liquidation preference

exitEvery founder of a growth startup dreams of a big, successful exit — a sale of the company for millions of dollars. But that dream could be shattered if the investors are able to cause the company to be sold prematurely with proceeds only equal to or barely exceeding the investors’ liquidation preferences, leaving little or nothing for the founders. Such a proposed deal will almost always be opposed by the founders, believing that the company could achieve a much higher valuation if it remained independent for a bit longer. Whether or not such a deal gets consummated over the objections of the founders depends on state law provisions and negotiated contractual terms that combined will determine the one factor that ultimately matters: control over the deal process.

Background: Liquidation Preference and Investment Horizon

In a typical round of venture funding, the investors receive a liquidation preference, i.e., the right to receive first dollars (after creditors are paid) up to an agreed amount in any sale of the company. In a company’s first institutional funding round (typically designated as Series A), a liquidation preference of 1X plus annual dividends of 8% is “market”, i.e., the investors get an amount off the top equal to the amount they invested plus accumulated dividends before the common shareholders receive anything. Later rounds (Series B, Series C, etc.) may have liquidation preferences of higher multiples of dollars invested, e.g., 1.5X, 2X, etc. A more investor friendly variation is what’s called participating preferred, in which the investors, after receiving their liquidation preference, then share pro rata in the remaining proceeds with the common shareholders, often up to some maximum amount.

So if a VC is not sanguine about a portfolio company’s long term prospects, he may be happy to sell the company for an amount equal to his liquidation preference, particularly at a point several years into the investment. In this regard, the time horizons of founders and institutional investors are inherently in conflict. A venture fund’s limited partnership agreement will typically limit the fund’s life tomoney vs. time ten years, with the initial three years designated for sourcing investments and the remaining seven for exits. With certain exceptions, a fund manager is required to distribute any profits to the fund’s limited partners by the expiration of that ten-year period, which is why a VC’s investment horizon in any given portfolio company is typically three to seven years. Consequently, a VC will often favor a quick exit because it offers a higher risk-adjusted return, and eliminates further risk to their investment. In other words, the VC might believe there’s some likelihood the company’s valuation may increase, but why risk it if he’s entitled to his liquidation preference, particularly if the wind-down of his fund is imminent? Free of such timing constraints, a founder on the other hand would almost always prefer to buy more time, particularly when the company’s projections show an upward trajectory. The founder’s problem, though, is that acquirors will generally value a company based primarily upon historical data, and will either ignore or heavily discount projected metrics.

State Law

So in a sale of the company proposed by the investors and opposed by the founders, who determines whether the deal gets consummated? The starting point is state law. The corporate statute of the state of the company’s incorporation will dictate the minimum vote threshold needed from shareholders. Some state statutes are more protective of common shareholders (founders almost always hold common shares) by requiring approval of the common holders voting separately as a class, essentially a group veto, and/or may require a supermajority vote, which gives the common the ability to block a deal if they collectively own enough shares to prevent the majority from meeting the vote threshold. States that are less protective of common shareholders will require only approval of a simple majority of holders of all shares outstanding, without requiring a separate class vote. That’s the Delaware model. New York voting rightscorporations organized before 1998 must secure a two-thirds majority of all holders unless their charter provides for a simple majority (simple majority for post-1998 corporations), and a separate class vote is required to approve a merger if the shareholders receive stock of the acquiror or another entity containing attributes not included in the target’s charter for which the target’s shareholders would have been required to approve in a separate class vote under New York law.

Another source of state law that impacts control over the deal process is case law regarding a director’s fiduciary duty. Before a proposed acquisition even gets to a shareholder vote, it must be approved first by a majority of the target company’s board, whose actions must be consistent with the directors’ fiduciary obligations. These include primarily the duty of care (generally, the obligation to be informed and diligent) and the duty of loyalty (essentially, the obligation to put the interests of the company and the shareholders above a director’s personal interests and not have any conflicts). Shareholders have a right to sue directors for breaches of fiduciary duty, and common shareholders will have a stronger or weaker case in attacking approval of the sale of a company as a violation of fiduciary duty depending on how favorable a particular state’s fiduciary duty case law is to the common holders. Delaware fiduciary duty case law is regarded as board friendly.

Contractual Terms

Some of the most important terms negotiated by VCs in a venture investment are the ones impacting control, both at the board level and the shareholder level. As mentioned above, a sale of the company must first be approved by a majority of the directors. The allocation of board seats is determined by negotiation during each round of funding. Although a fair outcome would be for investors to receive board representation in proportion to their share ownership (e.g., two of five seats when owning 40% of the outstanding shares), the investors will often negotiate for and receive disproportionate representation on the board and sometimes even a majority. A typical board composition arrangement might be a five-person board consisting of two directors designated by the investors, two directors selected by the common shareholders and one independent industry expert mutually selected by the common holders and the investors. But if the industry expert is someone with whom the investors have a preexisting relationship, human nature is such that he will view the investors as a source of future opportunities and tend to side with them, thus giving the investors an effective majority.

Other key control rights negotiated for by VCs are so-called protective provisions, which give the investors a veto over major decisions, including a sale of the company. Here, the battle is over what transactions or decisions make the list, and what vote threshold is required within the class of preferred. But a veto is only a right to block, not a right to approve. It doesn’t give the preferred the right to compel the company to consummate a deal opposed by the requisite holders. That’s where drag-along rights come into play.

Drag-along rights give investors the power to require other holders to vote in drag alongfavor of a deal the investors are proposing, sometimes conditioned on board approval. If a sufficient number of shares are so encumbered, the investors can ensure that holders of a requisite percentage of the outstanding shares or close enough to it vote to approve a deal favored by the investors.

So Who Controls the Deal Process?

Putting it all together, investors are more likely to control the deal process if all or at least some of the following are true: the company is incorporated in a state that does not require a class vote of the common to approve a sale of the company, the state has fiduciary duty case law favorable to directors, the investors have an actual or effective majority of the board and the investors control the cap table either outright or through a combination of ownership and drag along rights. In limited cases, the common shareholders will nevertheless be able to negotiate for a share of the proceeds in sub-liquidation preference deals, getting the preferred to relinquish some of the amount they’re otherwise contractually entitled to. Such an outcome is more likely to occur where the investors are able to approve a deal at the board level, but the common shareholders have one or more of the other factors in their favor, such as ownership of enough shares to block the vote or the benefit of common shareholder favorable fiduciary duty state case law. Or sometimes, the VCs just want to sweeten the pot to create the appearance of fairness to preserve a good reputation. But the VCs will rarely just give anything anyway; they’ll likely condition any common shareholder liquidation preference carveout on the recipients signing a release.

2016 turned out to be a terrible year for IPOs, both in terms of number of deals and aggregate proceeds.

According to Renaissance Capital’s U.S. IPO Market 2016 Annual Review, only 105 companies went public on U.S. exchanges in 2016, raising only $19 billion in aggregate proceeds. The deal count of 105 IPOs was downrenaissance 38% from 2015 and the lowest level since 2009.  The $19 billion in aggregate proceeds was down 37% from 2015 and the lowest level since 2003.  In fact, if you remove the financial recession years of 2008 and 2009, the 105 IPOs in 2016 were also the lowest since 2003.  And the drop in deal activity was indiscriminate; both VC- and PE-backed IPOs were at their lowest levels by deal count and proceeds raised since 2009.

The temptation would be to blame the weak IPO market on political election 2016uncertainty, with Brexit and the U.S. election being the biggest culprits. But then how to explain the broader U.S. capital markets, which were hot in 2016. The Dow Jones Industrial Average hovered around 20,000 at year end, and the S&P 500 Index was up 9.5% for the year.  One would expect that the market for IPOs would be pretty strong, as bullish markets normally encourage companies to go public.  To be fair, much of the market gains took place in the latter half of the fourth quarter.  But market weakness doesn’t explain the two-year drought in IPOs for technology companies, considered the mainstay of the IPO market.

Another common theory is that over-regulation, particularly Sarbanes Oxley, has made it much more expensive to go and remain public, thus discouraging many growth companies from doing so. The 2012 JOBS Act tried to remedy this by creating an IPO on-ramp for emerging growth companies, allowing for confidential registration statement filings with the SEC, “testing-the-waters” and scaled disclosure.  The immediate results were encouraging: a dramatic increase in IPO deals and aggregate proceeds in 2014.  Yet IPOs plummeted in 2015 and even further in 2016.

Renaissance Capital’s report points the finger squarely at the public-private valuation disconnect. The tech startup space in 2015 was a mystifying series of mega rounds, sky-high valuations, unicorns and unicornbubble fears. But another trend has been IPOs being priced below the company’s most recent private funding round.  In its pre-IPO round, Square Inc. was valued at approximately $6 billion, but IPO’d at just over half that valuation and then plunged further post-IPO.  Etsy Inc. and Box Inc. both reported $5 billion plus private valuations, only to plunge in the days leading up to their IPOs.  Many, including Benchmark Capital’s Bill Gurley, have blamed the late-stage bidding frenzy on institutional public investors such as mutual funds rushing into late-stage private investing.  Another major contributing factor in the escalation of late stage valuations is the trend toward generous downside protections being given to investors in exchange for lofty valuations, such as IPO ratchets and M&A senior participating liquidation preferences.  The former is simply antidilution protection that entitles the investor to receive extra shares on conversion in the IPO if the IPO price is below either the price paid by the late-stage investor or some premium above that price.  The latter means that, in an acquisition, the investor gets first dollars out ahead of earlier series of preferred and then participates with the common pro rata on an as converted basis.

Renaissance maintains that VC-backed tech companies with lofty late round private valuations chose in 2016 to avoid inevitably lower public-market valuations and had the luxury of remaining private due to ample available cash in the private markets. Mergers and acquisitions offered alternate pathways for other tech companies, such as TransFirst, BlueCoat and Optiv, all of which had previously filed S-1s for IPOs.

Although the private-public valuation disconnect was a major impediment to IPOs in 2015 and 2016, Renaissance believes this phenomenon is close to correcting itself and is optimistic about 2017. Many growth companies have seen their valuations flat or down in new funding rounds to levels that will be more palatable to public investors.  Also, the election results will likely bring a dramatic change in fiscal, regulatory, energy and healthcare policies, all of which should be stimulative to equity markets, new company formation and, ultimately, IPOs.

Another reason for tech IPO optimism for 2017 is Snap, Inc.’s highly anticipated IPO in the first half of 2017. It filed confidentially under the snapJOBS Act, and has begun testing the waters with investors.  The Snap IPO is rumored to raise $4 billion at a valuation of over $25 billion. Another one is Spotify, which raised $1 billion in convertible debt in March 2016 which signals a likely imminent IPO. These two IPOs might raise more capital than all VC-backed tech IPOs in the last two years combined.

The cost of launching an Internet-based startup has fallen dramatically over the last 15 years. This democratization of internet-based entrepreneurship resulted primarily from two innovations: open source software and cloud computing. During the dot-com era, Internet-based startups had to build serversinfrastructure by acquiring expensive servers and software licenses and hiring IT support staff. So the first outside round of investment in an Internet-based startup was typically a Series A round of $3 million or more from one or more VCs. With the emergence of open-source software, however, startups for the most part were no longer forced to acquire software packages bundled with hardware. Another issue, though, was that startups had to acquire and maintain bandwidth to accommodate peak loads, resulting in expensive underutilization. But this all changed with the advent of cloud computing, which enabled entrepreneurs to launch an Internet startup with minimal upfront IT costs and to pay only for used bandwidth. In real dollars, the cost of starting up has declined from a few million dollars to a few hundred thousand dollars.

With the precipitous drop in the cost of launching an Internet-based startup came a significant rise in interest in seed investing by angels and early stage VCs. But the typical Series A document package (amended and restated certificate of incorporation, stock purchase agreement, voting agreement, cloudinvestor rights agreement, right of first refusal and co-sale agreement) is complex, time consuming and expensive to negotiate, and contains several economic, management and exit provisions that don’t become relevant until much later (e.g., if and when the company goes public). This level of complexity can be justified when a company is raising several million dollars, but not so for a seed round of a few hundred thousand.

The resulting pressure for deal document simplification has resulted over the last several years in innovative seed investment deal documents. Seed rounds are either structured as a simplified version of a priced Series A preferred stock or as debt that converts into the security issued in a next round of equity, typically at a discount. This Part I of a two part blog series on seed round investing will focus on priced equity structures; Part II will address convertible debt.

There are currently two alternative open sourced sets of equity seed round deal documents to choose from, each with the common goals of term simplification, cost reduction, transaction time compression and document standardization. Both feature terms similar to those found in a typical Series A deal, but stripped down from the robust set of economic, voting and exit rights usually contained in a Series A. The two deal document products are:

Series AA: Created by Cooley cooleyfor accelerator Techstarstechstarsfenwick
Series Seed: Created by Fenwick & West

The main terms of Series AA and Series Seed are as follows:

1X Non-Participating Preferred: Both Series Seed and Series AA feature 1X non-participating preferred stock, meaning on a sale of the company the investor must choose between his liquidation preference of 1X (i.e., one times his investment amount) or the proceeds he would receive on an as converted basis, but not both. In other words, the investor calculates which would yield the bigger payout and choose that one. On the other hand, participating preferred would give the investor two bites of the apple: first his liquidation preference, and then his share of remaining proceeds as a common shareholder on an as converted basis.

Antidilution Protection: Series Seed provides no antidilution protection. Series AA, however, has broad based weighted average antidilution protection. Most notably, antidilution protects the investor from the economic dilution resulting from down rounds. Weighted average is the type of protection that is more fair in that it factors in the dilutive effect of the actual down round (i.e., the conversion price doesn’t adjust all the way down to the lower down round price but rather takes into consideration the number of additional shares issued at the lower price relative to the number of shares outstanding), and broad based requires inclusion in the number of shares outstanding all outstanding options and options reserved for issuance (as opposed to narrow based which would not include options).

Board Composition: Both Series AA and Series Seed provide for boards consisting of 2 common and one preferred, except that Series AA conditions the preferred board member on the Series AA shares constituting at least 5% of the outstanding equity on a fully diluted basis.

Protective Provisions: These are veto rights in favor of the preferred. Series AA gives vetos over only changes to the Series AA. Series Seed includes vetos over changes in the Series AA, but also includes vetos over mergers, increasing or decreasing authorized shares of any class or series, authorizing any new class or series senior to or on a parity with any series of preferred, stock redemption, dividends, number of directors and liquidation/dissolution.

Right of First Offer on New Financings: Both Series Seed and Series AA give investors the right to purchase their pro rata share of new issuances.

Right of First Refusal: Series Seed gives investors a right of first refusal on shares held by key holders. Series AA does not.

Drag Along Rights: Series Seed gives Series Seed holders and founders the right to require common holders to include their shares or vote for any transaction approved by the board, by a majority of the common and by a majority of the Series Seed. No drag along in the Series AA.

So what standard Series A terms are missing from Series Seed and Series AA? Missing are dividend preference (not a big deal here inasmuch as the overwhelming majority of startups will not pay out dividends), registration rights and tag-along rights (also not a big deal inasmuch as founders rarely have an opportunity to sell their shares).

Overall, Series Seed and Series AA are worthy efforts to simplify terms and reduce transaction costs. There will certainly be situations, however, where investors will resist the weaker investor protections such as the absence of participating preferred and anti-dilution protection and stripped down protective provisions. Any effort to negotiate some terms back in will undercut the objective of diversification and simplicity.

Seed stage investment deals, i.e., those in a range of approximately $100,000 on the low end and around $1.3 million on the high end, are structured either as straight equity or as convertible loans. If straight equity, the company typically issues to the investor shares of preferred stock usually designated as Series Seed which includes a package of enhanced rights but usually stripped down from seed investingthose typically associated with Series A shares.  Alternatively, the investor could invest in the form of a loan that converts into the security issued in the next equity round, usually at some discount to the next round’s price.

This post will focus on convertible note deal term trends based on the 2016 Venture Capital Report recently released by the helpful folks at Wilmer Hale. The convertible note data in the Report was compiled from over 100 deals handled by the firm from 2013 through 2015 for companies and investors in the U.S.

Conversion Discount

Seed investors often negotiate for a discount from the price per share in the next equity round to reward the seed investor for investing at an earlier, riskier stage. discount89% of convertible loan deals covered by the Report in 2015 had discounts, a significant increase from the 66% that had them in 2013.  Sometimes parties negotiate for an ascending discount in which the discount increases as the period between seed and next round increases.  The Report doesn’t provide any information on time periods between seed and next round, or on the percentage of deals that had a sliding discount.  The range of discounts was between 10% and 50%, with 74% of discounted deals having a discount of 20% or less and 26% having discounts of more than 20%.

Conversion Caps

A major advantage of convertible loans is that they allow the parties to defer negotiation of probably the most difficult business issue until the next round: valuation. But that advantage also poses a risk to the seed investor, namely that at the time of conversion at the next round the company’s pre-money valuation will be much higher and thus much more expensive for the seed round investor. caps A discount offers protection against valuation inflation, but only relative to what the next round investors are paying.  An added measure of protection is a cap on the next round valuation applicable to the seed investor’s conversion rate.  For example, imagine a $1 million convertible loan with no discount, no cap, and the company subsequently raises $5 million in a Series A round at a pre-money valuation of $20 million with a per share price of $1.  The note would convert into one million shares ($1 million loan (leaving aside interest for simplicity) divided by $1/share).  But if the note had a $5 million cap, the shares would convert at the rate of, not $1 per share, but $0.50 per share, so that the seed investor would receive two million shares ($1,000,000/$0.50) rather than one million.  I’ve previously blogged here about why valuation caps are loved by angels, tolerated by VCs and hated by entrepreneurs.

Although still popular, valuation caps seem to be trending down somewhat. The Report indicates that only 55% of convertible loan deals contained caps in 2015, nearly a 20% drop from the 74% that featured them the year before.

Conversion on Maturity

The truth about seed round convertible promissory notes is that they are promises that no one intends to be kept. At least the repayment part.  They are intended to be converted into equity.  But what happens if a qualified next round doesn’t occur prior to the maturity date of the note?  Very often, the note will provide that the outstanding principal and interest will convert on a given date, either automatically or at the option of the holder, at a set price or a price determined by a formula or procedure.  According to the Report, 60% of deals in 2015 had some kind of conversion at maturity.  Of those, 89% were at the investor’s option (up from 80% in 2013) and 11% were mandatory (down from 20% in 2013).  In addition, 32% of the 2015 deals that converted upon maturity convert into common stock, substantially unchanged from 2013 but a dramatic decline from the 54% of the conversion-at-maturity deals in 2015 that convert into common.  68% of the 2015 convert-at-maturity deals convert into preferred, also substantially unchanged from 2013, but a sharp increase from the 46% of the 2014 deals that convert into preferred.

Sale of the Company

Upon a sale of the company prior to maturity and prior to a next-round conversion, the outstanding principal and interest may convert into common or preferred stock, either automatically or at the option of the debt holder. In 2015, 74% of the convertible deals covered in the Report had some kind of conversion on a sale of the company, up from 66% in 2014.  Of those, the conversion-on-sale feature was overwhelmingly at the option of the holder (91%, up from 86% in 2014; 9% were mandatory).  Of these deals, they were pretty evenly split in 2015 between those converting into common and those converting into preferred.  In 2014, on the other hand, the conversion-on-sale provisions tended to favor conversions into common (60%) rather than preferred (40%).

Conversion Premiums on Sale of the Company

Seed investors sometimes negotiate for the right to be paid a multiple of principal and interest upon a sale of the company, similar to a liquidation preference associated with preferred stock. Roughly one half of the deals in the Report had company sale premiums.  The premiums ranged from 1.5x (i.e., 1.5 times the outstanding principal and interest) on the low end to 4x on the upper end, an increase from the upper range of 3x in 2014, although the median multiple was steady throughout 2013-2015 at 2x.

Secured Notes

Convertible note investors sometimes negotiate for the note to be secured by some or all of the company’s assets. If the note is not repaid or converted at maturity, the investor could look to the pledged assets to satisfy the loan.  Investors in 2015 were not as successful as they were in 2013 in getting their notes secured.  Only 15% of the convertible notes covered by the Report in 2015 were secured (85% unsecured), down from 25% in 2013 (75% unsecured in 2013).


The foregoing data on conversion discounts, caps, conversion at maturity, sale-of-company conversions and premiums and security suggests that the convertible note deal term pendulum may have started to swing back in favor of investors in 2015. Deal terms in the categories of conversion discounts, conversion at maturity, sale-of-company conversions and sale-of-company premiums were more favorable to investors in 2015.  Terms were more favorable to companies in 2015 with respect to caps and note security.  Given recent developments regarding cooling valuations and a stalled technology IPO market, it will be interesting to see whether the pendulum for convertible deal terms will move more significantly in favor of investors in 2016.


Lane Becker, Former CEO of Get Satisfaction
Lane Becker, Former CEO of Get Satisfaction

The Founder of a $50 Million Startup Just Sold His Company — And He Didn’t Make a Dime”.  Such was the provocative headline of the Business Insider article last year reporting the sad tale of young entrepreneur Lane Becker and how he and his management team received none of the acquisition proceeds on the sale of Get Satisfaction, the company Becker founded.  Becker’s fate was not anomalous, and happens when the cumulative liquidation preference amount payable to investors exceeds the value of the company itself.  In this blog post, I’ll briefly explain the liquidation preference overhang phenomenon and discuss how to keep founders and key employees incentivized with a carveout arrangement.

Liquidation preference is a key term negotiated in venture and even seed stage investments. It’s the amount of money the preferred stockholders are contractually entitled to receive off the top on a sale of the company before the common stockholders receive anything.  The common stockholders receive only the balance after the liquidation preference is paid, and if the liquidation preference has a participating feature, the preferred stockholders also participate pro rata in that balance on an as-converted basis.

I have previously blogged here and here about how entrepreneurs often are too fixated on valuation and tend to overlook at their peril the impact that liquidation preference can have on the value of the entrepreneurs’ equity stake. A rich valuation could be completely undercut by a heavy liquidation preference stack.  For example, suppose an investor is proposing to invest $20 million at a pre-money valuation of $60 million for Series B preferred stock constituting 25% of the total equity on an as converted fully-diluted basis and includes a 2x liquidation preference.  The founder is giddy about the $60 million pre-money valuation and takes the deal.  The company had previously raised $10 million in a Series A round where the Series A had a 1x liquidation preference.  Two years after the Series B, the company is sputtering, challenged by competitors and investors and management alike believe the company may only be valued at $40 million, $10 million below the cumulative liquidation preference of $50 million (2 x $20,000,000 (Series B) + 1 x $10,000,000 (Series A)).  Founders’ and management’s common shares are essentially worthless and, consequently, they have little or no incentive to work hard and help the company succeed.

Prior to being acquired, Get Satisfaction was reported to have raised $10 million in a Series B round at a pre-money valuation of $50 million, bringing the total amount raised to $21 million. The purchase price of the acquisition was not disclosed, but it must have been less than $21 million for management to have been washed out (assuming a 1x liquidation preference).

In Lane Becker’s case, he had been terminated as CEO a few years prior to the acquisition of Get Satisfaction, which could happen when founders negotiate away control of their company. But what happens in the more typical scenario when founders are still the CEO or otherwise are employed by and managing the company at a time when the liquidation overhang looms, i.e., when the aggregate liquidation preference amounts exceed the company’s valuation?  What incentive does the common stock holding management team have to stick it out?  Cash compensation will rarely get management satisfaction (pun intended), either because startups seldom have the cash to do so or because cash compensation was never a motivating factor for key employees to begin with.  By joining a startup, talented employees typically sacrifice higher cash compensation they could earn with more established companies in favor of the upside potential that comes with equity they receive in the startup.  Hence, the drill would be to come up with a mechanism that simulates the upside potential of equity without that upside being negated by the liquidation preference overhang.

That mechanism is a bonus or carve-out plan that provides for a payout to carveouteligible employees upon a sale of the company or other liquidity events identified in the plan. A typical plan sets aside a pool of money whose amount is determined based upon a certain percentage of acquisition proceeds.  A well drafted plan would address certain issues related to calculating the proceeds upon which the payout is determined, such as assumption of debt by the purchaser, deferred payments, earnouts and contingent payments.  The relevant percentage may also be on a sliding scale, e.g., 3% on the first $100 million, 5% on the next $50 million and 7% on amounts exceeding $150 million.

Inasmuch as these plans are intended to provide value to common stockholders when the common is worthless, plans could (or should) consider the value of the common (i.e., when the purchase price exceeds the liquidation preference amount) as an offset to payouts and also set a ceiling on payouts. The plan could be structured either as a quasi-contractual commitment by the company in the form of a benefit plan or as a special class of common stock that would be issued to founders and key employees that would be pari passu with the preferred but have a separately calculated payout formula upon the sale of the company.

In Part I of this two-part series, I explained how a favorable pre-money valuation can be undercut by a large option pool baked into the pre-money cap table.  In this Part II of the series, I will concentrate on one other deal term that can serve to undermine a negotiated valuation:  liquidation preferences.  Failure to focus sufficiently on liquidation preference mechanics could also lead to a distortion of incentives and serious strategic issues down the road.

First, a simple scenario.  You’re a startup founder negotiating a $5 million Series A round with a VC and you agree on what seems like a generous pre-money valuation of $10 million.  The company issues the VC preferred shares constituting one-third of the overall equity of the company ($5 million/$15 million post money).  The company grows nicely over the next seven years and receives an acquisition offer of $30 million.  You can hardly believe your good fortune as you quickly calculate that you, your co-founders and angel investors will collectively reap $20 million (2/3 of $30 million).  But your lawyer takes a look at your charter and delivers the bad news: the common holders’ share of the proceeds is actually only $11 million.  What happened?    

In most VC deals, the investors receive shares of preferred stock in exchange for their investment.  Although this form of security is usually associated with a whole range of economic, management and exit rights superior to common stock, the name preferred derives from one of the most important of these rights, namely the liquidation preference.  In its simplest form, the “liq pref” (as VCs often refer to it) is the investor’s right on a sale of the company to receive a certain amount of the proceeds off the top before the common holders receive anything.  In the real world, however, liquidation preference provisions are more complicated, so I’ll describe the typical variations and how they could end up impacting the acquisition proceeds waterfall in spite of the negotiated pre-money valuation.

The amount of the initial preference is usually not less than the amount invested, and is often a multiple of that amount, e.g., 1.5x, 2x, etc.  It’s also not uncommon for accrued but unpaid dividends to be added to the initial amount.  What happens next depends on whether the preference is participating or non-participating.  With participating preferred, the investor first receives the agreed-upon initial amount before the common holders receive anything, and then shares the balance of the proceeds (if any) pro-rata with the common on an as-converted basis.  With non-participating preferred, the investor does not share with the common after his initial preference amount.  But remember, preferred almost always has a conversion feature allowing a preferred holder to forego his preference and convert to common.  So with non-participating preferred, the holder has a choice to make, depending on what yields the most proceeds for him: either the preference amount, or his pro rata share on conversion.  With participating preferred, the holder generally does not have to make that choice; he gets the initial preference, and then he gets his pro rata share of the balance on an as-converted basis (but see below regarding capped participation).

In the above hypothetical Series A deal, the VC agreed to a $10 million pre-money valuation, thus receiving 1/3 of the overall equity, but also negotiated for and received a fully participating 2x liquidation preference with annual 10% cumulative dividends (payable on a sale).  The math works as follows:


Initial Preference                                             $13,500,000

            2 x $5,000,000            $10,000,000

            10% x 7 yrs.                $  3,500,000

 1/3 Participation                                               $ 5,500,000

            1/3 x $16,500,000       $  5,500,000

 Proceeds to Preferred                                       $19,000,000

 Proceeds to Common                                       $11,000,000

Companies will often try to limit the sting of the “double-dip” participation feature by negotiating a cap on the participation that follows the initial preference.  The cap is expressed in terms of a multiple of the investment amount, usually in the range of 2x to 3x, and the cap almost always includes the initial preference amount.  This is called capped participation, and participating preferred with no cap is referred to as full participating preferred. 

On the surface, both non-participating and capped participation seem better for the founders, but in practice both could lead to a distortion of incentives for the preferred and unintended consequences for everyone.  With full participation, the interests of the common and preferred will always be aligned; both classes will always be incentivized to seek the highest purchase price.  But with both non-participating and capped participation, there could be a range of prices in which the preferred have no incentive to seek a marginally higher price because within that range the common receive 100% of the marginal increase in price and the preferred receive no additional consideration. 

The two examples below illustrate this point.  Both examples assume a 1x liquidation preference on a $10 million investment, and a $10 million pre-money valuation where the investor is issued 50% of the equity.


Acquisition Price

Proceeds to Preferred

Proceeds to Common











Acquisition Price

Proceeds to Preferred

Proceeds to Common














Because neither of the above examples is fully-participating, the investor at some point will elect to convert to common and forego the liquidation preference, in each case at the point at which the purchase price is high enough so that the investor receives a higher pro-rata share on an as-converted basis than he’ll receive without conversion.  But notice that in each case there’s a range of purchase prices at which the investor stops receiving additional proceeds on the liquidation preference (on the lower end of this range) and before it makes economic sense for the investor to convert (at just above the upper end of the range).  In the first example, because there is no participation, the investor receives no additional proceeds between a $10 million and a $20 million purchase price (just above the latter being the point at which the investor would convert and take his 50% share).  So assuming the VC is looking to exit and the company receives an offer of $10 million, the investor would have no incentive to seek a higher price unless he believed the price could exceed $20 million.  Similarly, in the second example with a 1.5x participation cap, the investor would have no incentive to seek a price higher than $20 million (at which point he’s capped out at $15 million), unless he believes a $30 million price is achievable currently (above which he’d convert to common and surpass $15 million in proceeds). 

The foregoing phenomenon has been referred to by commentators as the dead zone or the zone of indifference.  I’ll call it the “range of indifference” just to be different.  Once the VC is in the range of indifference, he has no incentive either to negotiate for a higher price, or to defer a sale altogether to build more value in the company.  Even if the investor believed the Company may be worth 50% more in two years, he would have no incentive to take that risk because he’d receive no additional proceeds from the higher price.  The common holders, of course, would have the exact opposite set of incentives and would seek either to negotiate for a higher price or to continue to build value in the company in the hope of selling for a higher price down the road.  This distortion of incentives resulting from the range of indifference actually gets even more complicated as the company completes additional rounds of funding and particularly when an investor in a later round such as a Series D has priority over earlier rounds of preferred.