Entrepreneurs entering their first round of venture capital financing face many unknowns and hurdles. In fact, the Chief Counsel of one of Endeavor’s first entrepreneurs said, “not understanding this stuff – liquidation preferences, participation, etc – cost our team about $100M when we sold the company.”
To help entrepreneurs entering their first round of venture capital negations, Endeavor Insight has developed a Term Sheet Calculator. The interactive tool shows entrepreneurs how changes to critical parts of contracts can dramatically alter how entrepreneurs, investors and employees split shares of the company.
To further help entrepreneurs, Endeavor has featured a blog post by Brad Feld, a Venture Capitalist and Managing Director of Foundry Group, about liquidation preference.
I’ve written about liquidation preferences (and participating preferred) before, as have most of the other VC bloggers (and several entrepreneur bloggers.) However, for completeness, and since liquidation preferences are the second most important “economic term” (after price), Jason and I decided to write a post on it. Plus – if you read carefully – you might find some new and exciting super-secret VC tricks.
The liquidation preference determines how the pie is shared on a liquidity event. There are two components that make up what most people call the liquidation preference: the actual preference and participation. To be accurate, the term liquidation preference should only pertain to money returned to a particular series of the company’s stock ahead of other series of stock. Consider for instance the following 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).
This is the actual preference. In the language above, a certain multiple of the original investment per share is returned to the investor before the common stock receives any consideration. For many years, a “1x” liquidation preference was the standard. Starting in 2001, investors often increased this multiple, sometimes as high as 10x! (Note, that it is mostly back to 1x today.)
The next thing to consider is whether or not the investor shares are participating. Again, note that many people consider the term “liquidation preference” to refer to both the preference and the participation, if any. There are three varieties of participation: full participation, capped participation and non-participating.
Fully participating stock will share in the liquidation proceeds on a pro rata basis with common after payment of the liquidation preference. The provision normally looks like this:
Participation: 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.
Capped participation indicates that the stock will share in the liquidation proceeds on a pro rata basis until a certain multiple return is reached. Sample language is below.
Participation: 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.
One interesting thing to note in the section is the actually meaning of the multiple of the Original Purchase Price (the [X]). If the participation multiple is 3 (three times the Original Purchase Price), it would mean that the preferred would stop participation (on a per share basis) once 300% of its original purchase price was returned including any amounts paid out on the liquidation preference. This is not an additional 3x return, rather an addition 2x, assuming the liquidation preference were a 1 times money back return. Perhaps because of this correlation with the actual preference, the term liquidation preference has come to include both the preference and participation terms. If the series is not participating, it will not have a paragraph that looks like the ones above.
Liquidation preferences are usually easy to understand and assess when dealing with a series A term sheet. It gets much more complicated to understand what is going on as a company matures and sells additional series of equity as understanding how liquidation preferences work between the series is often mathematically (and structurally) challenging. As with many VC-related issues, the approach to liquidation preferences among multiple series of stock varies (and is often overly complex for no apparent reason.) There are two primary approaches: (1) The follow-on investors will stack their preferences on top of each other: series B gets its preference first, then series A or (2) The series are equivalent in status (called pari passu – one of the few latin terms lawyers understand) so that series A and B share pro-ratably until the preferences are returned. Determining which approach to use is a black art which is influenced by the relative negotiating power of the investors involved, ability of the company to go elsewhere for additional financing, economic dynamics of the existing capital structure, and the phase of the moon.
Most professional, reasonable investors will not want to gouge a company with excessive liquidation preferences. The greater the liquidation preference ahead of management and employees, the lower the potential value of the management / employee equity. There’s a fine balance here and each case is situation specific, but a rational investor will want a combination of “the best price” while insuring “maximum motivation” of management and employees. Obviously what happens in the end is a negotiation and depends on the stage of the company, bargaining strength, and existing capital structure, but in general most companies and their investors will reach a reasonable compromise regarding these provisions. Note that investors get either the liquidation preference and participation amounts (if any) or what they would get on a fully converted common holding, at their election; they do not get both (although in the fully participating case, the participation amount is equal to the fully converted common holding amount.)
Since we’ve been talking about liquidation preferences, it’s important to define what a “liquidation” event is. Often, entrepreneurs think of a liquidation as simply a “bad” event – such as a bankruptcy or a wind down. In VC-speak, a liquidation is actually tied to a “liquidity event” where the shareholders receive proceeds for their equity in a company, including mergers, acquisitions, or a change of control of the company. As a result, the liquidation preference section determines allocation of proceeds in both good times and bad. Standard language looks like this:
A merger, acquisition, sale of voting control or sale of substantially all of the assets of the Company in which the shareholders of the Company do not own a majority of the outstanding shares of the surviving corporation shall be deemed to be a liquidation.
Ironically, lawyers don’t necessary agree on a standard definition of the phrase “liquidity event.” Jason once had an entertaining (and unenjoyable) debate during a guest lecture he gave at his alma mater law school with a partner from a major Chicago law firm (who was teaching a venture class that semester) that claimed an initial public offering should be considered a liquidation event. His theory was that an IPO was the same as a merger, that the company was going away, and thus the investors should get their proceeds. Even if such a theory would be accepted by an investment banker who would be willing to take the company public (no chance in our opinion), it makes no sense as an IPO is simply another funding event for the company, not a liquidation of the company. However, in most IPO scenarios, the VCs “preferred stock” is converted to common stock as part of the IPO, eliminating the issue around a liquidity event in the first place.