

How Liquidation Preferences Work - RougeFemme
http://www.businessinsider.com/how-liquidation-preferences-work-2014-3

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chakkop
A few comments:

1\. The scenarios illustrated in the piece seem horrible but are biased.
Consider this: a VC invests $20 million in a business and acquires 50% of it,
valuing it at $40 million post-money. Assume the remaining 50% is owned by
founders/key employees. Five years down the line, the company hasn't done so
well and is sold for $10 million. Without a liquidation preference, the
founders and key employees get $5 million: a decent payout for losing $15
million of investor money.

2\. Fred Wilson repeatedly makes the point that when VCs invest in a company
at a valuation of $X million, they are not valuing the outstanding stock of
the company at $X million the same way a public market would. Instead, what
they are doing is buying a bond + an option. The liquidation preference is the
bond part of the equation: the investors are betting that the company is worth
at least its liquidation preference (which, at 1X, is the amount they
invested). The upside that the company might have if it succeeds is the
(deeply out of the money) option.

3\. Today, 1X liquidation preferences are standard and widespread, and
entrepreneurs have it good. If you want your eyes to water, go read/ask about
liquidation preferences in term sheets after the dot-com crash ;)

~~~
geophile
I find your points unconvincing. If a VC is uncomfortable with betting on a
startup, maybe he should find another line of work. About your second point:
I'm not sure what argument you are making. Yes, of course the VC would like a
guarantee. Maybe he would find it easier to sleep at night if he were a loan
officer at a bank instead.

VCs are betting money. The founders and early employees are betting their time
and foregoing other opportunities. If the thing blows up, the VC gets his
investment back. The founders/employees can't recover any part of their
investment. I still don't get why a liquidation preference is fair. The VCs
are imposing it because they can. Any justification based on fairness is
laughable to me.

------
geophile

      Imagine a VC that buys 50% of a company for $50 million, 
      for a $100 million post-money valuation. If that company
      then sells for $75 million, the VC gets more than 50% of
      the $75 million. The VC gets his or her $50 million out
      first, and then half of the remaining $25 million ($12.5
      million) for a total return of $62.5 million. The common
      stock holders split the remaining $12.5 million.
    
      That's a 1X liquidation preference. ...
    
      A 1X liquidation preference isn't unfair. The people who
      bring the capital should have some protection.
    

I was at a startup in the late 90s and discovered liquidation preferences. I
agitated to get them dropped from the B round, succeeded, and the VCs then
scrapped them. Which saved me from exactly this fate.

I don't agree that even a 1X liquidation preference is "fair". VCs are taking
a risk, that is supposedly their business model. Reducing risk on the backs of
the people sacrificing their personal lives doesn't strike me as fair at all.

