It seems a little unfair that founders may only get 1-2 experiences in term sheet negotiations whereas the VC has a wealth of experience. From a VC perspective, we’re looking to mitigate our risk through preferred shares.
If I invest $1 million into your company for 25% equity, what happens if the company exits for $2 million? Without liquidation preferences, I’d only get back $500,000 back (25% of the equity). With 1x liquidation preferences, I get my $1 million back.
Liquidation preference allows the VC investor who owns preferred shares to be paid “in full” prior to any of the common share investors (founders and employees) getting paid off. With a 2x liquidation preference, the VC gets the first $2 million and the common shareholders get $0.
I came from a real estate hedge fund background and we focused primarily on hard money lending. Higher levels of liquidation preference reminds me of a hard money loan. With a 2x liquidation preference, I have something like “the collateral of a house.” If we fire sale the startup for $2 million, I can still double my money.
It’s important to note that liquidation preferences typically apply to M&A exits or bankruptcy proceedings, but not to IPO exits. On most term sheets, the preferred shares convert to common shares in the event of an IPO.
Here are some tips on a few things to check on your term sheet.
Review your term sheet to double check that your conversion from preferred shares to common shares is on a 1-to-1 basis.
It’s uncommon to have participating liquidation preferences, which means that the VC preferred shareholder still owns a part of the company even after getting paid-out their liquidation preferences. This is like eating your cake and having it too. The typical term sheet has non-participating liquidation preference which means that the investor has to choose between exercising their liquidation preference or converting their preferred shares to common shares.
Seniority of liquidation preferences. It’s common for later round investments to have seniority in liquidation preferences over earlier rounds. You’ll want to understand exactly how the waterfall of payouts is constructed. Seniority alternatively could be Pari Passu.
I’ve also been involved with Hollywood feature film funding. Liquidation preferences for a VC remind me a lot of the film waterfall. Typically, the P&A (Print and Advertising.. the cost to market the movie) gains seniority in liquidation preferences. The seniority may not even be equal amongst the P&A investors. Something like 40% to 50% of the P&A goes to media buy spends (like tv commercials). If I were investing in a film, I would want to be like Disney or Fox and own the media buy company. I’d want the profits from the media buy, merchandising and distribution fees to exceed whatever money I have invested in the movie.
If you’re a start-up founder, you’ll want to master the financial structure of your term sheets. Don’t end up like the average movie producer who made more than $100 million in box office sales but ended up making nothing after all the liquidation preferences were paid out.