Why Valuation is Overvalued, Part II: Liquidation Preferences
June 22, 2014
In Part I of this two-part series, I explained how a favorable pre-money valuation can be undercut by a large option pool baked into the pre-money cap table. In this Part II of the series, I will concentrate on one other deal term that can serve to undermine a negotiated valuation: liquidation preferences. Failure to focus sufficiently on liquidation preference mechanics could also lead to a distortion of incentives and serious strategic issues down the road.
First, a simple scenario. You’re a startup founder negotiating a $5 million Series A round with a VC and you agree on what seems like a generous pre-money valuation of $10 million. The company issues the VC preferred shares constituting one-third of the overall equity of the company ($5 million/$15 million post money). The company grows nicely over the next seven years and receives an acquisition offer of $30 million. You can hardly believe your good fortune as you quickly calculate that you, your co-founders and angel investors will collectively reap $20 million (2/3 of $30 million). But your lawyer takes a look at your charter and delivers the bad news: the common holders’ share of the proceeds is actually only $11 million. What happened?
In most VC deals, the investors receive shares of preferred stock in exchange for their investment. Although this form of security is usually associated with a whole range of economic, management and exit rights superior to common stock, the name preferred derives from one of the most important of these rights, namely the liquidation preference. In its simplest form, the “liq pref” (as VCs often refer to it) is the investor’s right on a sale of the company to receive a certain amount of the proceeds off the top before the common holders receive anything. In the real world, however, liquidation preference provisions are more complicated, so I’ll describe the typical variations and how they could end up impacting the acquisition proceeds waterfall in spite of the negotiated pre-money valuation.
The amount of the initial preference is usually not less than the amount invested, and is often a multiple of that amount, e.g., 1.5x, 2x, etc. It’s also not uncommon for accrued but unpaid dividends to be added to the initial amount. What happens next depends on whether the preference is participating or non-participating. With participating preferred, the investor first receives the agreed-upon initial amount before the common holders receive anything, and then shares the balance of the proceeds (if any) pro-rata with the common on an as-converted basis. With non-participating preferred, the investor does not share with the common after his initial preference amount. But remember, preferred almost always has a conversion feature allowing a preferred holder to forego his preference and convert to common. So with non-participating preferred, the holder has a choice to make, depending on what yields the most proceeds for him: either the preference amount, or his pro rata share on conversion. With participating preferred, the holder generally does not have to make that choice; he gets the initial preference, and then he gets his pro rata share of the balance on an as-converted basis (but see below regarding capped participation).
In the above hypothetical Series A deal, the VC agreed to a $10 million pre-money valuation, thus receiving 1/3 of the overall equity, but also negotiated for and received a fully participating 2x liquidation preference with annual 10% cumulative dividends (payable on a sale). The math works as follows:
Initial Preference $13,500,000
2 x $5,000,000 $10,000,000
10% x 7 yrs. $ 3,500,000
1/3 Participation $ 5,500,000
1/3 x $16,500,000 $ 5,500,000
Proceeds to Preferred $19,000,000
Proceeds to Common $11,000,000
Companies will often try to limit the sting of the “double-dip” participation feature by negotiating a cap on the participation that follows the initial preference. The cap is expressed in terms of a multiple of the investment amount, usually in the range of 2x to 3x, and the cap almost always includes the initial preference amount. This is called capped participation, and participating preferred with no cap is referred to as full participating preferred.
On the surface, both non-participating and capped participation seem better for the founders, but in practice both could lead to a distortion of incentives for the preferred and unintended consequences for everyone. With full participation, the interests of the common and preferred will always be aligned; both classes will always be incentivized to seek the highest purchase price. But with both non-participating and capped participation, there could be a range of prices in which the preferred have no incentive to seek a marginally higher price because within that range the common receive 100% of the marginal increase in price and the preferred receive no additional consideration.
The two examples below illustrate this point. Both examples assume a 1x liquidation preference on a $10 million investment, and a $10 million pre-money valuation where the investor is issued 50% of the equity.
EXAMPLE ONE: NON-PARTICIPATING
|
Acquisition Price |
Proceeds to Preferred |
Proceeds to Common |
|
$10,000,000 |
$10,000,000 |
$0 |
|
$15,000,000 |
$10,000,000 |
$5,000,000 |
|
$20,000,000 |
$10,000,000 |
$10,000,000 |
EXAMPLE TWO: PARTICIPATION CAPPED AT 1.5X
|
Acquisition Price |
Proceeds to Preferred |
Proceeds to Common |
|
$10,000,000 |
$10,000,000 |
$0 |
|
$15,000,000 |
$12,500,000 |
$2,500,000 |
|
$20,000,000 |
$15,000,000 |
$5,000,000 |
|
$30,000,000 |
$15,000,000 |
$15,000,000 |
Because neither of the above examples is fully-participating, the investor at some point will elect to convert to common and forego the liquidation preference, in each case at the point at which the purchase price is high enough so that the investor receives a higher pro-rata share on an as-converted basis than he’ll receive without conversion. But notice that in each case there’s a range of purchase prices at which the investor stops receiving additional proceeds on the liquidation preference (on the lower end of this range) and before it makes economic sense for the investor to convert (at just above the upper end of the range). In the first example, because there is no participation, the investor receives no additional proceeds between a $10 million and a $20 million purchase price (just above the latter being the point at which the investor would convert and take his 50% share). So assuming the VC is looking to exit and the company receives an offer of $10 million, the investor would have no incentive to seek a higher price unless he believed the price could exceed $20 million. Similarly, in the second example with a 1.5x participation cap, the investor would have no incentive to seek a price higher than $20 million (at which point he’s capped out at $15 million), unless he believes a $30 million price is achievable currently (above which he’d convert to common and surpass $15 million in proceeds).
The foregoing phenomenon has been referred to by commentators as the “dead zone” or the “zone of indifference”. I’ll call it the “range of indifference” just to be different. Once the VC is in the range of indifference, he has no incentive either to negotiate for a higher price, or to defer a sale altogether to build more value in the company. Even if the investor believed the Company may be worth 50% more in two years, he would have no incentive to take that risk because he’d receive no additional proceeds from the higher price. The common holders, of course, would have the exact opposite set of incentives and would seek either to negotiate for a higher price or to continue to build value in the company in the hope of selling for a higher price down the road. This distortion of incentives resulting from the range of indifference actually gets even more complicated as the company completes additional rounds of funding and particularly when an investor in a later round such as a Series D has priority over earlier rounds of preferred.