Nothing better than sitting at LGA writing blog posts. Instead of heading for my meeting (does not start for a few hours), I decided to hang out in the food court for a bit and watch. I know……living on the edge.
Continuing with the “No Mess” theme of commenting on things that give VCs pause, I thought it would be good to touch on liquidation preference. Specifically, “too much” liquidation preference (I will use “LP” for liquidation preference).
As most of you probably know, LP is one of the fundamental economic attributes of preferred stock that preferred shareholders enjoy. Yes, it is possible to issue preferred stock without liquidation preference, but that is rarely done. Rather, preferred stock has the right upon a liquidation event to get its money back (a 1X LP) or, sometimes, a multiple of its money back (for example a 2X LP). Sometimes, after getting back the LP, the preferred holder then converts to common and gets its prorata share of proceeds left after all LP has been paid (this is called participating preferred). And sometimes the preferred stock holder has to choose between getting its LP only or converting to common and taking its overall prorata (this is called non-participating preferred; the holder will pick what ever route gives more $). Current “market” stats actually show about 50% of deals being done with participating preferred and 50% with non-participating preferred. One final background point, a “liquidation event” is a sale of the company and typically NOT an IPO. All the liquidation preference provisions and rights are contained in the company’s certificate of incorporation as opposed to some independent written agreement.
Ok, enough of the background. The “no mess” LP issue relates to investors in later rounds of financing (typically Series C and beyond). Let’s assume the following:Series A round = $3mm and the Series A preferred stock is participating with a 1X LP Series B round = $5mm and the Series B preferred stock is participating with a 2x LP
So, after the Series B round the company would have $13mm of aggregate liquidation preference ($3mm plus 2*$5mm). Fast forward 18 months after the Series B round and the company now needs to raise more VC $. The company has been preforming well, but not over the top. Yet, it is able to attract more investment capital. Is the $13mm of aggregate LP a problem? It might be.
With respect to the Series C round, let’s assume that the pre-money valuation is $12 million and that the VC investing is going to put in $4mm (and to keep things simple, let’s have only 1 Series C investor). Therefore, the new Series C investor would own 25% of the company post money ($4mm/($12mm + $4mm)). Let’s also assume that the Series C has a 1X LP with participation.
If all goes well, the company does not need to raise more $ prior to a liquidation event. If it is later sold for $40 million, the proceeds waterfall focused on the Series C investor would look something like this:$40 million ($100,000) of transaction expenses ($800,000) of investment banker fees assuming a banker is used $39.1 million balance ($3 million) to Series A LP ($10 million) to Series B LP ($4 million) to Series C LP $22.1 million balance to distribute to all shareholders prorata ($5.525 million) to Series C investor, which is 25% of $22.1 million $16.575 million to Series A, B and common holders
In the above waterfall, it is NOT possible to calculate the specific distribution to Series A and Series B or common holders because I have not made any valuation assumptions for the Series A and B rounds so we don’t know how much of the company the Series A and B own.
Is the Series C holder happy with investing $4mm and getting back $9.525mm? Better than a kick in the head and better than a loss, but a 2.38X return multiple is a good hit but not a home run. Depending on the stage of the company, this might be OK. In fact, it might be expected.
Had the Series B had only a 1X LP, the balance to distribute prorata to all shareholders would be $27.1mm and the Series C 25% portion of that would be $6.775 mm. Then the total return back to the Series C investor would be $4mm plus $6.775mm = $10.775mm or a 2.69X return. Healthy, but again not a home run.
Critically, as you lower the aggregate LP and also strip away the participation rights of earlier investors, the better off the last dollars in will fare (in this case the Series C). In our example, the Series C investor, prior to investment, likely would have modeled out its potential return and reached a conclusion that “this investment does not have the potential to return enough to make it worth it unless we alter the rights of the existing investors.” It may require a pay to play round that forced non-participants to convert to common (thereby lowering the aggregate LP) as an example.
Bottom line: we weary of building up too much aggregate LP. Things can get very ugly quickly. Later investors will be turned off and it will result in some interesting negotiations.
Off to my meeting!