Secrets of Sand Hill Road

by Scott Kupor

  Liquidation Preference

  Now we are getting to the good stuff.

  Liquidation preference is a fancy way of saying who gets their money back under certain circumstances. Those circumstances are called a “liquidation event,” which basically means the company gets sold or is being wound down. It’s true that there are corner cases where the company could have a change of control (i.e., selling more than 50 percent of its stock) that doesn’t involve an acquisition, but most of the time we are talking about a company sale.

  The specific type of liquidation preference in our sample term sheet is called “1x nonparticipating.” Let’s break that down.

  It’s “1x” because VCF1 gets its original investment amount back first, but no more. Liquidation preferences can be structured to be 1.5x, 2x or any “x” the company and VC agree upon. In those cases, the VC would be entitled to that multiple of its original investment off the top of any sale proceeds. Having a liquidation preference greater than 1x can be a big hurdle for startups, because it increases the acquisition price by that multiple of the monies invested by the VCs. As a result, 1x is the predominant form of liquidation preference for early-stage venture financings.

  It is the case, however, that VCs that invest at later stages of a company’s development may demand more than a 1x preference. Why is that? The idea is that if a VC is investing at a much later stage, she might be worried that there will not be enough upside on the investment if the company were to sell itself in close proximity to the financing, before the business has had a chance to grow to a point where its value is some greater multiple of the valuation paid in the financing round.

  This can be particularly worrisome for a later-stage investor if there are a lot of other investors who invested in the company at much earlier stages and therefore much lower valuations. Those early investors may have very different economic incentives from this later round investor and be motivated financially to sell the company at a more modest increase in valuation relative to the later-stage investor’s entry valuation. Thus, a greater than 1x liquidation preference can be a way of aligning interests more closely among investors (and employees) who have a much lower entry valuation into the company with those who are just entering the company for the first time at a significantly higher valuation.

  “Nonparticipating” means that the VC doesn’t get to double dip. Rather, she gets a choice: take her liquidation preference off the top or convert her preferred shares into common shares and take the equity value of her percentage ownership of the company. “Participating” is the opposite flavor—not only does the VC get her liquidation preference first (her original investment back), but then she also gets to convert her shares into common and participate in any leftover proceeds as with any other shareholder. Double-dipping is pretty unusual in the standard venture capital financing.

  Let’s do a quick example to illustrate the difference.

  Assume that VCF1 has invested its $10 million (for which we said it owns 20 percent of the company) and a year later the company gets sold for $40 million. Because we have a 1x nonparticipating liquidation preference, VCF1 has to choose between taking its 1x off the top or converting into common. Which does she choose? The answer is the liquidation preference, because that nets her $10 million, whereas if she were to convert into common, she would receive only $8 million (0.20 × $40 million). That will leave $30 million for the common shareholders to take from the acquisition.

  Hopefully you can see that her indifference point is at a $50 million acquisition—she would get $10 million in liquidation preference or $10 million from converting into common and getting her 20 percent of the $50 million acquisition price. This makes sense because she invested at a $50 million valuation, so we would expect that to be the indifference point.

  Last example. Assume VCF1 successfully negotiated for a 1x participating liquidation preference. How does that change the math? Well, in the $40 million acquisition scenario, VCF1 would first get its $10 million liquidation preference, and then it would convert into common. As part of the common shareholder base, VCF1 will get an additional $6 million (0.20 × the remaining $30 million in proceeds). So you can see how the rest of the common shareholders are affected in this scenario—they get to share only the $24 million remaining after VCF1’s double-dipping versus the $30 million in the nonparticipating example.

  One other nuance to liquidation preference that we don’t see in the sample term sheet—because it’s for the first institutional financing round of the company—is the order of preference among the various parties who enjoy the liquidation preference. Recall that as a company goes through its life cycle, it will often raise multiple subsequent rounds of financing, each with a new series of preferred stock (Series B, Series C, etc.).

  The question then becomes, do all the various series of preferred stock holders share equally in the liquidation preference, or do some have preference over the others? This preference is known as “seniority,” which means that someone has a preference to acquisition or liquidation proceeds ahead of the other preferred holders. The opposite of seniority is pari passu, which is a fancy Latin saying that means we are all treated the same. Seniority typically only gets introduced into the term sheet negotiations at a later stage of financing when there are at least two classes of preferred stock who might want to fight over this right; that’s why we don’t see the discussion in this current term sheet.

  At first blush as an entrepreneur, you might rightly think, “Who cares? If I’ve agreed to a liquidation preference overall, do I really care whether the VCs have decided among themselves to split it pari passu or to introduce some element of seniority?” You’re right in one respect, in that the ultimate amount of money that you and your other common shareholders (mostly your employees) will receive in an acquisition or liquidation is not changed by seniority—no matter how the preference gets divided, it’s still a finite amount of money that will go to the VCs. In practice, though, this term does matter in that it can create different incentives for your various VCs and thus cause them to think differently about an acquisition offer.

  For example, assume you have a total of $30 million in liquidation preference and two different series of preferred stock (A and B) representing two different venture capital firms. Assume also that each firm has invested $15 million in its respective class of preferred stock. If you receive an acquisition offer for $25 million, all those proceeds would go to the preferred holders because the acquisition price is less than the $30 million in preferences. If the preference were pari passu, the VCs would split it fifty-fifty, each getting $12.5 million back on their original investments of $15 million. If the B shares were senior to the A shares, though, the B holders would receive their full $15 million back and the A holders would then get only the remaining $10 million.

  In either case, you as a common holder are likely to get nothing because there simply isn’t any money left over after satisfying the liquidation preferences. But the decision to vote for or against the acquisition could be influenced by the presence of a senior preference. As you see, the A holders lose money on the deal as a result of a senior preference in favor of the B holders, so they might be inclined to vote against the deal if they think there is some prospect of getting a better deal down the road that would make them whole. And even though you and your employees might not be getting paid on your common stock in the current deal, you might be getting employment offers with the acquiring company that could be attractive, and you may also believe that being part of the acquiring company is the best way for your original product vision to be realized. Not being able to realize these opportunities as a result of a competing set of incentives among your VCs would be a bad outcome.

  Redemption

  This explanation might even be shorter than the dividends one—no redemption! Think about it—the whole idea behind selling equity to a VC is that you want the money to be permanent so you c
an use it to build your company. If you had wanted to pay it back on some schedule, you would have raised debt instead. Thus, redemption is extremely unusual in VC. But, for completeness, if it existed in the term sheet, it would basically allow VCF1 to give back its stock to XYZ Company at some future time period in exchange for getting its money back (and sometimes with interest).

  Redemption rights, if they exist, are likely to come into play at precisely the worst time for the company. Why would a VC, who is playing for home runs, want to redeem? Only if she felt as though the company were walking dead, and thus getting her money back was a better option than watching it slowly being vaporized. However, this is exactly when the company would not likely have sufficient cash to be able to give the money back. As a result, most state laws restrict the ability of investors to exercise their redemption rights if doing so would put the company in a dire financial situation. Thankfully, most venture deals keep things simple by just stipulating that the investment is in fact not redeemable.

  Conversion/Auto-Conversion

  Let’s take these two together.

  Recall that VCF1 is investing in a different security (Preferred Series A) than the founders/other employees likely have (common shares). So, at some point, VCF1 might want to convert its shares from preferred into common and, at other points, the founders (and maybe other later venture investors) might want to force VCF1 to convert into common.

  Why would a VC ever want to do this (and why would the company/others ever want to force you to do this), given that the preferred shares have so many more rights and privileges than do common?

  In the former case, a VC might want to do this as part of the IPO of the company. To take a company public, you will want to clean up the capital structure of the company by having everyone convert into common shares. It’s not impossible to have multiple types of shares as a public company—in fact, more recently we have seen many technology companies implement “dual-class stock” as part of their IPO, which often splits common stock into a high-voting class and a low-voting class. For example, Google and Facebook each have dual-class voting structures, and Snap actually has a tri-class structure. This notwithstanding, preferred shares generally need to go away at the time of the IPO.

  In most cases, an IPO is a good thing, and most VCs are more than happy to convert their shares into common in connection with the process of going public. But, as our term sheet reflects, VCF1 wants to make sure that the IPO is of sufficient size—both as a way to ensure that the valuation is attractive relative to their initial investment valuation and that the company will have sufficient market capitalization for enough trading liquidity (so VCF1 can at some point in time sell its shares in the public market).

  Recall that we talked earlier about the reduction in the overall number of IPOs in the last twenty years and, in particular, the decline in the number of smaller-capitalization IPOs. Among the reasons for this are that smaller-cap public companies don’t have great trading liquidity. This means that the volume of shares traded on any given day is small, making it hard for a shareholder who has a lot of shares to be able to sell that stock without moving down the price of the stock. To combat this, the IPO conversion term often includes a provision that the IPO be of a specific minimum size, which equates to a minimum expected market capitalization of the company intended to avoid being stuck in a low-trading-volume, small-cap stock.

  In our term sheet, VCF1 agrees to be converted (we call this “auto-conversion”) into common in connection with an IPO, as long as the proceeds from the IPO are at least $50 million. If you assume that most companies sell between 10 and 20 percent of the company at an IPO, this would imply a market capitalization of $250–$500 million. In today’s market, however, this would be a very-small-cap IPO that would be likely to have little trading volume. But at the Series A stage of investing, it would be hard for VCF1 to argue for a significantly higher initial IPO market capitalization. Presumably, as there are other, later financing rounds, this minimum IPO threshold will increase.

  Another flavor of the IPO auto-convert is to put in place a specific per-share price or a return on investment threshold to force conversion. For example, VCF1 could have said that it would only auto-convert on an IPO where the return on its $10 million investment was at least 3x. You sometimes see these return-based terms in later-stage venture financings where a new investor might be coming in close in time to an IPO and worries that the company might go public too soon before it has seen enough appreciation on its investment.

  The other mechanism to convert shares from preferred to common that the term sheet stipulates is a voluntary conversion. In this case, the term sheet says that a vote of a majority of the preferred stock is another way to convert preferred into common.

  When would a VC ever want to do this? Mostly, in a bad situation.

  We are going to talk later about recapitalizations of companies, but for now let’s just agree that oftentimes things don’t go as planned in the startup world. Believe it or not, every now and then the company raises a lot of money and needs to effectively restart the company many years in. At that point in time, the company may have raised several different rounds of venture capital and thus has different investors who’ve invested different amounts and at different valuations. As a result there might be $30 million or $50 million or more in combined liquidation preference on the company.

  Often, in order to restart the company, you want to clean up the capitalization table by getting rid of some or all of that liquidation preference. Doing so may make the company more attractive to a new investor and provide capital for the restart. For a new investor, having too much liquidation preference simply means that the valuation the company needs to achieve in a sale for the VC to make money on the deal may be prohibitively high. It also helps reincent the employees who otherwise have a very high bar to clear before they can earn any money on their common equity. Recall that employees hold common stock, so they don’t get any proceeds from an acquisition until the full liquidation preferences of the VCs have been satisfied. Thus, employees can be financially disincented to stay at the company if they don’t think there is a reasonable prospect of an acquisition clearing the liquidation preferences. So if the VCs believe in the go-forward prospects for the company, they might want to volunteer to give up liquidation preference to provide the company a fresh start.

  How would a VC eliminate liquidation preference if she were so inclined? Precisely through this conversion mechanism. Remember that the liquidation preference attaches to the special type of shares that the VC holds—preferred stock. If the VC were to convert her preferred shares into common shares, the bells and whistles that she enjoyed as a preferred shareholder would simply disappear.

  And this takes us to a very clever item in our term sheet that we’ve overlooked so far but now comes into play. Not clever as in “sneaky,” but clever as in “smart.” Who gets to vote on whether the preferred convert into common and thus give up liquidation preference?

  Notice that the term sheet is very specific in using capital “P” Preferred Stock as the group that has to get to a majority vote as part of the voluntary conversion mechanism.

  And who is that Preferred Stock? Go back to the dividends section of the term sheet and you’ll see that “Preferred Stock” is defined as “any prior series of preferred stock, Series A Preferred Stock, and all future series of preferred stock.” This means that no matter how many different classes of preferred stock may exist over the life of the company, they all vote together as a single group in determining whether a majority of them wants to voluntarily convert into common.

  This is important, particularly in the case where the company turns south after having raised many different rounds of capital, as the alternative to this definition could have been to give each individual series of preferred stock its own majority vote. In that case, if any one of the different classes of stock refused to go along
with the conversion, the whole deal would grind to a halt.

  This, unfortunately, is not just a theoretical risk. We’ve seen it many times in our short history at Andreessen Horowitz, and it can create real issues. For example, we had a portfolio company that had raised about seven different rounds of financing in a series of ever-escalating prices. But when the business struggled later on and was in need of a capital infusion at a price materially lower than most of the previous rounds, the terms from the prior rounds came back to bite everyone. That’s because each class of preferred stock (representing each of the previous rounds of financing) had its own conversion vote specific to its class only. There was no majority of “Preferred” vote, but rather a series of individual votes by each of the preferred series independently. As if that weren’t tough enough already, each class of preferred was controlled by a separate VC firm.

  Any new investor coming into the company at this point in time was unwilling to invest new money without converting at least some, if not all, of the existing series of preferred stock into common. Why? Because recall that one of the rights of a preferred shareholder is often liquidation preference, and the simplest way to get rid of liquidation preference is to convert shares from preferred into common. Having been through seven rounds of prior financing, the liquidation preference was sufficiently high that the return prospects for any new investor would be materially dampened without some abatement of the preference.

  There is of course another alternative to help this new investor get comfortable with the size of the existing preference stack—allow that new investor to have a senior liquidation preference. Recall from our earlier discussion that this would mean that the new investor gets her money out first, ahead of all the other preferred investors, therefore protecting her investment much more than if she were to be pari passu (or even) with the other existing preferred investors.