From Olivier Verhage – Kennet Partners (@olivierverhage)
In one of my previous blogs I discussed what every entrepreneur needs to know about how revenue growth translates into pricing and deal valuation for a typical SaaS business. Fast forward, you’ve decided that your business is worth 5x ARR, is there another important thing that matters before you sign a term sheet with that hungry investor? Yes, there is: The liquidation preference.
The initial liquidation preference entitles investors to a fixed per share distribution of liquidation proceeds before holders of common stock receive anything. The initial preference is designed to provide downside protection for investors and will therefore rarely be less than the amount of the investors’ initial investment.
For example, if a company has raised $10 million of venture money in exchange for a 30-percent stake and is subsequently sold for $25 million, the venture investors will collect $10 million in proceeds in the form of a liquidation preference, even though their pro rata ownership would entitle them only to $7.5 million. This protection is known as a 1X liquidation preference, because it covers the dollars invested on a one-to-one basis, and it’s completely standard.
Now, understanding liquidation preference is easy but there are a number of different types available which all have very different distribution waterfalls and so may significantly outcome the founder’s exit proceeds. The most common preference structures include:
A: Non-participating preferred stock;
B: Participating preferred stock subject to a cap (e.g. 2x Multiple of Money invested); and
C: Fully participating preferred stock.
Let’s think of the following scenario, you’ve just raised $5 million at a $10 million pre-money valuation, this gives the investor 50% of your company.
Non-participating Preferred Stock
Starting off with a scenario in which the company issues non-participating preferred stock, the exit funnel looks as following:
There are two critical exit valuations: (1) the valuation at which the initial preference is reached (at an exit value of $5 million, which is also where holders of common stock will start to receive proceeds) and (2) the exit valuation at which the holders of preferred stock would receive greater proceeds if they were to convert to common stock (at $10 million, this is the inflection point). Between these two valuations (here, between $5 million and $10 million), holders of preferred stock are indifferent as to the exit valuation. This is frequently referred to as the “dead zone” and can lead to misaligned incentives between founders and investors and/or among various classes of preferred stock.
Participating Preferred Stock subject to a Cap
Using the same pre-money valuation and cap table, the following chart illustrates the effect of a participation feature, subject to a 2X cap, on the liquidation waterfall.
Here the three critical exit valuation points are: (1) the initial liquidation preference amount (at $5 million), (2) the exit valuation at which the participation feature caps out (at $15 million) and (3) the exit valuation at which conversion to common stock is optimal (at $20 million).
Fully Participating Preferred Stock
After receiving the initial liquidation preference distribution, holders of fully participating preferred stock will share in the remaining liquidation proceeds on a pro rata basis with holders of common stock. The following chart shows the distribution waterfall with a 1X, fully participating preferred stock.
As the chart illustrates, because there is no cap on the participation feature, there is never an incentive for holders of preferred stock holders to convert to common stock. For this reason, the 1X preference (a $5 million) is constant and holders of common stock never “catch up” to preferred stock holders and there’s no “dead zone”.
As discussed earlier, liquidation preferences are typically used to provide some downside protection for investors. However, in some cases investors may propose a structure to match certain valuation expectations. For example, if the founder here were to demand a 7x or 8x ARR and is for forecasting a high value exit, the investor could propose a 2X fully participating liquidation preference or a 3X non-participating liquidation preference, this could provide extra incentive for the founder to achieve a high value exit. The downside here is that founders may become over-ambitious while trying to achieve minimum return targets, this might result in more aggressive hiring and expansion strategies causing a higher than budgeted burn rate and a higher risk of bankruptcy. The art is all in balancing.