The goal of this post is to shed some light on one of the most important economic terms in the negotiation between a startup founder and their investor: liquidation preferences. The implications of this key term seem often not well understood, while it can have a real impact on how much startup shares and (early) employee options are really worth.
Raising outside capital is a key way for entrepreneurs to finance the growth of their business. Investors are offered shares in the company in exchange for $$ at a certain valuation. Simple, right?
Right. Well.. additionally, investors typically negotiate: (1) Control rights (e.g. board seat, blocking rights on certain purchases, …)
(2) Economic rights (blocking rights on sale, liquidation preferences, …).
The way this is achieved is by offering investors shares with different rights than the founders/employees. The investor shares are referred to as “preferred stock”, while the stock owned by founders is typically referred to as “common stock”. Employees typically are offered options on common stock.
It’s important to understand that all these elements are simultaneously negotiated, and that there are often trade-offs between them. Understanding every aspect of the negotiation is therefore important for entrepreneurs. First-time entrepreneurs are often at a significant disadvantage here as they are still learning about certain aspects of this transaction, while investors typically go through these negotiations multiple times each year. As a consequence, in my experience, many (first-time) entrepreneurs over-index on negotiating the easier-to-understand elements such as valuation/price and under-index on negotiating other key terms during fundraising processes.
A simple example to illustrate the impact of a 1x or 2x liquidation preference
Let’s consider a simple example:
ABC Inc. raises $4 million
SweetDeal VC obtains 40% of the shares > Post-money valuation is thus $10 million ($4M / 0.4 ) > Pre-money valuation is thus $6 million (post-money valuation - $4M)
15% of company is for employee option pool
Founders own 45%
Let’s call this event a “Series A” financing.
Furthermore, the VC's term sheet contains a section, with the following liquidation preference language:
Liquidation Preference: In the event of any liquidation or winding up of the Company, the holders of the Series A Preferred shall be entitled to receive in preference to the holders of the Common Stock a per share amount equal to [x] the Original Purchase Price plus any declared but unpaid dividends (the Liquidation Preference).
For early-stage financing, x = 1 is common and what you should probably aim for (typically referred to as a "1x liquidation preference"). For later-stage financings, x can range from 1 to as high as 3 or 4. What does this mean in practice? To keep things simple, we’ll consider an “exit” scenario (liquidation) in which the company is sold for an amount in cash, which we’ll call the exit price. In layman’s terms, a liquidation preference of [x] means that SweetDeal VC gets at least [x] times $4 million before anyone else gets paid in an exit scenario.
Some examples for x = 1 in case of an exit: who gets what?
Exit price = $ 2 million > SweetDeal VC gets $ 2 million (or 100% of exit price) > Founders get $0 (or 0% of exit price) > Employees get $0 (or 0% of exit price)
Exit price = $ 8 million dollars > SweetDeal VC gets $4 million (or 50% of exit price) > Founders get $3 million (or 37.5% of exit price) > Employees get $1 million (or 12.5% of exit price)
Exit price = $ 20 million dollars > SweetDeal VC gets $8 million (or 40% of exit price) > Founders get $9 million (or 55% of exit price) > Employees get $3 million (or 15% of exit price)
More generally, the plot below illustrates the payouts on the y-axis for the different stakeholders as a function of the different exit prices on the horizontal axis for a liquidation preference where x = 1.
Note that even though founders and employees own 55% on paper, SweetDeal VC takes home more than them for “low” exit prices. Founders and employees only really get 55% of the exit value in case the exit price is higher than the valuation. Have a look at the google sheet if you want to ensure you understand the way this is calculated.
For fun, let’s look at the pay-outs assuming the scenario above with a 2x liquidation preference:
Entrepreneurial psychology versus outcome reality
As the graphs and examples have shown above, the pay-outs for entrepreneurs and employees change in perhaps unexpected ways after the imaginary series A financing. The psychology of the entrepreneur is often to be very optimistic about the future. Therefore, considerations like liquidation preferences often don’t get the attention they may deserve. While “optimism is a moral duty” is the credo of many entrepreneurs, knowing thy data will make you a smarter entrepreneur and more cautious in the fundraising process. The reality is that most startups do stall or fail at some point.
If you take this knowledge into account, you can demonstrate that the expected value of shares of the different stakeholders can be quite different from the simple ownership percentage. To illustrate that, let’s consider the following expectations on the future for ABC Inc.: right after the fundraising process, you think there’s a…
10% chance of total failure
40% chance of an exit at $6 million
20% chance of an exit at $10 million
30% chance of an exit at $20 million
In this example, the expected value of an exit is $10.4M (10% x $0 + 40% x $6M + … ), slightly higher than the post-money valuation of the company. With an x=1 liquidation preference, the payout for SweetDeal VC is 46.15% even though their ownership is only 40%, and for a 2x liquidation preference, their expected share of the outcome becomes a whopping 61.54%. Have a look at the second tab in the google sheet for the calculations.
This example serves as a reminder that in the face of liquidation preferences, your ownership percentage can be very different from your expected payout percentage. That’s not a problem per se, as long as everyone is aware of the terms of a financing deal (which is certainly not always the case).
Incentive misalignment with angel investors, VCs, Growth and Private Equity firms
Liquidation preferences can also create subtle and sometimes not-so-subtle forms of misalignment between investors and entrepreneurs.
Determination of the “right” amount to raise
During the fundraising process, the entrepreneur and investor typically jointly decide on the amount of money that gets invested into the company. Given that a liquidation preference protects the investor better in mediocre outcome scenarios (i.e. they will get x times their money back first) and that investors want sufficient ownership in the case of the great outcomes, investors often push founders to accept more money than companies really need at that stage. From the founders perspective, it is important to realize that the additional investment amount will affect their pay-out in mediocre exit scenarios more than the percentage of additional dilution. For employees, the dynamic is similar but it can be particularly dangerous for them, as founders are typically in a better negotiating position in exit scenarios. Obviously, there are other factors influencing the “right” amount to raise. Raising more money typically also correlates with the company taking on more risk. VCs are generally more willing to take on more risk as they have a portfolio of companies while founders put all their eggs in one basket. Liquidation preferences just increase this already existing misalignment.
At the time of this writing (2019), interest rates are extremely low and there’s certainly no shortage of money in the system. In my opinion, these market conditions in combination with the factors discussed above, have pushed many startups to raise more money than they may need from the perspective of common shareholders (founders / employees).
Board structure and liquidation preferences
The board structure of a startup will often determine to what extent the problem of misaligned incentives is exacerbated. As long as the company is doing well and the board is founder controlled or balanced between founders and investors by independents, liquidation preferences can often be kept to a minimum to avoid too much misalignment. That said, when companies end up in (financial) trouble or the board is controlled by investors, deliberate and (sometimes) justifiable attempts can be made to change the pay-out structure. This is not a problem in itself as long as all stakeholders understand what’s going on. The latter, however, is often not the case.
Conclusion
This post focused on explaining startup share value for 2 types of startup equity: common stock (owned by founders/employees) and preferred stock (owned by investors). We explained the importance liquidation preferences have in thinking about exit scenarios and touched upon the ways in which they can create misalignment of incentives between investors and entrepreneurs. Note that this post was written at a time when low interest rates and the abundance of money have enabled many entrepreneurs to negotiate relatively clean terms. Therefore, I deliberately did not talk about impactful terms such as participating preferred that used to be fairly standard in a distant past.
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P.S. Here are some good links to learn more about this topic: