“That’s the thing about smart guys: we cover our asses!” This quote succinctly explains why VCs want to have a Liquidation Preference clause in the term sheets.
Can’t blame them — as much as they would love to be seers, they are not. Most of the startups that they are going to back — I might add with a very strong conviction — will not exist in the next 5–10 years. That is why they want to pull back each and every penny they can so that they can live to fight some other day. Funds are not immortal; they too can die.
So, when you are signing the term sheet, you will definitely find the Liquidation Preference clause somewhere in the long legal document. However, there are a lot of nuances which the Liquidation Preference might take. Let us deep dive a bit.
What is It?
The preferred shareholders (these are the shares which VCs initially take) have the right to receive the funds they have invested before any other common shareholders (usually the founders) in case of a liquidation event.
You Think You Know It But It is Not What You Think…
Let me solve this riddle.
A lot of founders believe that liquidation events stand for bankruptcy or winding down of business.
You sell the business? Boom!! Liquidation event.
You sell a large part of your operations? Double Boom!! Liquidation event.
You want to join hands with your competitors and merge with them? You know what I would say.
In short, if there is a major rejig in the ownership control of the EXISTING shareholders, it is going to invoke that clause.
Think Milkbasket. Think liquidation event.
Is There a Standard Ask by the Investors?
Life would be dull without any variety, so would have been this article. The rights which investors give themselves vary in type and extent dramatically. Let me explain.
- The first right is called Non-Participating Liquidation Preference. Please, do not get confused by the name — investors will always participate if founders are getting any penny. It is not a question of “if” but “how much”.
So this is how Non-Participating Liquidation Preference works. In this case, investors would tell the founder, “I am not very greedy. So, if our partnership comes across a liquidation event, you can either give me 1.5X (It is a range, some cute ones ask for 1.1X and some even ask for 2.5X) of the investments I have made.
A percentage of the stake I have in the company assuming the shares are converted to equity.”
Whichever is higher.
Let’s deep dive with an example. Suppose a VC invests $300K for a 10% stake and their clause says that in case of a liquidation event, they will get 1.5X of the money they had invested or the proportion of stake they will have, assuming their preference shares were converted to equity shares.
After 2 years, you sell the company for $5M. Now the VC would have the option of asking for either 10% of $5M, i.e. $500K OR 1.5X of $300K. That would be $450K.
The associate is going to treat himself/herself with a beer at least (30% IRR). Whereas, for you, the pie left would be smaller. If there are many investors on your cap-table, then you might not even have enough left for a taxi.
2. The second one is called the “Participating Liquidation Preference” a.k.a “Double Dipping”. This one is my favourite. Here, the investor does not like the “OR” mentioned in the Non-Participating Liquidation Preference right. They want an “AND” in its place.
They would first ask for the investment they have made (it can be a multiple as well) and then from whatever is left, they would also take the corresponding percentage of the investment made. Reminds me of the bullies from school.
For instance, in the previous example, if the investor had participating liquidation preference rights, then they would first get $450K for the investment and then from the remaining money ($5M - $450K = $4.55M), they would get 10%, which would be about $455K. This would bring the total to $905K on an investment of $300K in 2 years. So earlier, if the founders were left with $4.5M, in this case, they are left with $4.095M.
Savdhan rahe, satark rahe, ek oversight aapki zindagi badal sakti hai.
I am pretty sure a dinner at the Taj will be due for the associate, while the LPs and GPs make merry.
Can You Be Saved?
Founders should be wary of the second set of investors the most. While it is the fiduciary duty of the investors to make money, we personally don’t believe that it should happen by bleeding someone dry.
For this very reason, founders can incorporate “multiple liquidation preference” as a clause. It would be best if the founders go for Non-Participating Liquidation Preference with a cap on the multiple, i.e. 1.5X or 2X max. This also happens to be standard industry practice. The investor will just get a multiple for the preference shares. And everyone can go home happy.
This is the first in a series where we untie the knots of the term sheet and see what the eight most-dreaded clauses mean. See you next time with another clause.