The Liquidity Preference Question

Suzanne Dingwell Williams has a posting up about Liquidity Preferences and if you, the start up, can negotiate them away.  

While she added the "more later" part to the posting, I wanted to comment on a couple of things from my perspective as a VC. Suzanne is a top flight lawyer running a practice in Toronto which is dedicated to sitting on your side of the table.  As you might expect, we have some different views on these things. 

Suzanne makes the following observation:

"Are you likely to negotiate away a liquidation preference? No, unless you have a very solid track record for successful startups. VCs must have a floor that will guarantee some minimum return on investment."

There are some things worth noting, the first being language.

Common Share Deal. This is a transaction where I write a check to the company and they issue me shares. Simple.  Do VCs do these types of deals?  Yes, I've done them.  They are my favorite because all the shareholders are treated the same with respect to being shareholders. We all sign up to the same agreement, etc, etc.

Preferred Shares.  The simple English on this is that this is a different class of shares with rights and privileges different than the common shares. Pref shares, as they are called, can have a different redemption structure vs. the common shares.  There are many other things can be associated with pref shares but for purposes of this discussion, we can stay with the financial (liquidity) point.

The simple example you can consider is this:

I buy 20% of your company for 5 million dollars in preferred shares.  A 'simple' preference model would be something along the lines of I get my money back or I convert to common and share in the proceeds along with everybody else based upon my ownership proportion.  This means that if the company is sold for 6 million dollars, I will take my 5 million dollars back and everybody else splits the remaining 1 million dollars.  If the company is sold for 30 million dollars, I convert and take my share of the proceeds.

The above example is sometimes referred to 1x non-participating preferred share.  All that mumbo jumbo means is that I either get my money back or convert into commons and take my share but not both.

Another example of a Participating Pref Share is this:

Same 20% for 5 million transaction. This time, tho, the shares call for a 'participation' which can have a meaningful impact on who gets what.  Using the same math as above, if the company is sold for 6 million dollars, under a participating preferred share, I would get my 5 million back and then the remaining 1 million would be split among all shareholders including me.  Hence the reason for the term participation.  This example is also what is known as a double dip because the investor is dipping into the proceeds twice.

In other cases you will see 2x or 3x liquidation preferences with or without participation attached.  In a 2x participating share, using the above example, if the company was sold for 10 million, all of it would go to the investors.

So, to Suzanne's negotiation point.  Part of the problem is that people tend to view the valuation a VC places on a business as some kind of single commentary on the opportunity just by itself.  This isn't true.  Valuation is a mixture of many things, including calculation of risk, share structure, stage of the company, etc, etc.

Just looking at valuation without factoring all these things is a mistake just like ignoring financial terms/share structure and loving that 50 million dollar pre-money value is equally a mistake. Never mind it is a 3x liquidation participating preference with a 12% coupon.

You will hear many debates on this issue but in general, my opinion is that you should always try to go for the simplest share structure, even if it means giving up some value.  It certainly can be reduced to a math exercise, as Suzanne points out and I know a VC saying go for less value is a bit disingenuous. Even so, I'd urge you to spend some time looking at the various options and understand this issue fully so you will be prepared for this entertaining part of the VC dance.

Comments

[chris]

Rick....how many common share deals are cut these days? I had the impression they are kind of rare.

[Rick Segal]

Chris,

I suspect in the great scheme of things, they are raw as a percentage of deals done. I'd hope that as more and more education gets done, we might see more of them done.

Keep in mind, there are other rights that VCs want which typically get shoved into the pref shareholder agreements.

[Suzie Dingwall Williams]

I have seen two common share deals in the last 6 months. In both cases, they were competitive term sheet situations - the teams had great success at their last startup and had done a great job using their own cash to nourish their current businesses along. Different circumstnaces from many deals, but not rare.

[Matt]

I'd think the VC community would have an incentive of their own to keep preference to within reasonable limits. After all, the more preference the VC has in a liquidity event, the less incentive the founders have to consent to a reasonable-but-not-stratospheric buyout offer...and in a sane market, the majority of offers are going to be of that sort. After all, in the real world no sale would ever go down with a price tag that meant all the money went to the investors...if the founders wanted to walk away penniless, they'd find it easier to just quit, rather than go out pimping their work to acquirers.