Terms > Valuations

Why terms can matter more than valuations

Jan 19, 2017 · 6 min read
Photo credit: Unsplash

It goes without saying that the valuation placed on a company is a key variable forming part of any negotiation at a financing round. However, I’d argue that terms can matter more. This is never more true than when considering a VC favourite, the “liquidation preference”.

What is a liquidation preference?

Liquidation preference often referred to as the “waterfall”. Photo credit: Unsplash

A liquidation preference is a right that can be required by investors in respect of their capital contribution (i.e. their investment amount). It is a common right given to preference shareholders. It effectively provides a mechanism by which they can receive a certain amount before other shareholders on some form of liquidation event (this often also covers winding up, merger and acquisition). The amount they will receive could be equal to the amount they invested (typically referred to as 1x), or some multiple thereof, depending on the terms negotiated.

What’s the impact?

This largely depends on the drafting of the liquidation preference. In particular, whether the liquidation preference is “participating” or “non-participating”.

To explain let’s consider two simplified scenarios:

Scenario 1 — Non-participating liquidation preference

Company X has received an offer for an investment of £5m from “VC Fund” for its Series A at a £15m pre-money valuation. This will be its first outside investment (good going Company X!). The £5m will be invested in return for preferred shares that, amongst other things, benefit from the right to a 1x non-participating liquidation preference.

In Scenario 1, post investment the equity split amongst investors and founders is as follows:

  • VC Fund = 25%
  • Founders = 75%

In Scenario 1, assume the company struggles to achieve traction and fails to raise again and with limited options decides to pursue an exit for £10m.

From a £10m acquisition offer the proceeds would be split as follows:

  • VC Fund = £5m = 50%
  • Founders = £5m = 50%

Even though the equity split is 25:75 in favour of the founders, in this scenario, the 1 x non-participating liquidation preference results in a 50:50 split of the acquisition proceeds. This is because VC Fund would choose to get its preferred amount in order to recover their investment rather than participating pro rata with other investors.

Scenario 2— Participating liquidation preference

Assume the same economics as scenario 1 (£5m at a £15m pre) but this time the VC Fund has negotiated a 1 x participating liquidation preference.

The same post investment equity split amongst founders would apply:

  • VC Fund = 25%
  • Founders = 75%

Again, assuming a situation transpires whereby a £10m acquisition offer is to be pursued.

In scenario 2, for a £10m acquisition offer the proceeds would be split as follows:

  • VC Fund = £6.25m = 62.5%
  • Founders = £3.75m = 37.5%

Again, the VC Fund would elect to maintain its preferred share rights rather than convert into ordinary shares. This results in a significant swing in favour of the VC Fund in terms of returns received.

Participating vs. Non-participating

The two scenarios highlight the difference between participating and non-participating liquidation preferences. The non-participating variant can be thought of as an “either or” clause whereby the investor can receive the amount they invested or their pro rata share of the proceeds. In the above scenario 1 they would choose to receive their preference amount because this is the greater (£5m vs. £2.5m). However, if the acquisition price exceeded £20m the VC Fund would elect to convert its preferred shares to ordinary shares in order to participate pro rata because this would result in a greater return than £5m. This is why non-participating liquidation preferences are often classified as “down-side protection” provisions because they help investors potentially limit their loss on a liquidity event.

If participating preferred was a sweet…

The participating variant gives the investor the right to receive their preference amount and their pro rata share of the remaining proceeds. In scenario 2 this results in £5m (1 x their investment amount) plus £1.25m (25% of the remaining £5m). A participating liquidation preference provides down-side protection whilst also giving the investor the right to participate in the upside, hence the “double-dip”.

In addition to non-participating and participating, other terms to look out for in relation to liquidation preferences are:

  • senior liquidation preferences that stack on top of liquidation preferences that were provided to investors on previous rounds.
  • multiple liquidation preferences in the above two scenarios we have assumed a 1 x liquidation preference but this could be higher (i.e. 1.5x, 2x etc.)

For a useful maths cheat sheet on the implications of participating, non-participating, senior and multiple liquidation preferences on exit proceeds check out this post.

How is this fair?

Whilst providing any form of preference may seem disproportionately favourable to an investor, let’s consider this for a moment from the investor perspective. Again using my £5m round and £15m pre example from above, a £10m exit is a very poor outcome for an investor and especially so for an institutional VC investor. When you take VC money you’re setting on a course to pursue outsized returns, a £10m exit likely does nothing for a VC with regards to them returning their fund. So although the inclusion of a liquidation preference does provide downside risk protection for an investor it also serves a secondary important purpose - aligning incentives. Without a liquidation preference a £10m exit would be an OK outcome for founders in the event there’s two of them and they each walk with £3.75m (£7.5m / 2) — that’s a pretty nice payday. But with the preference their potential proceeds are reduced significantly. Therefore the inclusion of a liquidation preference also further incentivises the founders to shoot for higher growth and a larger exit outcome and provides an additional mechanism for aligning their interests with that of their investors.

What’s market here?

I don’t like solely looking at “what’s market” and would always rather encourage founders to discuss with their investors why they are looking for certain terms and get a sense for how important they are for them. However, for early stage financings where the company is issuing preference shares, 1 x non-participating is standard. If you’re a founder negotiating an early stage financing round and your investor is looking for participating or a multiple you should ask them to explain why they require this. If what they are asking feels inequitable this may be an area to push back because it could set a nasty precedent for future rounds.

Fenwick and West’s “The Terms behind Unicorn Valuations” analysed the terms of financings undertaken by US based unicorns during the 9 month period ended December 31 2015. The following is interesting to note with regards how liquidation preferences were structured in the surveyed companies documents:

  • Non-participating liquidation preference over common (ordinary) shares was included in 98% of the equity documents
  • Participating liquidation preference was in 6%
  • Senior liquidation (preference over common and other series of preferred stock) was in 21%
  • Multiple liquidation preference was in 6%

Hopefully the above illustrates why I think terms matter more than (or at least as much as) valuations and why it’s so important for founders to appreciate this and go into financing discussions armed with this knowledge.

The above points are by no means exhaustive and I’d love to hear feedback or potential additions. You can find me on Twitter @tom_wils.

Thanks to my esteemed colleague Dave Haynes for proof-reading a draft of this post.

Tom Wilson

Written by

early-stage investor @seedcamp

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