I'll throw out a VC's perspective on liquidation prefs:
1) I think 1x is very fair and meant to protect investors from bad company behavior. If you didn't have 1x preference, this would be an easy way for an unscrupulous founder to cash out: raise $X for 20% of the company, no liquidation preference. The next day, sell the company and its assets ($X in cash) for, say, 0.9x. If there's no liquidation preference, the VC gets back 0.18x and the founder gets 0.72x, even though all that the founder did was sell the VC's cash at a discount the day after getting it.
2) >1x liquidation preferences are sometimes the founder's fault and sometimes the VC's fault. Sometimes it's an investor exploiting a position of leverage just to be more extractive. That sucks. But other times it's a founder intentionally exchanging worse terms for a higher/vanity valuation.
For example, let's say a founder raised a round at $500m, then the company didn't do as well as hoped, and now realistically the company is worth $250m. The founder wants to raise more to try to regain momentum.
A VC comes and says "ok, company is worth $250m, how about I put in $50m at a $250m valuation?"
Founder says "you know, I really don't want a down round. I think it would hurt morale, upset previous investors, be bad press, etc. What would it take for you to invest at a $500m+ valuation like last time?"
VC thinks and says "ok, how about $500m valuation, 3x liquidation preference?"
The founder can now pick between a $250m and a 1x pref, or $500m and a 3x pref. Many will pick #1, but many others will pick #2.
It's a rational VC offer -- if the company is worth $250m but wants to raise at $500m, then a liquidation preference can bridge that gap. The solution is kind of elegant, IMHO. But it can also lead to situations like the one described in the article above where a company has a good exit that gets swallowed up by the liquidation preference.
3) generally both sides have good lawyers (esp. at later stages of funding), so the liquidation preference decision is likely made knowingly.
Related to #3, if you're fundraising, please work with a good lawyer. There are a few firms that handle most tech startup financings, and they will have a much better understanding of terms and term benchmarks than everyone else. Gunderson, Goodwin, Cooley, Wilson Sonsini, and Latham Watkins are the firms I tend to see over and over.
Leo does a great job explaining why VC's want liquidation preferences.
But founders/employees want them too! With all the crazy founder-friendly deals of 2021, I never heard of one in the US without a liquidation preference.
Why? Liquidation preferences allow the VC bought securities to be treated as "preferred" and reduce the common stock price in the 409a valuation report, allowing early employees to get options at low prices.
If VC's invested in common stock the strike prices would be much higher, making it less lucrative to be an early employee.
In parts of Europe there is different tax treatment for options and employees generally don't own as many shares due to it... and some of those companies don't have liquidation preferences. I believe Klarna (Sweden) doesn't have preferred shares, meaning the huge swing in valuation they had over the past few years is not as bad as it seems.
TBH the whole 409a thing is a charade & we probably need to clean up how we do accounting & taxes but until we do, preferred shares are here to stay.
This is a good explanation. However, if you do take on liquidation prefs, you should be open with other parties (employees) who are affected. I have never, ever experienced employers who have volunteered this information. I have also been told, when I asked about liquidiation prefs, that they had no way of determining whether or not that provision existed in their investment terms (!).
For liquidation preference >= 1x, why even call it equity instead of debt?
The point of equity is that you own a part of it, and you get a proportional share. The point of debt is that the money owed to you is preferred over other owners (i.e. equity owners). It seems to me that liquidation preferences allow investors to take the best of both worlds.
It's "mostly" equity. If a company doesn't exit for anything it's not on the hook for the VC $, there are no monthly interest payments, etc. OTOH if there's a great exit that clears the preference stack, then the liq preference is irrelevant. A bit more debt-like in the middle.
The liquidation (or dividend) preference is the differentiating feature of preferred stock. In corporate finance, preferred stock is, for the reasons you give, treated as a hybrid of equity and debt.
Very enlightening thanks! I wonder if there is or could be some notion of "vesting" over time of the investment such that (1) could not happen. So if the founder tried to sell tomorrow, the investor would get back 1x, but that 1x decays to 0.2x over 5 years or something.
But I guess VCs generally have the leverage and wouldn't want such terms.
I've thought about that kind of system before, and it's an interesting approach but it doesn't fully protect against bad actors. E.g. what if the founder raises $5m, puts it into a bank account, moves to Hawaii, and then sells it for $4.9m in 5 years?
There are some ways to make this work, I think (but I agree that time based vesting wouldn't work for the reasons you suggest). I've most commonly seen structures that contemplate something like this referred to as either a "bleed off" or a "kick out".
Bleed Off: set up a participating preferred with 1x liq pref and bleed off between investors A-Zx MOIC. In practice the preferred investors would participate by taking their 1x off the top, then sharing pro rata in proceeds. As the investors implied MOIC reaches the bleed off MOIC range, their participating preference would bleed off or be reduced ratably in the bleed off range until the participating portion approaches 0 (and eventually investor converts to common).
Kick Out: set up as a participating preferred with a 1x liq pref and a Ax kick out. In practice, investors would take their 1x then participate pro rata up until they Ax their capital. After Ax, the investor would collect no additional proceeds unless they convert to common.
I've seen both used, but the latter probably more appropriately works for instances in which there is a bid ask spread and founders want to solve for valuation (with the belief that they'll blow through the preference anyway and it won't matter) and investors want to shift the returns curves to higher probability (lower) equity values.
Something I've seen recently is the founder thats willing to let a company die.
I suspect these founders find some way to extract as much as possible from their company after raising funds.
Without naming names, I've seen a startup go boom (raise huge money and be valued at 3x that huge money), then all the senior leadership disappear: moved out of state, only show up for pre-recorded town halls (that used to be live), no longer a part of engineering meetings, cancelling department meetings, etc.
That went on for a couple years until the founder minimized their position in the company.
I don't understand how that could happen unless that founder extracted what they wanted and were just riding the ride rather than marching towards IPO.
Sometimes they get sidelined by vcs, but you can't see it from lower levels. Other times they started something else, and have insider information that the company will not work
This helped my understanding of VC/founder relation much better. Thanks for putting a broader perspective to the situation described in the original post.
1) I wouldn't call it "very" fair. VCs can (and almost always do?) also have a veto on such sales in the terms, so they don't need the preference to protect their investment. Which is more fair?
2) You missed the 3rd case, sometimes the business is simply a bad one (like the example in TFA), or all the oxygen is getting sucked out by the new shepherd dog, eg right now with AI. The business can die right then and there, or the founder can take the equity on the only terms they can get. Given that any decent founder is drunk on their own kool-aid, and believes their fortunes will change in just 1 quarter or even 1 year, they just need to ride it out, it often seems like a good idea, and what's the difference? Die now or die later. At least take a shot at it.
IOW it's not all villains on one side and incompetent heroes on the other.
The real downside is that now you're working for the VCs. You kind of were the entire time -- that's built-in -- but it's more pointed now. If you make it to IPO none if it matters ...
As the theme of TFA's website goes, build a "fundable" startup. Easier said then done, of course. Like so many of such self-help in the startup world, the entire site is a bit of a lie, selling false hope. They even position FanDuel as some VC abusive situation (thus selling themself as the savior), by talking only about the huge amount of money, "half a billion" dollars. No mention at all of how much FanDuel raised ...
why would a liquidation preference not have an expiration date? it's wild to me that a VC can ask for this with unbounded time, that goes far beyond protecting from the #1 outcome described above.
Related to #2, professional investors understand that the implied valuation in a round with a >1x liquidation pref is, in a word, bullshit. As an employee, you too should keep this in mind when you are valuing your equity package.
1) I think 1x is very fair and meant to protect investors from bad company behavior. If you didn't have 1x preference, this would be an easy way for an unscrupulous founder to cash out: raise $X for 20% of the company, no liquidation preference. The next day, sell the company and its assets ($X in cash) for, say, 0.9x. If there's no liquidation preference, the VC gets back 0.18x and the founder gets 0.72x, even though all that the founder did was sell the VC's cash at a discount the day after getting it.
2) >1x liquidation preferences are sometimes the founder's fault and sometimes the VC's fault. Sometimes it's an investor exploiting a position of leverage just to be more extractive. That sucks. But other times it's a founder intentionally exchanging worse terms for a higher/vanity valuation.
For example, let's say a founder raised a round at $500m, then the company didn't do as well as hoped, and now realistically the company is worth $250m. The founder wants to raise more to try to regain momentum.
A VC comes and says "ok, company is worth $250m, how about I put in $50m at a $250m valuation?"
Founder says "you know, I really don't want a down round. I think it would hurt morale, upset previous investors, be bad press, etc. What would it take for you to invest at a $500m+ valuation like last time?"
VC thinks and says "ok, how about $500m valuation, 3x liquidation preference?"
The founder can now pick between a $250m and a 1x pref, or $500m and a 3x pref. Many will pick #1, but many others will pick #2.
It's a rational VC offer -- if the company is worth $250m but wants to raise at $500m, then a liquidation preference can bridge that gap. The solution is kind of elegant, IMHO. But it can also lead to situations like the one described in the article above where a company has a good exit that gets swallowed up by the liquidation preference.
3) generally both sides have good lawyers (esp. at later stages of funding), so the liquidation preference decision is likely made knowingly.
Related to #3, if you're fundraising, please work with a good lawyer. There are a few firms that handle most tech startup financings, and they will have a much better understanding of terms and term benchmarks than everyone else. Gunderson, Goodwin, Cooley, Wilson Sonsini, and Latham Watkins are the firms I tend to see over and over.