Venture Terms - Liquidation Preferences and Participation
The Wizard was out of town on vacation and what the Wizard learned on vacation is that the family makes no distinction between the evils of working or blogging on vacation. I'm back with a series of posts I wrote on the plane(s) based on assorted emails I've received.
First up, another important term in a venture financing term sheet, the liquidation preference. This section of a venture term sheet essentially defines how much money the people financing this round will have the right to pull out of the company on an exit before anybody else gets anything. Once again, Brad Feld has written an extensive and thorough post on liquidation preference, so I won't retrack all that ground here. Rather, I'll dive right into some of the key thoughts and distinctions and assume that you'll do the work of reading Brad's post first, or after this, or sometime.
I like FAQ's, and I got a lot of Liquidation Preference questions, so let's do this as a FAQ.
What is the liquidation preference?
Already with the questions that are answered in Brad's post? The liquidation preference simply (or complexfully) defines the money that will be returned to a particular series of the company's stock before the holders of any other series of stock. The Series A term sheet, for example, (always a good example because it's the easiest!) will define how the series A preferred shareholders will/can be paid before the holders of the common stock.
What the hell does the liquidation preference section really mean?
Here's what's going on. What your investors are doing here is making sure they get paid out on a subpar exit. Let's say you raise series A 5 million at 5 pre for a 10 post and then sell the company for 8 a year later and through the magic of simple examples, you never vested any options so the series A owns 50% of the company in preferred stock and the common owns 50% of the company in common. On the 8 exit, your investors have to be able to turn around and look their investors in the eye and NOT say "we lost a million bucks but the founder made 4 million" because that would "suck" and nobody would invest in their fund again. The liquidation preference defines the order and quantity in which an exit is paid out. The investors with a "liquidation preference" get paid first AS DEFINIED IN THIS SECTION, and then others are paid out.
Liquidation is bad. That means something happened that i didn't want to happen and we went bankrupt, so if I am a confident entrepreneur, I don't need to pay attention to this section, right?
Well, that was more of a rhetorical question, but no, that's not correct. This section defines how the moneys are going to get doled out on almost any kind of non-ipo exit, good or bad. Pay careful attention.
What's the difference between liquidation preference, participating preferred, capped participation, and a preference multiple?
I was afraid you would ask that. Let's see if I can really boil this down with examples. Here's sample language for a liquidation preference section of a term sheet that's about as vanilla and entrepreneur friendly as you could want. Maybe you'd like to start with the question "what does a vanilla liquidation preference section look like?"
Sure, I'll start with that. Uh, what's some sample language?
Great. Here's a very pro-entrepreneur liquidation preference language on a Series A term sheet.
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 1x the original purchase price plus any declared but unpaid dividends (the “Liquidation Preference”).
After the payment of the Liquidation Preference to the holders of the Series A Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock.
Upon any liquidation or deemed liquidation or Fundamental Change (as defined in the articles of incorporation, as mutually agreed in the negotiation of the definitive documentation), holder of the Series A Preferred shall be entitled to receive the greater of (i) the amount they would have received pursuant to the prior sentence, or (ii) the amount they would have received in the event of conversion of the Series A Preferred to Common Stock [with some blah blah blah exceptions].
This is what you would call your straight 1x non-participating liquidation preference section. What this section is saying is that when there's an exit, the series A investors can choose to EITHER just take their investment out before anybody else gets anything (but only their original investment) OR convert to common and share in the proceeds pro-rata with everybody else. It doesn't really get any more pro-entrepreneur than this. If you get this language in a term sheet, good for you. It will depend entirely on how much you've accomplished, the economic climate, what round you're raising, the demand for the deal, etc. Chances are very good you won't see this language on a Series A term sheet for a new venture run by founders without a track record or insufficient demand for the round. Don't stress, it's not the end of the world.
So, what's a preference multiple?
Well, you see that 1x in the pro-entrepreneur language above? That might say 2x or 3x and that would mean your Series A investor have a 2x or 3x preference multiple on an exit. Let's say you raise 2 on 3 pre for a 5 post-money, but the liquidation preference is a 3x multiple. Although the investors own 40% and the common 60% (again assuming no vested options....options are like friction in physics examples....the math is so much easier without them), on a 10 million exit, do you think the Series A investors are going to want to convert to common and share pro-rata or do you think they'll just take their 3x preference multple thanks. The math is easy - they take their multiple and get 6 million instead of 4.
What's the concept behind a preference multiple?
Your investors put two million into your company on month 1, and you have so far put in no million but have come up with something that can attract 2 million at 3 pre. Good for you. A month goes by and somebody offers you 4 million for the company. You've only been working 2 months. No preference multiple? you get 2.4 million and your investor loses 1.6. But wait! you say, couldn't the investor just block the sale? Sure, the investor will have a blocking right. Ask most investors how they feel about blocking a deal when the entrepreneur or management team all say "time to sell!".
Can I negotiate a preference multiple out?
Go for it. As I've said before, too many entrepreneurs focus on valuation at the expense of everything else, and I would strongly encourage that you pay careful attention and energy on the liquidation preference and run through multiple scenarios to see what different outcomes entail.
Are you going to talk about particpating preferred? Did you already talk about it but in such a ponderous manner that we slept through it?
Participation, or the Double Dip as Fred Wilson likes to call it. Let's say instead of the language in the second paragraph in my example above where we saw "After the payment of the Liquidation Preference to the holders of the Series A Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock.", in term sheets with participating preferred, you'll see:
"After the payment of the Liquidation Preference to the holders of the Series A Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock and the Series A Preferred on a common equivalent basis.
See what's going on here? In a term sheet with participating preferred, the Series A investor doesn't need to decide if they want their preference or to convert to common and participate pro-rata. They do both. Some smart folks realize that participating preferred (aka participation) is only really fair at smaller exit values where the clause is in there to protect the investor and if the company does very well, the investor shoudn't participate inequitably. That leads you to your next question, right?
Um, what were we talking about again? I was just watching Escape from Witch Mountain on TBS
Right. Enter capped participation. Essentially "participating preferred up to a point". Again, I lift language freely from Brad Feld's liquidation preference post and include his example here:
After the payment of the Liquidation Preference to the holders of the Series A Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock and the Series A Preferred on a common equivalent basis; provided that the holders of Series A Preferred will stop participating once they have received a total liquidation amount per share equal to [X] times the Original Purchase Price, plus any declared but unpaid dividends. Thereafter, the remaining assets shall be distributed ratably to the holders of the Common Stock.
You see how these variations on the theme can have very different meanings but start to look very much alike.
This is a great overview, but what do i care about?
You should run multiple scenarios on your liquidation preference language that help you see who gets what in different exit scenarios. Rest assured on an A round that you are likely to see strong investor preferences (some multiple or participation) and you may or may not be able to negotiate them away, but you can certainly try different angles. Everybody should be comfortable with a cap on participation, for example. Remember that you should never take "we always do it this way" as a valid answer to any of your questions or negotiations. Everything is negotiable. The valuation is under pressure? Maybe you agree to that if the liquidation preference changes. Maybe you take a term sheet with a lower pre-money valuation but more favorable liquidation preference language.
Well, sure, there are always gotchas. For example, when the language states that the investors can choose to convert their series A preferred to common, you want to check the Conversion section of the term sheet and make sure that conversion looks something like:
The holders of the Preferred Stock shall have the right to convert the Preferred Stock into shares of Common Stock. The initial conversion rate shall be 1:1, subject to [blah blah blah]
....and of course you should always watch out for "blah blah blahs" in the language.
As always, I've left out a bunch of stuff but the post is already five times longer than I'd originally intended.