Liquidation preferences

Welcome back to Above Board! For those who are new subscribers, you can see the last edition here where we covered terms sheets, types of stock, and more. In this post, we’re picking up where we left off and talking about liquidation preferences. Jim Armstrong, Managing Director of Composite Ventures and Forbes Midas List investor, joins us again.

AB: Thanks again for being with us, Jim. Let’s get started with asking what a liquidation preference is?

JA: Liquidation preferences exist for a good reason. Here’s an example of what could happen without liquidation preferences. Let’s say Melissa (founder) comes to Jim (investor) and says: ‘Jim we’re raising $5 million for our start up and Jim says ‘Okay, I'm in.’ So, Jim will own 20% of the company at a $25 million post-money valuation.

Jim wires $5 million on Monday. On Tuesday, Melissa calls Jim and says ‘Great news. I sold the company.’ Incredible. Melissa adds: ‘I sold it for $4 million. I found someone who wanted your $5 million in cash and I sold it to him for $4 million.’

So, Jim gets his 20% of the $4 million exit which is $800,000 and Melissa/other equity holders get 80% of the $4 million exit which is $3.2 million. Melissa/other equity holders did well… but Jim lost most of his investment.

The above example is what would happen without liquidation preferences. With liquidation preferences, until all preferred shareholders are paid back their full investment amount, common stockholders receive nothing. So, let’s say there is approval by those with protective provisions (a concept covered in the last post) for the sale of the company: in this case, the $4 million sale would all go to Jim.

Note that there’s a feature that's becoming common again called participating preferred, which I don't like. It says, I get my $5 million back and I participate; in other words, I get my cake and I can eat it too. Right now, a lot of start ups are giving that to get an investment given the challenging fundraising environment. It’s investor friendly, but I don’t like it because you have to give it to everyone.

AB: What should founders be thoughtful of surrounding this conversation about liquidation preference?

JA: Be careful how much money you raise. When your capital stack starts to get large, it demotivates common stockholders. If you raise $500 million and you create the next Uber, you're fine. But if you raise more than you can deliver in exit value, then common shareholders will see nothing.

There probably is some ideal ratio that someone has calculated related to the ratio of preferred stock to market cap at exit [editor’s note: if you have any leads on this topic, please reply to this email].

AB: To be clear: if I'm a founder that works their tail off for 7 or 8 years on a company that raised a billion dollars and the company exits for $900 million, what happens? 

JA: Well, it’s almost a unicorn exit, but given the amount of capital raised, the investment will return 90 cents on the dollar back. So, investors have not done well for the risk they put in (because they aren’t even getting a dollar in return for each dollar they put in), but they're at least getting much of their money back. 

As for the founder and their team (and anyone else holding common shares): they get nothing.

AB: Follow up question: how can early employees of a company protect themselves so they don’t leave with nothing?

JA: I've been through company acquisitions half a dozen times in my career where the liquidation preference was rather large. What usually happens is the acquirer says I want both the technology and the team to come as part of the acquisition. If the team isn’t coming, the acquirer very well might not be interested in further pursuing the acquisition. So, the founder might go to the preferred shareholders and say ‘Look, right now, I'm not gonna get anything but I need something to incentivize me and my team to go to the acquirer.’

In other words, even though the documents say the preferred shareholders should get everything, the preferred shareholders may provide a carve out to existing employees in an effort to make sure that the deal goes through.

In this case, a 10% carve out of the acquisition price (given to common shareholders) is fairly standard. As an investor, I’m always excited to do that because I want to get the deal done at this point.

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