Protecting Management from a Liquidation Preference Overhang
March 14, 2016
“The Founder of a $50 Million Startup Just Sold His Company — And He Didn’t Make a Dime”. Such was the provocative headline of the Business Insider article last year reporting the sad tale of young entrepreneur Lane Becker and how he and his management team received none of the acquisition proceeds on the sale of Get Satisfaction, the company Becker founded. Becker’s fate was not anomalous, and happens when the cumulative liquidation preference amount payable to investors exceeds the value of the company itself. In this blog post, I’ll briefly explain the liquidation preference overhang phenomenon and discuss how to keep founders and key employees incentivized with a carveout arrangement.
Liquidation preference is a key term negotiated in venture and even seed stage investments. It’s the amount of money the preferred stockholders are contractually entitled to receive off the top on a sale of the company before the common stockholders receive anything. The common stockholders receive only the balance after the liquidation preference is paid, and if the liquidation preference has a participating feature, the preferred stockholders also participate pro rata in that balance on an as-converted basis.
I have previously blogged here and here about how entrepreneurs often are too fixated on valuation and tend to overlook at their peril the impact that liquidation preference can have on the value of the entrepreneurs’ equity stake. A rich valuation could be completely undercut by a heavy liquidation preference stack. For example, suppose an investor is proposing to invest $20 million at a pre-money valuation of $60 million for Series B preferred stock constituting 25% of the total equity on an as converted fully-diluted basis and includes a 2x liquidation preference. The founder is giddy about the $60 million pre-money valuation and takes the deal. The company had previously raised $10 million in a Series A round where the Series A had a 1x liquidation preference. Two years after the Series B, the company is sputtering, challenged by competitors and investors and management alike believe the company may only be valued at $40 million, $10 million below the cumulative liquidation preference of $50 million (2 x $20,000,000 (Series B) + 1 x $10,000,000 (Series A)). Founders’ and management’s common shares are essentially worthless and, consequently, they have little or no incentive to work hard and help the company succeed.
Prior to being acquired, Get Satisfaction was reported to have raised $10 million in a Series B round at a pre-money valuation of $50 million, bringing the total amount raised to $21 million. The purchase price of the acquisition was not disclosed, but it must have been less than $21 million for management to have been washed out (assuming a 1x liquidation preference).
In Lane Becker’s case, he had been terminated as CEO a few years prior to the acquisition of Get Satisfaction, which could happen when founders negotiate away control of their company. But what happens in the more typical scenario when founders are still the CEO or otherwise are employed by and managing the company at a time when the liquidation overhang looms, i.e., when the aggregate liquidation preference amounts exceed the company’s valuation? What incentive does the common stock holding management team have to stick it out? Cash compensation will rarely get management satisfaction (pun intended), either because startups seldom have the cash to do so or because cash compensation was never a motivating factor for key employees to begin with. By joining a startup, talented employees typically sacrifice higher cash compensation they could earn with more established companies in favor of the upside potential that comes with equity they receive in the startup. Hence, the drill would be to come up with a mechanism that simulates the upside potential of equity without that upside being negated by the liquidation preference overhang.
That mechanism is a bonus or carve-out plan that provides for a payout to eligible employees upon a sale of the company or other liquidity events identified in the plan. A typical plan sets aside a pool of money whose amount is determined based upon a certain percentage of acquisition proceeds. A well drafted plan would address certain issues related to calculating the proceeds upon which the payout is determined, such as assumption of debt by the purchaser, deferred payments, earnouts and contingent payments. The relevant percentage may also be on a sliding scale, e.g., 3% on the first $100 million, 5% on the next $50 million and 7% on amounts exceeding $150 million.
Inasmuch as these plans are intended to provide value to common stockholders when the common is worthless, plans could (or should) consider the value of the common (i.e., when the purchase price exceeds the liquidation preference amount) as an offset to payouts and also set a ceiling on payouts. The plan could be structured either as a quasi-contractual commitment by the company in the form of a benefit plan or as a special class of common stock that would be issued to founders and key employees that would be pari passu with the preferred but have a separately calculated payout formula upon the sale of the company.