5 ms·

Here's Why You Need A Liquidation Preference

32 points by rpledge 16y ago

sx 16y ago
I am an entrepreneur myself and I think an 1x liquidation preference makes sense. You cannot get X dollars at a 3X valuation and then turn around and sell the company for X keeping 2/3 of X and only giving 1/3 of X to the investor. I think what most people disagree with are the 2x and 3x liquidation preference terms that are not uncommon in term sheets. They are a very effective way, for the investors, to push the founders to a more risky / bigger potential path so that they can also make money. This works well in the context of the VC model (for the VCs).
metajack 16y ago
The plural of anecdote is not data. How many companies with exits with liquidation preferences didn't make the VCs money? How many without preferences didn't make the VCs money? How many involved the founders getting screwed because of these preferences? I don't object to the preference in general, but any multiplier greater than 1.0 is a red flag for me. You can find VCs that will do 1x preferences. I don't know what the options are for deals without preferences.
- cperciva 16y ago
  The plural of anecdote is not data. If you're a VC investing $50M in a company, you don't wait for data before trying to protect that investment. I don't object to the preference in general, but any multiplier greater than 1.0 is a red flag for me. Personally I think a preference of (1.1)^[# years since investment] would be more fair (otherwise founders can make money by simply investing in treasury bonds). But I don't plan on taking funding anyway, so it's a moot point.
  - deleted 16y ago
    [deleted]
- fredwilson 16y ago
  i agree 1x is right and fair
  - hubb 16y ago
    i don't know anything about investing, but why would VCs invest in a company if they only expect to just get their money back? can a VC investing a series C or D get more than just what they invested?
    - adw 16y ago
      If the valuation of the company is higher than the VCs invested at (post-money), then assuming something screwy isn't going on with the pref structures in earlier rounds - ie, there aren't any or they're 1x non-participating, plus the round you're investing in isn't a down round - then they will. Basically post-money valuation, exit price and pref structures are the only important numbers here. 1x non-participating means all investors get their money back, so as long as every round was an up round and the exit is above the last round post-money, everyone will do better by converting to common and taking their share rather than their pref right.
johnrob 16y ago
And investing in common stock when the founder controls the company and the exit is not a fair deal. Don't tell that to any employees of your portfolio companies.
- fredwilson 16y ago
  they don't invest cash they get paid a salary and get options on the upside
  - deleted 16y ago
    [deleted]
  - johnrob 16y ago
    Do they understand that? I think they believe those options are worth more than they really are.
    - frederickcook 16y ago
      Their stock is the same class as the founders. Everyone who had options in Slide also made money proportionate to Levchin, which is better than the investors did, who made nothing. (This assumes early, cheap options. Later ones may have lost money and be worthless.) The situation the OP is referring to is when the founder decides not to sell the company or IPO, or makes a poor decision about when. With the former, there is no liquidity and stock in a private company with no liquidity or profit sharing is pretty useless. If a company takes VC investment, it is basically committing to sell or IPO at some point (VC wants control to ensure this), ensuring the options will at some point be liquid. So, technically, having a VC with board control could be a good thing in some situations to ensure that the founder doesn't get any ideas about building a "lifestyle" company and that everyone gets a payday at some point.
      - tptacek 16y ago
        Preferences address the problem opposite to "lifestyle companies" (which, by the way, is a silly term). Preferences cover the case where the founder wants to ditch the company in a "cheap" acquisition instead of rolling the dice on the investment return the VC bought into.
shin_lao 16y ago
Can someone explain what a liquidation preference is?
- fnazeeri 16y ago
  Here's a post I wrote a while ago on how liquidation preferences work. http://www.altgate.com/blog/2008/05/how-liquidation.html http://www.altgate.com/blog/2008/05/how-liquidation.html
- angelbob 16y ago
  A liquidation preference, expressed as a multiple like 1x or 2x, says that the investor gets that multiple of their money back, before anybody else gets paid, on an exit (sale of the company, IPO, etc). Normally the LP is paid separately from the proceeds of common stock, so the investor also gets paid for the common stock, as well as the liquidation preference. So if the company gets sold for a small amount, the founder gets little or nothing but the investors don't lose money. If the company is sold for a large amount, the investors get an extra chunk but the founder still does very well.
  - adw 16y ago
    Depends if the prefs are participating or non-participating. Most of the rounds I've heard of recently here (UK, early stage) have been non-participating.
- ulf 16y ago
  It means that when an exit happens, investors can have different rights to how the money is distributed. Suppose you own a company and sell 50% of it to VC X for 1 Million Dollars (2M$ valuation). The VC gets a liquidation preference, which means they will get paid before you in an exit. If you sell for more than 2 million, that is no problem. But if you sell for less, the following happens: Suppose someone wants to buy you for 1.2M$, which you agree to because you feel like the business is a dead end. According to the shares, you and the VC should get 600K$ each. But since VC x has a liquidation preference, they get their money back. So you get just 200K$ as the found. Even worse if you sell for less than 1M$, in that case you walk away empty-handed...
charlesdm 16y ago
A liquidation preference of 1x seems fair. However, how common are deals where the liq pref is 2x or 3x?
- sabj 16y ago
  1x is fair as long as everyone knows what's going on and what is expected. Especially for later investments, when less risk might be expected. I don't know how common higher preferences are, but they often seem... more unsavory, shall we say.
bosch 16y ago
The tough part about being a first time entrepreneur is stock preferences and setting them up properly. You want to find a way that the future employees won't get screwed, but you also want to ensure that your company is an attractive investment opportunity for possible angels/vcs. From what I understand there's not really a good balance to keeping things equal unless one group gets shafted. Does anyone have any examples of how to setup the stock situation to benefit both employees and investors?

32 points by rpledge 16y ago

sx 16y ago

I am an entrepreneur myself and I think an 1x liquidation preference makes sense. You cannot get X dollars at a 3X valuation and then turn around and sell the company for X keeping 2/3 of X and only giving 1/3 of X to the investor. I think what most people disagree with are the 2x and 3x liquidation preference terms that are not uncommon in term sheets. They are a very effective way, for the investors, to push the founders to a more risky / bigger potential path so that they can also make money. This works well in the context of the VC model (for the VCs).

metajack 16y ago

The plural of anecdote is not data. How many companies with exits with liquidation preferences didn't make the VCs money? How many without preferences didn't make the VCs money? How many involved the founders getting screwed because of these preferences? I don't object to the preference in general, but any multiplier greater than 1.0 is a red flag for me. You can find VCs that will do 1x preferences. I don't know what the options are for deals without preferences.

cperciva 16y ago
The plural of anecdote is not data. If you're a VC investing $50M in a company, you don't wait for data before trying to protect that investment. I don't object to the preference in general, but any multiplier greater than 1.0 is a red flag for me. Personally I think a preference of (1.1)^[# years since investment] would be more fair (otherwise founders can make money by simply investing in treasury bonds). But I don't plan on taking funding anyway, so it's a moot point.
- deleted 16y ago
  [deleted]
fredwilson 16y ago
i agree 1x is right and fair
- hubb 16y ago
  i don't know anything about investing, but why would VCs invest in a company if they only expect to just get their money back? can a VC investing a series C or D get more than just what they invested?
  - adw 16y ago
    If the valuation of the company is higher than the VCs invested at (post-money), then assuming something screwy isn't going on with the pref structures in earlier rounds - ie, there aren't any or they're 1x non-participating, plus the round you're investing in isn't a down round - then they will. Basically post-money valuation, exit price and pref structures are the only important numbers here. 1x non-participating means all investors get their money back, so as long as every round was an up round and the exit is above the last round post-money, everyone will do better by converting to common and taking their share rather than their pref right.

johnrob 16y ago

And investing in common stock when the founder controls the company and the exit is not a fair deal. Don't tell that to any employees of your portfolio companies.

fredwilson 16y ago
they don't invest cash they get paid a salary and get options on the upside
- deleted 16y ago
  [deleted]
- johnrob 16y ago
  Do they understand that? I think they believe those options are worth more than they really are.
  - frederickcook 16y ago
    Their stock is the same class as the founders. Everyone who had options in Slide also made money proportionate to Levchin, which is better than the investors did, who made nothing. (This assumes early, cheap options. Later ones may have lost money and be worthless.) The situation the OP is referring to is when the founder decides not to sell the company or IPO, or makes a poor decision about when. With the former, there is no liquidity and stock in a private company with no liquidity or profit sharing is pretty useless. If a company takes VC investment, it is basically committing to sell or IPO at some point (VC wants control to ensure this), ensuring the options will at some point be liquid. So, technically, having a VC with board control could be a good thing in some situations to ensure that the founder doesn't get any ideas about building a "lifestyle" company and that everyone gets a payday at some point.
    - tptacek 16y ago
      Preferences address the problem opposite to "lifestyle companies" (which, by the way, is a silly term). Preferences cover the case where the founder wants to ditch the company in a "cheap" acquisition instead of rolling the dice on the investment return the VC bought into.

shin_lao 16y ago

Can someone explain what a liquidation preference is?

fnazeeri 16y ago
Here's a post I wrote a while ago on how liquidation preferences work. http://www.altgate.com/blog/2008/05/how-liquidation.html http://www.altgate.com/blog/2008/05/how-liquidation.html
angelbob 16y ago
A liquidation preference, expressed as a multiple like 1x or 2x, says that the investor gets that multiple of their money back, before anybody else gets paid, on an exit (sale of the company, IPO, etc). Normally the LP is paid separately from the proceeds of common stock, so the investor also gets paid for the common stock, as well as the liquidation preference. So if the company gets sold for a small amount, the founder gets little or nothing but the investors don't lose money. If the company is sold for a large amount, the investors get an extra chunk but the founder still does very well.
- adw 16y ago
  Depends if the prefs are participating or non-participating. Most of the rounds I've heard of recently here (UK, early stage) have been non-participating.
ulf 16y ago
It means that when an exit happens, investors can have different rights to how the money is distributed. Suppose you own a company and sell 50% of it to VC X for 1 Million Dollars (2M$ valuation). The VC gets a liquidation preference, which means they will get paid before you in an exit. If you sell for more than 2 million, that is no problem. But if you sell for less, the following happens: Suppose someone wants to buy you for 1.2M$, which you agree to because you feel like the business is a dead end. According to the shares, you and the VC should get 600K$ each. But since VC x has a liquidation preference, they get their money back. So you get just 200K$ as the found. Even worse if you sell for less than 1M$, in that case you walk away empty-handed...

charlesdm 16y ago

A liquidation preference of 1x seems fair. However, how common are deals where the liq pref is 2x or 3x?

sabj 16y ago
1x is fair as long as everyone knows what's going on and what is expected. Especially for later investments, when less risk might be expected. I don't know how common higher preferences are, but they often seem... more unsavory, shall we say.

bosch 16y ago

The tough part about being a first time entrepreneur is stock preferences and setting them up properly. You want to find a way that the future employees won't get screwed, but you also want to ensure that your company is an attractive investment opportunity for possible angels/vcs. From what I understand there's not really a good balance to keeping things equal unless one group gets shafted. Does anyone have any examples of how to setup the stock situation to benefit both employees and investors?