Liquidation Preferences

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.

  1. 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.
  2. 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.