A new type of liquidation preference to reward founders— el Kolchon
Starting a new business is hard and often implies going through s**t. Not only does it imply less time to sleep, for family, friends or leisure time, but it also implies a fundamental economic risk for entrepreneurs.
Moreover, if you are starting a new business you come across Venture Capital (VC) which, can make that s**t become even worse. Oftentimes, professionals in the VC industry, with the excuse of watching over the wellbeing of our investors, forget to do an exercise of self-criticism and improvement.
VC isn’t only negative, it’s also a tool that can allow you to accomplish in two years what would normally take you at least four, without it. The challenging aspect is that taking money from a VC is no longer an option because your competitors will likely resort to it, if they can.
This post will explain an exercise of self-criticism that we have conducted in K Fund about the liquidation preference clause that we normally include in our agreements. Furthermore, we will comment on the countermeasure we have invented to make this section of VC more logical and thereby more sustainable.
A small note on Liquidation preference (preferential liquidity right)
This clause gives the investor the right to, in case of a liquidity event, a certain predetermined amount of money with priority to other partners, founders and employees. This makes some sense since the ultimate goal of this clause is to discourage the sale of companies at low valuations. The VC has to protect itself from the hypothetical event that the companies it has invested in are sold for 2x and thus not fulfill the investment criterion of their investors (around 3x). For example, a 1x LP means that if an investor invested € 1M and the company sells for € 1M, all the money would be taken by the investor. If it were € 1,5M, the remaining € 0.5M would be distributed among the rest of the partners until they reach the point where they all received the amount that would correspond to their participation in the company. From that moment on, it is like there is no LP clause.
Below is an overview of different valuation scenarios and what would happen if € 1M was invested in exchange for 20% of a company:
Expressed graphically it would look something like this:
But there are many types of LPs:
- 1x, 2x… as in the example mentioned. We have never seen 3x but 2x yes.
- With IRR rather than x. For example, with an IRR of 10% it would mean that if the sale is made in in one year, the LP would have an implied value of € 1,1M [€ 1M * (1+0.1) 1]. Similarly, after two years the value would be € 1.21M [ € 1M * (1 +0.1) 2] and so on. In our humble opinion, the IRR on LP is a little exaggerated. An exit may take a substantial amount of time and when the IRR is linked to time the LP amount can become substantial (IRR 15% for 7 years is 2.67x). I have seen IRR in the 20% level.
- And finally, some Americans (I have not seen this in Spain yet) love the concept of full paritipacing LP (participating or double dip). In practice, this means that they will charge the prorate ownership subsequently and in addition to the payment of the LP. It’s basically like charging twice.
Here is the example above, but with participating LP:
As you can see in this example, the asymptote is not in the 20% which correspond to the VC’s participation, but its closer to 30%. Well played, right?
Creativity is something that has no hold on VC so do not be surprised if you see rare clauses in issues of liquidation preferences.
K Fund and Liquidation Preference
Until now K Fund has always had the practice of putting a 1x non-participating LP in our partner agreements. In practice, the rest of the market does the same and by now you could say it is considered a standard clause.
During the closing of a recent round, Jesús Monleon made us rethink the philosophy on this clause, which resulted in completely abandoning this “standard”. Thank you Jesús.
Jesus argued that the injustice becomes apparent if a company is sold with a low valuation, because the founders and shareholders that supported the project prior to the investor (previous stage to the investor) aren’t compensated with even one euro.
He was absolutely right:
- The founders, besides spending years of their time with the project, usually devote a large part of their savings, if not everything, to the project. This is in addition to the opportunity cost and personal and professional stress.
- Other shareholders, such as business angels and FFF’s also incur more risk than a VC that enters at a later stage
How could we take away a small retribution from the founders and early investors if the company is sold for a low valuation? It doesn’t seem logical.
Our countermeasure, the “Kolchon” (mattress in Spanish):
What we have done in all of the deals that we have closed since is the following.
- To the founders: We give them a Liquidation Preference with priority over us, i.e. a fixed amount of money. Basically, we want to facilitate the beginning of their new lives. The final amount will depend on several variables, such as number of founders, salary levels and stage of the company. To give an example, this amounted to €400,000 in our last deal.
- What we offer to business angels and FFF’s is to share our 1x non-participating Liquidation Preference. In other words, following the previous example, after €400,000 all non-founders would share a liquidation preference until they reach 1x.
The only flaw that we find in this model is that in the case of an acquihire (acquisition of a company to recruit its employees) an agreement under the table could be struck between the founders and the buyer. That is, a decrease in the value of the company in exchange for a higher salary.
In this case the big losers are the investors (FFF’s, business angels and the fund), however we believe that the vast majority of us (75%? 80%? 85%?) can agree that the “Kolchon” executes.
We truly believe that the Kolchon is reasonable, at the very least it expands the options within the LP framework with more than what it currently constitutes. And for that reason, we do it. Maybe in time we are proved wrong and a party to a future agreement takes advantage of the clause. But he who does not walk, does not stumble, does he?
For that reason, we are very happy to say that until proved otherwise we will institute the “kolchon” at K Fund.
As an additional reflection, I would like to add that at K Fund we believe that Venture Capital is a business where you have to focus and center around the investments that generate the large returns necessary to satisfy our promises to our investors, rather than scraping the last euros of a transaction, which won’t change the overall result much.
Disclaimer: If K Fund does not lead the round we will do our best to implement the “Kolchon”, but it will always depend on the fund that is leading.
