Participating liquidation preference can be a huge failure…

… aka why you should convince your early investors not to ask for it

Quick recap: A liquidation preference becomes relevant at exit. It provides for the investors first getting their money back before the remainder of the proceeds is being distributed pro-rata amongst all shareholders. There are many varieties of liquidation preferences (“LP”). The two most common ones are the 1-time participating LP and the 1-time non-participating LP.

Example: The investor invested EUR 3m and holds 25%. The founders hold 75%. The exit proceeds amount to EUR 15m.

· 1-time participating LP: In a first step the investor receives EUR 3m. The remaining EUR 12m are distributed pro-rata (i.e. 25% / 75%) to the investor and the founders. The investor accordingly receives EUR 6m in total. The founders receive EUR 9m.

· 1-time non-participating LP: In a first step the investor receives EUR 3m. The remaining EUR 12m are distributed pro-rata, however, the investor does not immediately participate in the pro-rata (non-participating) but the amount that has been received in preference in the first step has to be taken into account. The investor accordingly receives EUR 3,75m and Founders EUR 11,25m.

Does this example show that your investors are smart to ask for a participating LP? The answer is no for those early venture investors who believe that your company will be successful.

Why is that? It is likely and common that later stage investors will continue to ask for the same preferential rights that you have granted to your early investors; at least it will be hard to negate a participating LP to later stage investors if early investors have successfully asked for it.

If all VC investors (Seed, Series A, Series B, etc.) hold a participating LP (with the latest investor, i.e. Series C, in the highest rank, Series B in the second rank, etc.) the negative effect of it will not only hit you as founders and holders of the common shares but also the early stage investors. Let’s take a look at the following example: At the time of exit your successful start-up has raised EUR 48m and the cap table looks as follows:

Sample shareholding/amounts invested at exit

The individual share classes would participate in the exit proceeds as follows (I will explain the graph in more detail below).

  • Series C: The black line represents the proceeds of the Series C holders. Only they participate in the proceeds at exit values between EUR 0 and EUR 35m as they have invested EUR 35m and hold a 1-time LP in the highest rank. In the case of a non-participating LP (solid black line) their proceeds would only start rising again (pro-rata their shareholding) at exit proceeds higher than the post-money valuation they have paid for the Series C shares (i.e. EUR 135m). In the case of a participating LP (dashed black line), however, their proceeds would start rising already (pro-rata their shareholding) as soon as all lower ranking LPs (i.e. EUR 13m for the Series B, A, and Seed shares) have been satisfied (i.e. at EUR 48m). For the Series C holders a participating LP is highly attractive.
  • Series B: The green line represents the proceeds of the Series B holders. The same logic as for the Series C shares applies: In the case of a non-participating LP (solid green line) their proceeds would only start rising again at exit proceeds higher than the post-money valuation they have paid for the Series B shares plus the preference amount of the Series C shares (i.e. EUR 36m + EUR 35m = EUR 71m). In the case of a participating LP (dashed green line), however, their proceeds would start rising already as soon as all lower ranking LPs have been satisfied (i.e. at EUR 48m). As you can see from the graph the participating LP becomes less and less attractive for the Series B holders with higher exit valuations. And it is hardly a benefit anymore if the exit value is above the latest post-money valuation. That is, because the participating LP of the Series C holders is “eating away” proceeds that otherwise would have been distributed to the Series B, A, Seed and Common shares at exit values between EUR 48m and EUR 135m.
  • Series A: The yellow line represents the proceeds the holders of the Series A would receive. As you can see, the benefit of a participating LP is even faster “eaten away” as the Series B and C shares participate in the proceeds at a much lower valuation (i.e. both starting at EUR 48m) than they would do in the non-participating model (i.e. EUR 71m and EUR 135m, respectively). The Series A shares would profit from a participating LP only at exit values between EUR 48m and EUR 75m. At exit values north of EUR 75m (which is still almost 50% below the latest post-money!) the participating LP becomes a bad bargain for the Series A holders.
  • Series Seed: The negative effect of a participating LP for early investor hits the Series Seed holders the hardest. They would profit from it only at exit values between EUR 48m and EUR 56m. Beyond EUR 56m they earn substantially less.
  • Common Shares: Red line. Please don’t cry — but this is how a participating LP would hit you as a founder. In this example, at an exit value of EUR 135m (latest post-money) the participating LP model returns EUR 17m less to you than the non-participating LP model does (i.e. EUR 31m vs EUR 48m).

So what to learn from this?

  • Don’t just optimize on valuation but also on terms: If in the above example you had accepted a lower valuation at your Seed, A and B round the deal may still be better for you with a non-participating LP than with a participating LP:
Exit proceeds for commons at EUR 300m total exit volume
  • The above table shows how the exit proceeds for the common shares (at a total exit volumen of EUR 300m) in the above example develop if the pre-money valuations had been lower. As you can see it would still have been more attractive for the commons to accept a lower Seed, A and B pre-money valuation and instead negotiate a non-participating LP. This may change however, in case of higher exit proceeds → thus, build your own model for your individual case and understand how the liquidation preference affects you!

Note: When I built an excel for the above example I realized that it is really hard to build a “one-size-fits-all” excel that works in all situations (including up- and down rounds, virtual shares with and without strike prices, etc.). In the end, I believe I came up with a good one. I will publish it in my next post.

Questions, comments, etc? Please leave a comment or send an email: frederick at senovo.vc

About Senovo

Senovo is a Munich and Berlin based early stage venture capital fund with a focus on B2B SaaS investments. The Senovo team believes that SaaS should be the dominant model for delivering software and is thrilled about the great market opportunities which are continuously created by the secular shift towards SaaS. Senovo funds outstanding entrepreneurs and teams building world class products and generally gets involved soon after product launch. More: www.senovo.vc

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