Liquidation Preference and Participation Commentary

A few months ago, Dick Costolo (a.k.a. Ask The Wizard) wrote a great post on Liquidation Preference and Participation in a venture financing round.

Since Dick and I are "brothers from different mothers" (i.e. both Chicago-based tech entrepreneurs with blogs on startup issues, who post too infrequently but make up for it with posts that are far too long!), we started an email dialog on this topic.  I should re-write / re-organize the content of the email, but since the end of summer is here and I'm too lazy to do it, I'm just going to post it as is.

I have also done an open source spread sheet (see below) to help fellow entrepreneurs model out the effects of different preference and participation terms in a venture financing.  If anyone is going through that phase and don't *really* understand the ultimate effect of those terms, its worth going through. You can change different amounts of dilution, change from a preferred security to a participating preferred security, put in different preference multiples and institute different levels of caps on participating preferred securities, and then change the exit price range.  Changing these variables rolls through the whole model and shows what cash returns go to management and what goes to investors, and compares it to what each would get at those exit levels in a plain vanilla preferred stock financing.  Please feel free to take it and post it elsewhere so more people have access to it.

Download Cap_table_decision_support_tool_v1.0b_(open_source)

(the v1.0b is the corrected version of spreadsheet; do not use v1.0 or v1.0a as they both contain errors!)

You can read Dick's post first, and then read my email reply below to him.

Dick:

Just read your post. Very good info. Some of my thoughts on the topic are below:

1. Preferred stock is debt OR equity
2. Participating preferred stock is debt AND equity. The word "preferred" represents the debt and the word "participating" represents the "AND equity" (simple, everybody gets it when explained that way)
3. A lot of VCs use participating pfd because that is how LPs charge VCs. E.g. in a $100mm fund, LPs in effect loan the VC firm $100mm and the LP gets their $100mm back PLUS they get 80% of the profits...and we all know which way sh*t usually rolls when on a hill. Deal with it. If you're lucky enough or good enough to be on a hill that reverses the laws of physics, more power to you!
4. Caps can create very funky return profiles. They usually create pockets where the investor return flat-lines for a period of time, i.e. the investor is indifferent between exit at X and X+a because the money back to them is the same. Entrepreneur is NOT indifferent between X and X+a so it can create misalignment at a very critical time.
5. Every single one of these terms can be thought of on a risk/return curve. I would even draw a curve to highlight it. 99.9% of VC - Entrepreneur misunderstandings is because VCs are almost myopically focused on the low end of the curve and entrepreneurs are focused on the high end. But they never discuss it in those terms...its like a Mars - Venus thing. If entrepreneurs can put their Venus glasses on and talk to them that way, then you can usually find creative ways to bridge the gap. Give them the protection they want on the downside but tell them you need more upside for it. It doesn't always come in the form of higher valuation, but sometimes in additional options for founders...maybe out of the money options if necessary. Or some other mechanism. You don't want to get too cute, especially on a Series A, but it at least signals to your Venusian that you understand and acknowledge their issues and are trying to be creative about how to solve them. That alone can work wonders in the relationship.
6. Entrepreneurs should always always always (did I say always?) remember how the VC gets paid and understand how the other investments in the fund are doing because that drives 90% of how a VC will think about your company (remind me to tell you a relevant story from the book The Tipping Point...about the Good Samaritan and the power of context). Its like a CEO always has to know how his sales guys are getting paid and where they are in their quota. If the other investments in their fund are middling to poor then they are going to take a more conservative stance and use the return from your company to just get them above water so they can stay in business and raise another fund (or keep their job inside of their firm). If you have a VC who is cranking away on good deals in their fund then they are going to take an aggressive stance and swing for the fence. Different VCs are drawn to different places on the risk - return curve based on the context of your company inside their fund. One place on the curve is not inherently better than another place...you just need to make sure that your eyes are open to that and that hopefully the entrepreneur wants to live on the same place of the curve as their investors. Doesn't always happen, but to make sense of your spouse's (er...your investor's) behavior you always need to keep that in mind.

Comments

[AlFromChicago]

Dan --
Great post. On your last point -- best advice I ever received from a private equity friend of mine was "everyone acts in their own best interests" - once you understand where VC is coming from life gets a lot easier.

Reality is, entrepreneurs need home runs to do great in a VC deal. That's the price you pay to the cash -- that a small successful business will not be great outcome for you as a founder. Not making value judgement just stating fact

[Will]

Be careful with that excel file - it needs a little (but significant fix). It uses the new super-duper preferred: take the preferred and then add the investors ownership percentage by the original equity value (not deducting for the preferred). I sent a fix to the author which I suspect he'll post, but if not - just fix the far right column.

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Will is correct in that the original file had an error. I have fixed it now. If you are reading this (and see the file version as 1.0a) then you have the right file.

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