Shortly after he sold his company, a CEO called his lead venture capital backer in a panic. He believed that the management team owned 34% of the company, but it received just 5% of the sale proceeds. “How did we get such a bum deal?” he asked. “Liquidation preferences,” the VC patiently explained.
Liquidation preferences ensure that in the event of a sale, investors get a certain return on their money before anyone else gets a cent. This staple financing tool is a must-have for the savvy preferred investor. But management often doesn’t understand the potentially draconian consequences of preferences.
Those consequences are only getting worse. Recently, liquidation preferences have become particularly aggressive as burned investors seek to protect themselves from future disaster. However, deals with liquidation preferences can be structured to provide investors with the protection they seek and keeping management from feeling exploited and resentful.
What’s Your Preference?
Liquidation preferences provide preferential treatment for preferred shareholders in the event of a liquidation of the company or a sale of a majority of the company’s stock. Essentially, the investor receives a multiple of his original investment as the first money out. For example, a $10 million investor with a 2X liquidation preference would be entitled to receive the first $20 million generated by a sale.
Because liquidation preferences give a VC firm a guaranteed return on its investment of anywhere from 1X to 5X and beyond, (as long as the sale price matches or exceeds that), they are an attractive way to limit downside loss. But this protection comes at the expense of common stockholders and preferred shareholders who don’t hold liquidation preferences. They’re left to divvy up a smaller pie maybe even crumbs.
Liquidation preferences come in two shades: participating and non-participating. With a non-participating liquidation preference, the investor receives only the liquidation multiple. In contrast, an investor with participating liquidation preferences gets to double-dip, receiving both the multiple of the original investment plus his or her share of the rest of the proceeds.
As with ratchet clauses (see “Bury the Ratchets,” VCJ, January 2002), liquidation preferences protect preferred shareholders when a company’s value turns out to be less than expected. But since liquidation clauses are only invoked at the terminal point of a company’s independent life, not at interim financings, they often receive less attention by company managers when they’re considering investor term sheets. Indeed, sometimes a startup is more attracted to a deal with liquidation preferences, because the preferences can make the valuation of a company look better than it actually is.
Here’s why: The effect of a liquidation preference depends on the liquidation, or sale price, of the company, which is not known at the time of a financing. In the event that the company is highly valued in the final transaction, the liquidation preference has little effect on common stockholders’ (i.e. management’s) share of the proceeds. In a non-participating situation, the multiple is easily matched by the sizeable value of the investor’s shares. In a participating situation, the multiple may be minimal given the whopping total value of the equity.
It’s understandable that a startup’s management team might be confused by liquidation preferences. Take the following example: If the company is sold at a valuation at or below the liquidation preference multiple times the post-money valuation of the company at the financing round, the liquidation preference effectively grants the preferred shareholders a greater percentage of the company at the time of sale. The preference multiple times the post-money valuation represents the sale value at which the non-participating preferred investor would be equally compensated by receiving the liquidation preference amount, or the percentage ownership times the liquidation value. At any lower valuation, the investor’s liquidation preference would exceed his or her percentage ownership times the liquidation value. Hence, effectively, the investor owns more of the company on liquidation than this percentage ownership.
Valuation: What’s Real?
All of this can be made more confusing to a company founder because a financing round is generally quoted in terms of price per share, and the associated valuation is based on that share price. If a financing has relatively few new shares but an aggressive liquidation preference, the apparent valuation based on per share value may appear to be a flat or even up round. But in reality the pre-money valuation could next to zero.
Say, for example, a venture capitalist invests $10 million with a 4X liquidation preference for 10% of startup XYZ. Presumably XYZ is worth $100 million. If the company is sold for $40 million, the VC effectively owns 100% because of the liquidation preference. The post-money valuation is $10 million and pre money valuation is zero.
This ability of liquidation preferences to confuse the valuation picture can be used to an investor’s advantage when negotiating around other anti-dilution provisions from an earlier round. A VC can invest at the previous round’s price, but it can secure a substantial liquidation preference, effectively gaining a larger share of the company at the time of sale.
Liquidation preferences are a sound way for a VC to protect its investment. But they can create strife within a management team. Top executives are usually paid substantially through their shares, so they focus more on per share valuation than on nebulous liquidation preferences. But if they come to learn that preferences will wipe their money off the table, they may lose motivation and jump ship.
Blinded By Optimism
Even if managers are savvy about preferences, they might be unconcerned about them at a financing round when they are feeling optimistic. That sentiment is sure to change as tough realities set in.
It is important, therefore, for investors to find ways to satisfy management’s needs while protecting their own. (See “How to Keep Employees Motivated When Their Stock Hits Zero,” page 34.)
One approach is for investors to offer management a transaction bonus. This cash bonus aims to make up for any share of proceeds foregone to the preferences. The bonus needs to be in cash rather than new options because the whole idea is that after the preferences, shares aren’t worth much.
Transaction bonuses are usually done in side agreements, sometimes even verbally. That can be a problem. The message is usually, “Don’t worry, we’ll take care of you.” But if the rules of the game aren’t clear, management might not buy what the investors have promised, and investors won’t get the desired response they’re seeking – a company sale.
Another approach to keeping management motivated is for a VC to offer management a slice of its liquidation preference. For example, if a VC has a 4X multiple on a $10 million investment, it can offer, say, 5% of its $40 million. Again, such arrangements would be in a side deal. But these slices can be somewhat self-defeating in that they reduce the protection of the preference.
Yet another approach is for investors to set up a valuation hurdle at which point the preferences would disappear. This approach aligns management’s interests with investors’. The message is: “If you hit a home run, our liquidation preferences go away.”
How high should you set the hurdle? The higher the valuation hurdle to erase the liquidation preference, the less of an impact the liquidation preference will have on a preferred investor’s return. (IPOs are another story. Investment bankers generally insist that all preferred stock converts to common, and liquidation preferences go away.)
Let’s say a venture capitalist invests $2 million for 25% of a company with a 2X participating liquidation preference that goes away if the company sells for more than $100 million. If the company sells for exactly $100M, the liquidation preference applies and the investor’s return would be $28 million ($4 million plus 25% of $96 million), or 14X. But if the company sells for $100 million plus $1 the preference disappears and assuming there is no further dilution after the VC invests his or her return would be $25 million (and 25 cents), or 12.5X. The difference between the two scenarios is $3 million, or about 11% of the return with the preference. Clearly the liquidation preference is not generating the bulk of the investor’s return. A $100 million hurdle for management would not inflict too much pain on the investor.
Hurdles can be problematic if they are defined too narrowly. Using the example above of a $100 million hurdle, management technically wouldn’t get the benefits of its efforts if it sold its company for $95 million, even though it essentially met the goal. Knowing that, management might be inclined to pass on a perfectly reasonable deal because it doesn’t satisfy the internal hurdle.
You can get around this problem by setting up a “sliding scale” of hurdles, so that preferences are reduced by greater percentages as the sale price increases.
While there are several ways for investors to keep management motivated in the face of liquidation preferences, it’s important to remember that every situation is unique. The key is to address these issues squarely and clearly at the time of financing. If liquidation preferences come into play, it’s because things haven’t turned out as expected. And that’s the worst time for more surprises.
Colin Blaydon and Michael Horvath are professors at the Tuck School of Business at Dartmouth and directors of the university’s Foster Center for Private Equity. They can be reached at