I received a number of comments, private emails, and a few links to my post on Venture Capital Deal Algebra. The consistent theme was "tell me more about how VC investments work." As a result, I'm going to write a series of posts on the structural and financial components of a typical venture capital investment. I'm going to use a bottom up approach - talking about individual components over time and then tying them together in a comprehensive term sheet.
An important place to start is the concept of a liquidation preference. Fred Wilson hints at it in his post on valuation. A liquidation preference is a standand (and rarely negotiable part) of a VC investment. It's the downside protection on an investment that VCs expect to have as a baseline of any equity investment.
The vast majority of VC investments are structured as preferred stock. It's called preferred because it "sits in front of" the common stock (or is "preferred to the common") where common stock is the plain vanilla stock that a company has. Typically in VC investments, founders receive common stock, employees receive either common stock or options to purchase common stock, and the VCs receive preferred stock. This preferred stock has a series of special rights which almost always include a liquidation preference. The liquidation preference means that the VC will have the option - in a liquidity event - of either receiving their liquidation preference as their return or converting into common stock and receiving their percentage ownership as their return.
Consider the following example. Acme Venture Capital (AVC) makes an investment in an established company called Homer Software that has been bootstrapped by the founders. Homer Software has shipped a product in an exciting market and generated $3m of revenue in the past 12 months. AVC invests $5m at a $10m pre-money valuation. As part of this investment, AVC and the founders of AVC agree to a 20% option pool for new employees that are going to be hired to be built into the pre-money valuation (see Venture Capital Deal Algebra if this doesn't make sense). The result is that AVC owns 33.3% of the company, the founders own 46.7% of the company, and 20% is reserved for options for employees. In this example, AVC purchases Series A Preferred Stock that has a liquidation preference.
Now - consider two outcomes.
- Homer Software continues its rapid growth and is acquired for $100m. AVC has a choice - either receive the liquidation preference ($5m) or convert to common and receive 33.3% of the proceeds ($33.3m). Easy choice.
- Homer Software struggles and is acquired by a competitor for $9m. AVC again has a choice - either receive the liquidation preference ($5m) or convert to common and receive 33.3% of the proceeds ($3m). Again, easy choice.
When cash or public company stock is used in an acquisition, the valuation can be mathematically determined with certainty. However, when the acquirer is a private company, the valuation is much harder to determine and is often ambiguous as it depends on the value of the private company and the type of stock (common, preferred, junior preferred, or some other special class) being used. In these cases, the use of the liquidation preference is less clear cut and it's critical that the company have objective, outside (independent) directors and experienced outside legal counsel to help with determining valuation.
One exception to the liquidity event is an IPO. Typically, an IPO will force the conversion of preferred stock to common stock, eliminating the liquidation preference. In most cases, the IPO event is an "upside liquidity event" so the need for the liquidation preference (and corresponding downside protection) is eliminated (although this is not always the case).
Next up - To Participate or Not (Participating Preferences) - an often maligned and typically hotly negotiated issue that is a more complex form of liquidation preference.
Posted in: Venture CapitalCOMMENTS (7)
Brad-
Great idea to write this series of posts. Cogent, concise, well written information about the ins and outs of the process of venture investing is actually hard to find.
I remember when I went to work for Primedia Ventures, having previously been a non-MBA journalist and entrepreneur, I read all the conventional basic books on VC. They were horrendous almost without exception. Poorly written, poorly edited. I remember reading a passage in Joseph Barlett's book over and over. What he described in the passage didn't make sense unless new stock had been issued, but nowhere did he write that new stock had been issued. I asked my wife to read it--who is a structured finance lawyer and no slouch at structuring deals--and she was as mystified as I was. It was just a poorly written, poorly edited book that provided no real illumination.
You and Fred should think about working up a little guide to venture as a book, I'm sure you could sell it and it would be a real contribution to the literature on the subject.
Brad--
Nicely stated.
One addition: Most entrepreneurs and employees are confused why there needs to be two classes of stock... and are often surprised that there is some benefit beyond VC greed.
In order to price options as cheaply as possible (thus maximizing their use as a motivational tool), the stock associated with these options has to be truly different than the stock a VC buys... else, the government won't let you price common shares (and options) differently than preferred.
As it turns out, this is a big deal to employees, who would rather get options, say, at 10 cents vs. $1. (The $1/share being what the VC pays for a preferred share.)
So, something like a liquation preference can be used as a differentiator, which hopefully helps entrepreneurs and employees feel better about this class distinction.
As you tear into the components of the term sheet, though, it might get a bit uglier. Only two speeds of term sheets: Onerous and very onerous!
Brad,
Great post. I think you could add some more information though - namely why a VC demands and liquidation preference (at least 1X). In your hypothetical example the founders (and employees) could decide to liquidate the company immediately after receiving the $5 mil from AVC - giving founders $2.33 M, and AVC $1.67 M. Also some "in the trenches" examples of different liquidation preferences would be great (any stories out there about bully VCs that received 5X preferences).
One addition: Most entrepreneurs and employees are confused why there needs to be two classes of stock... and are often surprised that there is some benefit beyond VC greed.
I have a question about how venture capital firms calculate their rates of return. I've heard of "Internal Rate of Return" which is a return based on cash inflow and outflow, and I have also heard of "Realization Multiples" which is a multiple of what has been distributed to what has been invested in the fund. I have done some research online, and many articles suggest an excess of 25% internal rate of return for venture investments...how does this reconcile with a realization multiple (i have heard it is about 3 x's...but logically/arithmetically how does it reconcile)
Thanks,
Jeff
I have a question on stock options within a company. Is it legal for certain employees (management) to be given stock options with no vesting period (in other words stock is fully vested upon issuance) while all other employees are granted stock options with a vesting period of 2 years? Is this not discriminatory?
This is perfectly legal.
, August 24, 2006 7:46 AM
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