Time To Hit the Reset Button On Liquidation Preferences? –

When it comes to term sheets in today’s venture capital market, there is simply no bigger issue floating around than the impact of liquidation preferences upon the future health and well-being of private portfolio companies. I say this while acknowledging that, as a preferred shareholder in many recent venture rounds, firms like ours have embraced liquidation preferences as a necessary way to hedge risk among portfolio investments.

Nevertheless, I am concerned that we not make risk aversion such a high priority that we penalize the very incentives offered to present and future managers and employees of our own portfolio companies. Indeed, it is their creativity and human capital that we rely most heavily upon for the success of our own investments.

Bob Latta, a partner with Wilson, Sonsini, Goodrich & Rosati, frames the liquidation preference issue this way: “Unlike any other time in the history of the [Silicon] Valley, we have never had such a large distinction between what you get on an IPO and what you get on a merger.” What Bob is referring to is the essential consequence of liquidation preferences when placed in the context of alternative exit strategies.

In the event of an IPO, an exit option currently considered all but nonexistent right now, all shares convert to common. This means that all of the added benefits that preferred shareholders might have reaped in the event of an acquisition disappear if a company goes public. Such a tradeoff makes sense if the value of an IPO is so robust that it pays everyone back multiple times for the risk taken and money invested. However, in the event of an acquisition, as most VCs know and many private company employees do not, preferred shareholders get paid first. And they get paid – according to the terms within most recent term sheets, themselves loaded with liquidation preferences – at multiple times the value of their most recent and even previous capital infusion.

“Even the accounting staff at the Securities and Exchange Commission doesn’t understand the impact of liquidation preferences in the event of an acquisition, let alone whether private company employees do,” says Latta. Other VCs have put it more bluntly: “If the employees of one of my companies knew how much money we’d have to sell the company for before they even see dollar one, I’m not certain they would even choose to work there.”

Basic Math

Put in terms of dollars and cents, the math becomes simple. If a VC firm puts in $10 million at even a 3x liquidation preference, that means the first $30 million of any acquisition payout goes to that investor. The next $20 million may even go to other investors with 1x liquidation preferences on previous rounds. Consequently, you’re looking at a company that doesn’t even start to share its spoils with management and employees in the event of a buyout until after the first $50 million is doled out. In many cases, this amount can start at $100 million or more, acquisition prices not easily attained before employees see a return.

I raise this issue not to go against the grain of current VC wisdom. I am a member of the venture capital community and am committed to providing the best backing, guidance and moral compass to be offered to companies and employees we have chosen as our partners. However, there are often hidden, or more likely, unforeseen consequences of our actions as investors, consequences worth exploring for the negative results that can be averted. Or the positive benefits that can be exploited.

The first and most obvious consequence of liquidation preference is the potential backlash that might occur should employees, particularly engineers, feel they have been deceived either directly or through a sin of omission. As my colleagues know, engineers are a very moral group. If they feel they have been misled by not being told what the true impact of liquidation preferences may be – if the liquidation preferences are even disclosed at all – they could leave en masse.

In more stable market conditions than these, it’s not unlikely that such a company could come under a headhunter’s attack, as well, with certain headhunters even now admitting they would look for private companies where they knew dangerous liquidation preferences had been written into term sheets. Such terms, while often not apparent to employees uneducated in the nuances of finance, are there for the viewing in any re-filing of the articles of incorporation filed with the state when new rounds of funding are closed. For the sake of employee retention, the impact of liquidation preferences should at least be considered in this new longer-term light.

Second, we as investors, charged with seeking to maximize shareholder value for our limited partners, should reconsider whether we may have inadvertently incentivized management to steer their companies away from buyout overtures.

Last In Line

Put more simply, if CEOs, managers and employees become painfully aware that they will be last in line behind preferred in the event of an acquisition – and even that such a sale price would need to be inordinately high before employees saw a penny of return on their exercised options – there’s little doubt they’ll spurn acquisition opportunities and steer the company toward a public offering.

Not bad thinking if you’re an entrepreneur, but as an investor, board member, and representative for my valued limited partners, I’d much rather have company managers and employees running hard toward a sale or IPO rather than one over the other. As we already know, there’s an emotional bias by company founders to avoid parting with their company through a sale: It would seem shortsighted to create a financial bias against it, as well.

One of my colleagues recently described liquidation preferences and preferred shares this way: “Companies are now so beaten down they’re starting to treat preferred shares like debt.” It’s a preferred shares overhang to some entrepreneurs. I don’t believe that’s the gulf between preferred and common stock that we meant to establish when we merely tried to hedge our risk exposure post the dot-com shakeout.

True, in many cases, we’ve been smart enough not to go overboard, capping the payouts on our liquidation preferences to reach a maximum amount above a certain valuation. Yet, in certain cases, that bar has been raised too high, higher than what most management and employee teams would deem reasonable.

There are some liquidation preference remedies, and pre-investment considerations, which could be instituted to keep all parties at the table and happy during deal time and beyond. First, it’s important to keep employee ownership high. Even if down rounds are painful, while share price takes a hit, overall employee ownership stakes should not. As an example, with our portfolio company Quantum 3D, we keep employee ownership at 23% to 24%. We’re also trying to effectively communicate (perhaps at first educate) employees and managers about terms associated with recent venture rounds and how they might affect them. Although this may seem like giving away trusted VC secrets where employees were always held on a “need-to-know” basis, we believe that there is a legal if not fiduciary obligation for communicating such information.

Legal Obligation

Ask Bob Latta and he will tell you that under the law, employees considering whether they should purchase their stock options or not (or even prospective employees deciding whether to take a position with a private company) have the right to make an informed decision before exercising their options. As a result, says Latta, “If a CFO calls me and says an employee wants to see the capitalization table and the articles of incorporation, unfortunately, but legally, I’d have to say: Give it to him!'” Indeed, it’s a legal issue no one would want coming back at them later on should an employee decide to sue.

At Charter Ventures, we’re very much an advocate of management and the employee. It’s a virtue we espouse not to stake out some higher moral ground, although that is a consideration. It’s a bias that’s important simply because it’s good for business, as important to having employees fully informed as it is to have them incentivized and excited about ensuring their own company’s success.

Like A Mushroom

As a former private company employee myself, as I suspect most venture capitalists are, it was never fun, nor was it enlightening, to be kept in the dark about the investment terms an employer was operating under. Think about what it’s like to invest close to a life’s savings in exercising stock options only to learn those stock options are worthless. It’s tough for any employee to come home and tell his family that his company won by getting bought out but he did not get to share in the upside.

Liquidation preferences have their place. They are designed to protect VCs and our limited partners from undue risk. They were not meant to make up for past losses embedded in future investments. Such a tactic simply won’t work. Sometimes you’ve just got to hit reset and start over, otherwise, your 3x preference today may go to someone else at 5x in the next round, as future investors want to do better. Perhaps it’s time to reconsider what liquidation preferences were truly intended for and how they and other terms might be better used to enhance shareholder value for all players.

Ravi Chiruvolo is a general partner at Charter Venture Capital, a seed- and early stage venture capital firm based in Palo Alto, Calif. He sits on the boards of six companies, including Talaris, a Web services company, and Winery Exchange, an e-commerce site for the wine industry.

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