Why founders should be well informed on financing terms sheets and negotiate harder on the liquidation participation feature.
In Venture Deals, Feld and Mendelson suggest that entrepreneurs should band together to reinstate the participating preference "kick-out" whereby participation rights in the liquidation preference are void if the company achieves a meaningful return for the VC.
Two Different Classes of Stock
Many startup founders and employees fail to understand the differences between common and preferred shares and why those differences matter.
In a sale of a venture-backed startup, a common shareholder's percentage of ownership is not based on the entire percentage of ownership of the company (all classes of stock). The common shareholder only meaningfully owns a percentage of the total percentage of common stock (at the very best).
► For example:
In the least complicated, absolute best case scenario, in a startup worth $100M, where the preferred shares equal 35% of the company and the common shares equal 65% of the company, the preferred shares are worth $35M, and the common shares are worth $65M. A common shareholder with 2% ownership would only meaningfully own $1.3M worth of shares (2% of $65M common shares, not the full $100M value).
Most employees think that, if they own 1% of a company sold for $100 million, they will get $1 million. But that’s not the whole equation.
(Heidi Roizen, Medium)
Liquidation Preferences
Generally, in a liquidation event (e.g., a sale of the company), the preferred shareholders (investors) are entitled to a payout of the full amount of their investment first, prior to other expenses (legal fees, banker fees, etc.) and prior to any payout to common shareholders (founders and employees).
► For example:
Investors paid $20M for their preferred shares. The company sells for $100M. The investors receive $20M first. Then, expenses (which can be hundreds of thousands or more) are deducted from the remaining $80M. Then, the common shareholders are paid out based on their percentage of ownership.
Thus, if you own 2% of a startup, you do not receive 2% of the sale price (not $100M x 2% = $2M). Instead, you receive 2% of ($80M - expenses). If expenses are $2M, then the remaining $78M is split between the founders and employees based on their percentage of common shares. Your 2% ownership would get you $1,560,000. Not terrible. Unfortunately, this example is not the most common.
More often, investors will negotiate for a multiple of their investment (e.g., 1.5x - 2x).
► For example:
Same example as above, except the investors are entitled to 2x their investment: The investors receive $40M first. Then, expenses are deducted from the remaining $60M ($60M - $2M in expenses = $58M). Then, the common shareholders are paid out based on their percentage of ownership.
When the remaining $58M is split between the founders and employees, your 2% ownership would get you $1,160,000. Not terrible at first blush. When you start doing the math, however, this view may change. If 5 years were put into the startup with minimal to no salary, that means is only averaged $232,000 per year from the sale. A talented software engineer can make this amount without working for a risky startup.
Cumulative Dividends
Let's say the investment took place four years prior to the liquidation event and the investors are also entitled to an annual cumulative dividend of 10%.
Here, the preferred would also receive $4 million in dividends, for a $24 million total liquidation preference payout. ((10% of the $10 million investment = $ 1 million); ($1 million per year x 4 years = $4 million); ($4 million in dividends + the $20 million from the return multiple = $24 million total payout)).
Non-participating preferred shareholders only receive one or both of these optional preferences and their payout stops here. They will not be eligible to participate with the common shareholders in the division of the remaining liquidation proceeds based on their percentage of ownership.
In this example, with a liquidation payout of $40 million, the non-participating preferred would first receive its $24 million. The remaining $16 million would then be split between the other shareholders based on their ownership percentages.
So, that $16 million could be split between the company's co-founders, employees, advisors, Angel investors, friends & family investors, and/or anyone else who holds common shares in the company.
Entrepreneurs are sometimes unaware that the common shareholders combined can own more than 50% of the company, but receive less than half of the liquidation payout because of the liquidation preference multiple and dividend.
The Participating Preferred
The biggest difference between non-participating and participating preferred shares, is that the latter does not stop participating in the liquidation payout after their preference is received. Instead, after their preference is received, their preferred shares are converted into common shares and they participate in the distribution of the remaining payout with the common shareholders based on their percentage of ownership in the company on an as-converted basis.
The as-converted ratio is generally 1:1, although the term sheet could specify something else.
► For example:
Use the liquidation preference hypo above and add the participation feature. Let's say that the preferred owned 25% of the company and the liquidation payout was $40 million.
From the $40 million, the preferred would first receive their $24 million preference payout as previously outlined.
The preferred shares would then convert into common shares and the holders would receive a payout with the rest of the common holders based on their percentage of ownership on an as-converted basis. If the conversion ratio was 1:1, they would receive a payout based on their 25% ownership in the company, which equals $4 million, for a total of $28 million. ((25% of the remaining $16 million pot = $4 million) ($24 million already received from the preference + $4 million = $28 million)).
Now, with the participation feature, the other 75% owners of the company would have only $12 million to split amongst themselves based on their ownership percentage.
Consider that many companies have had multiple Series of investments before a liquidation event—each Series with their own liquidation preferences. In many cases, the participating preferred owns a more substantial portion of the company than just 25%.
Why This Extra Participation Payout Matters
Let's say this founder has been working on her company for a decade. In order to grow she had to give up equity at multiple points to obtain funding or acquire talented employees. She now owns only a small percentage of her company.
► For example:
In the scenario described above, say the founder only owns 10% by the time a liquidation event occurs. She would only receive just above $1 million from the payout for a decade of hard work, sweat, and sacrifice.
One way to view it is that she earned a $120K year salary ($1 million ÷ 10 years = $120K per year). However, it's not quite that simple.
Conventional wisdom says that: (a) most people wouldn't risk the comfort of a stable job (with raises and benefits), time with family, and their sanity for the very small chance of receiving the equivalent of $120K a year at some indiscernible time in the future; (b) the financial opportunity cost of waiting for a payout is too high; and (c) the payout would be reduced by the amount of any personal debt accumulated while building a business.
If said brilliant founder instead chose to work as an engineer for an established corporation making a stable annual salary of $120K (with raises) for that decade, she could probably have been home in time to have dinner with her family (on most nights) and have continually invested a percentage of her annual six figure income.
So, instead of building a startup, she could have spent that decade compounding the investments from her income year over year (it's always better to have money now than later), have become a debt-free multi-millionaire, and had time to raise her kids, learn to golf, or take some vacations.
When founders are not adequately compensated for risks and hard work required to build a company, it's just not worth the struggle. Often times the participation feature delivers an unnecessary blow to the entrepreneur.
History of the Participating Preferred
Prior to the dot com bubble, the participating preferred was only featured in East Coast venture capital term sheets.
During the 1990's entrepreneurs seeking money from East Coast VCs were still able to negotiate on the liquidation preference by asking for "kick-outs", whereby the participation feature would cease to apply if the company reached a meaningful ROI for the VC. "Meaningful" in the 90's usually meant 2 - 3 x the investment.
Much of the money lost in digital companies during the bust came from New York-based venture capital firms.
It's not a correction, it's a crash.
(Fred Wilson, managing partner at Flatiron, a NY-based VC firm dedicated to investing in the digital economy. Nov. 2000).
Unsurprisingly, the participating preference, designed to be a protective provision for high risk investments, became a standard term of all venture deals on both coasts after the bust regardless of industry or stage of the company.
Is the Participating Preferred Still Relevant Today?
Seventeen years have passed since the dot com bubble and the startup economy has changed drastically.
The JOBS Act significantly increased the ability to invest in private companies by easing certain securities regulations. As such, startup investing has become a key strategy for many looking to add high-risk, high-potential-reward alternative assets to their portfolios.
In the first three quarters of 2018, VCs poured $86 billion into startups, more than at any other point since the dot-com era.
Source: Pitchbook.
With the amount of private capital available to startups and the potential for significant ROIs investors, entrepreneurs should ask themselves whether it's now possible to negotiate harder on the participation feature. Startups will always be risky due to the unproven nature of the business. This risk is generously compensated for with the potential for a higher ROI than can be achieved through other means, such as public markets or government bonds.
The liquidation preference was designed to protect the VC from an exit that is lower than the amount invested. It is meant to ensure, at the very least, a return of investment in any liquidation event. The additional participation feature was borne out of the need to protect investors from extremely high risk ventures, and may now be an unnecessary extreme.
Possible Answer: Maybe Only for High(er) Risk Startups
Perhaps today the participating preference is only relevant in extraordinarily high risk investments—situations where a company carries a higher level of risk than an average startup of not giving the investor any ROI.
It's true that the standard for "meaningful" ROI may have increased from the standard 2 - 3x multiple of the 90's. However, perhaps entrepreneurs and investors negotiating a deal can agree on a percentage that would be a "meaningful annual return" for that particular investment.
The Participating Preference Counter-Argument
Understanding the VC's point of view is an important aspect of the negotiation. Entrepreneurs cannot tackle issues head on that they don't understand.
The counter-argument entrepreneurs may encounter from VCs is that the startup economy is on the verge of a worse crash than in 2001.
The venture business is all about excess and then correction. It's like disk drives in the 1980s, when venture capitalists funded 50 disk-drive makers when the world needed three. . . companies that don't have a path to profitability or a leading position in their market will be shut down rather than receiving second or third rounds of funding.
(Steve Bengston, early-stage advisor at PwC, San Jose, CA, Nov. 2000).
The concerns of VC firms and the basic principles of economics haven't changed. Some deals made in the 90's were not bad because the company had a bad product, but merely because the VC activity in the industry was oversaturated.
Like digital companies in 2000, the current tech boom has led to significant venture backing in tech companies for several years now. Likewise, many investors and analysts are predicting the tech bubble will burst.
How Startups Can Negotiate the Kick Back
One way for a startup (in any industry) to negotiate a kick back of the participating feature is to show investors how the product or service is different than other players in the market, and the path to profitability and/or an exit plan. If there are other players in the market, perhaps one of them will acquire the startup once it becomes profitable or its technology too competitive.
Whatever the startup's playbook, entrepreneurs should show investors its been well thought out in advance. Of course, this is a good strategy for all aspects of funding negotiations.
It's might also be good to mention to the VC that Pitchbook has reported that the percentage of deals with participation rights have been steadily decreasing from about 55% in 2008 to about 18.6% in 2018.
Relevant reading:
• Venture Deals, by Brad Feld & Jason Mendleson
• Venture Capital Deal Terms, by de Vries, Van Loon & Mol
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