The last few years have been exceptional in the high risk/reward entrepreneurship and investing business. Venture investors have raised record piles of capital, and have been throwing more of it at more entrepreneurs at higher valuations and on friendlier terms than ever before. The COVID-19 pandemic is putting an end to that, and entrepreneurs best prepare for heavier sailing in the months (and possibly years) ahead. ‘Tis a sellers’ market no more.
Liquidation preferences are the canary in the venture capital business cycle. In the entrepreneur-friendly environment of the last few years they take one form (non-participating) and in a buyers’ market they take another form (participating). You can figure on a pretty dramatic shift from non-participating to participating over the rest of this year as the venture business cools in the wake of the COVID-19 pandemic.
And so, this is a good time for a review of liquidation preferences in venture capital financings. If it seems a bit complicated, that’s because it is. It can also be very, very impactful at exit time. Many entrepreneurs have, with hindsight, rued the day they skipped over this particular section of fine print in the deal docs.
(First, a point re terminology. You might think that a term like “Liquidation Preference” would provide mostly for what happens when a startup craters. Who gets what, that is, when a startup closes up shop and liquidates? And, in fact, in the startup/VC world, liquidation preferences do come into play when a startup kicks the bucket, so to speak. But liquidation preferences are also operative when a company hits a home run via a sale or other exit transaction that generates proceeds sufficient to pay off any creditors and reward some or all of the various shareholders. And that – what happens to the money generated in a successful exit transaction – is what the liquidation preference is really about.)
Basic Principles: Last Money In, First Money Out; The Exit Waterfall
Liquidation preferences embody a first principle of venture capital investing: Last money in, first money out. The notion is that whoever put the last dollar into a deal should, if/when the deal exits, have a preferential call on getting that dollar back before any dollars are shared with others, including finally the holders of common stock. When the next investor comes in, she/he takes the first spot in the line, knocking the previous investor back a spot. And so on.
Note that when there are two or more rounds in a deal, there is thus a “waterfall” of liquidation preferences, with the last money in getting the first preference followed in sequence by the more junior investors until there is nobody left but the common stock. The holders of common stock – the founders, team and any others – get what’s left; the residual payout after all the preferential amounts are paid.
The waterfall concept tells you something important about most every venture-backed deal. If Newco has raised $X over any number of venture rounds, you can figure that if Newco has an exit, the venture investors as a group will collectively get at least $X of that exit before any residual money is available for distribution to the holders of common stock. At least $X. As we’ll see, it could be much more than $X.
The Plain Vanilla Liquidation Preference
Liquidation preferences are part of the vast majority of venture deals, even the most entrepreneur-centric. The base model is the “non-participating” liquidation preference. The non-participating preference provides that if VCI puts $X dollars into Series A Preferred Stock of Newco, and Newco subsequently has an exit transaction, VCI has a first call on the proceeds from the exit up to $X. If the proceeds of the exit are $X million or less, VCI gets all of those proceeds. If the proceeds are greater than $X million, VCI has a choice: it can take $X off the top (leaving the residual to the common shareholders) or it can instead convert its Preferred Stock to Common Stock and share in all the proceeds pro rata with the other holders of Common. (For later reference, think of this as a “single dip” preference.)
The math for the non-participating preference is straightforward. The “pivot” exit proceeds – the exit proceeds where VCI is indifferent to taking its preference or converting to common – is equal to the dollars invested by VCI divided by the fraction of the fully-diluted capitalization owned by VCI at the exit. So, if VCI invested $1 million and has a 1/3 share of the fully-diluted equity, the indifference price is $1 million divided by 1/3 or $3 million (Fact Pattern 1). Below $3 million in exit proceeds, VCI will always takes its $1 million preference amount (or smaller amount if the exit proceeds are less than $1 million). Above $3 million of exit proceeds VCI will always pass on the preference and takes its pro rata share of 1/3 of the proceeds.
Thus, the fundamentals of the (comparatively) entrepreneur-friendly “non-participating” liquidation preference. Non-participation has been standard issue in most VC rounds over the last couple of years (as it always is in a sellers’ market). While some thought those times would never end (some always do), those days are over, at least for now. In Part II of this brief primer on liquidation preferences, we’ll see what’s coming as the COVID-19 pandemic shock works its magic on the venture capital business. It’s not pretty.