understand?
Thank you. Your posts are very educational.
For full participating preferred you will usually see language similar to this:
“First pay [X] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred. Thereafter, the Series A Preferred participates with the Common Stock pro rata on an as-converted basis.”
You will see the multiple in place of the X and you the second sentence describes “participating preferred”. Does that help? There is a link above to a sample VC term sheet you can download to see more of the language.
Clear, concise, to the point. Good job! Keep ‘em coming.
I suggest that you do both a service and a disservice to your readers in discussing this subject. Defining what a liquidation preference (1X or otherwise) and participating preferred is the service…..many entrepreneurs are unfamiliar with those terms and concepts. Where you lapse into disservice is as you begin to suggest which are “bad” and which are “good” for the entrepreneur. Reverting to my long ago mathematics training, liquidation preference and participating preferred structures are nothing but mathematical functions for deciding who gets what under different sets of outcomes, just like straight percentage ownership is. To wit, with straight percentage ownership, all parties know they get X% of proceeds, whatever the proceeds are. Similarly, under these other structures (“functions”), each party knows what it can expect to receive, whatever the proceeds are….its just that the percentage they receive varies depending on the size of the outcome. It is no more, or less, determinable or mysterious. You seem to suggest that entrepreneurs avoid situations where there’s a participating preferred or a greater than one times preference multiple. But answer me this: Is it clear that an entrepreneur should select a financing proposal which comes with a 20% straight ownership percentage vs. a proposal for the same amount of money that proposes a participating preferred with a 10% residual percentage ownership? The answer lies in each party’s analysis of the range of probable exits, how they balance risk and return and where their quotient of optimism vs. pessimism pans out. Structures like participating preferreds and liquidation preferences simply provide more tools and flexibility to arrive at a suitable middle ground between parties that quite naturally have different agendas and perspectives….the entrepreneurs and financiers. I.e. they reduce the negotiation friction thereby leading to the consummation of more deals. By contrast, assigning “good/bad” tags does just the opposite.
Steve – thanks for the note and thoughts.
in general, i think there is a difference in a good and bad term sheet and it is important to try and normalize them as much as possible so that they look and act as much like a straight ownership % model as you mentioned.
when there are lots of different terms which provide a greater percentage return than that of one’s ownership, that is, in my opinion “bad” because it simply complicates things. Now as an investor you might see that differently, but i believe in the principle of keeping things simple and when term sheets start to have multiples on liquidation preferences, and participating prefferred that is certainly not keeping things simple.
And having complicated preferences creates a greater “negotiation friction” than keeping things simple.
If investors and entrepreneurs have different agendas, then they should not work together. Investors should not invest and entrepreneurs should not take investors money.
Ultimately, I believe that good investors and entrepreneurs always have the same agenda which is to make a company as wildly successful as possible whereby maximizing the return to all shareholders.
Thanks for reading and sharing your thoughts.
joseph
Again, I disagree that with the notion that one size fits all. The most fundamental “disagreement” between buyers and sellers & investors and entrepreneurs is the bid/ask on the price (or valuation). Liquidation preferences and participating features can be quite helpful in moving away from the “black and white” of getting one party or the other to bend to the other’s position. They provide plenty of gradations which can be manipulated to more easily make each party comfortable. Simple is a laudable goal, but it’s not the only one, nor necessarily the preeminent one. If it was, all investments would be in the form of common stock.
Steve Harris
Managing Princial, MidCoast Capital
i had a feeling you would disagree!
In all seriousness, preferred stock has its place and a model of common stock investing is not what is being advocated. However, there are term sheets that obscure what as you say is the valuation. For example, an investor may own X% of a company, but through the use of liquidation preferences, participating preferred and other terms, the valuation and ownership do not correlate with how a layout occurs.
For example, if a series A investor owns 40% of a company at a $10M post money valuation which gets an acquisition offer for $150M, if there is a liquidation preference of 5x and participating preferred, they effectively own 48% of the company based on how much they are paid out.
That is still pretty “black and white” with respect to the outcome but it is an obscure way for investors to achieve a greater share than their ownership stake.
I simply suggest that ultimately everyone should be focused on the long term goal and that a simpler structure tends to make that easier.
At the end of the day, most venture investors make the lion share of their returns on their straight ownership stake in their most successful companies and not based on liquidation preferences which are designed to protect them in case of a mediocre outcome. Some protection is reasonable, but there are terms which don’t serve the companies long term interest.
Thank You Joseph!
This is extremely educational and to the point!