Liquidation Preference

Business by on October 18, 2004 at 9:35 pm
Many VC’s consider the most important deal point of an investment term sheet to be the liquidation preference. Most first time entrepreneurs enter into a negotiation expecting the VCs to push hardest on valuation and are often more than happy to trade a higher valuation for a greater preferred liquidation preference.

Liquidation preference is a right given to holders of preferred stock (investors), that provides them priority if the company is sold. This priority allows them to get paid a guaranteed amount of money first before all of the common stockholders are paid (founders and employees). Let’s consider a company where the investors hold 10% of the company and have a $1M liquidation preference. If the company is sold for $2M, the investors will receive $1M and the common stock holders $1M. Typically this preference is negoiated as a factor of the investment amount and is expressed as 1.5x, 2x, etc. An experienced entrepreneur will be able to negotiate a 1 to 2x preference, while a troubled company may see a preference as high as 5x.

I used to believe that liquidation preference wasn’t that important as it was primarily intended to manage downside risk (if the company was sold for less than it was valued at investment). Since the goal with any start up or venture investment is a large liquidating event (going public or a large acquisition), the liquidation preference doesn’t apply in that scenario.

A few years back, I started a small angel fund with a few colleagues and our first was just purchased in an all cash transaction. The majority of the money had already been raised when we came in, and we were offered the same terms as the other investors (all angels). An entrepreneur at heart, I didn’t focus on the liquidation preference or the valuation that much. (I did make a few changes to the deal and company structure that were certainly for the better).

Our investment was pre-product and of course pre-money (high risk). The company grew steadily, however we realized that it wasn’t going to be a home run. Many companies exist profitably, but aren’t able to grow fast enough or big enough to successfully compete and grow in the long run. Anyway, the company was sold at essentially the same valuation that we had placed our investment for, and we received a flat return. Management however, walked out with high six digit gains from the transaction and with equity and executive roles in the acquiring company.

I couldn’t be happier for them, and I certainly don’t begrudge them their success at all. However, as a seed-stage investor, I can’t but look back at our initial deal and feel that I should have negotiated much harder on the liquidation preference. If I’d negotiated a 2x liquidation preference (not at all uncommon or unexpected), the deal would have returned a healthy 25% return (and the founders would still have been will taken care of). Instead - 0% to the investors.

1 Comment

  1. altico — October 21, 2005 @ 10:57 pm

    I found this very inertesting and would love to talk to you about your experience…..

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