
Liquidation Preference (my case for 2x, non-participating) - reitzensteinm
http://www.gabrielweinberg.com/blog/2010/05/liquidation-preference-my-case-for-2x-non-participating.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+yegg+%28Gabriel+Weinberg%27s+Blog%29
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grellas
For a technical explanation of the difference between participating and non-
participating preferred stock, see
[http://www.startupcompanylawyer.com/2007/06/15/what-is-
the-d...](http://www.startupcompanylawyer.com/2007/06/15/what-is-the-
difference-between-non-participating-preferred-stock-and-participating-
preferred-stock/).

Liquidation preferences at the angel stage are not in themselves too critical
so long as they are generally reasonable and 2x/non-participating doesn't work
any particular hardship for founders and early-stage employees where the
investment amount is in the $1 million range.

The problem is the impact on later rounds. If VCs take a 2x liquidation
preference, say, for a $10 million investment, then any exit of $20 million or
less is a wipeout for founders and early-stage employees. Couple that with the
pressure to shoot for a 10x return on whatever that VC investment is and you
can get a shoot-for-the-moon mindset that heightens risk on the one side and a
let's-cut-our-investment-risk-and-get-rid-of-this-non-performing-startup
mindset on the other that heightens risk on the other (assuming the VCs have
control, which they normally do).

Thus, 2x (or higher) is usually seen as _highly_ unattractive by founders even
if its immediate implications at the angel stage are not necessarily bad. In
my experience, in all normal investment environments, founders will resist it
and fight for 1x only (usually going for participation with a cap).

Your experience may vary but this has been mine over many years in Silicon
Valley.

I can understand the logic of 2x as explained in this fine piece from the
angel perspective. On its own terms, it makes sense and is reasonable for that
stage. As long as it doesn't spill over into subsequent rounds, it creates no
problems in itself.

~~~
epi0Bauqu
Thx for your comment--that is great validation. I also just found your other
great posts (<http://www.twitter.com/grellas>).

I should have been more clear in my post about my current strategy. I'm really
looking for deals that, if successful with the angel money, may not need VC
with decent probability, and if they do take VC, it wouldn't be for that much.
In other words, I'm less concerned with the risk of follow-on terms at the
moment.

That being said, I wonder if they can be justified if the angel round is
small. Say I it's a $250K round and so the preference takes up $500K. You go
to raise $3M VC and the VC says we want 2x because they got it. Can't the
entrepreneur say, look that was for the angels because the round was so small
and it doesn't make sense for us in a round this large? Of course it is all
negotiable but the knee-jerk "we need to get everything they got and more"
seems out of place here.

Also, I'd personally be fine with participation with a cap. It just seems
entrepreneurs are more willing to go with 2x, non-participating. But my
experience is very limited so if that's the norm it's fine with me. What terms
do you usually see, 1.5x with participation at a 3x cap?

~~~
grellas
Thanks in turn for your kind words.

Your strategy makes perfect sense for startups that look to take in angel
money only or that look to do so at first in hopes of building significant
value before approaching VCs down the road, they hope, from a position of
strength. This is the going strategy today in the Valley and many of our
startups use it.

The issue in dealing with the VCs is primarily a psychological one and I would
say that, other than in an extremely down investment environment, most would
be willing to let go on something like 2x if the market as a whole for VC
investments is not supporting it (the long-term norm is 1x - during the dot-
bomb phase, it was more like 3x-5x - today it is somewhere in between). So,
yes, I think the issue can normally be argued, and argued successfully,
especially if the startup is positioned well and can be selective.

The terms for participation with a cap will vary widely but, in essence, do
not come out much differently in practical terms than would a 2x/non-
participating type of preference.

------
cletus
Interesting post. It's probably worth adding columns to show things like the
founders' return in these scenarios to illustrate where this middle plateau is
(where the investors return is the same or near the same).

~~~
_delirium
There's a bunch of other complicating factors, too, which interact with the
founders' share. For example, when hiring early employees, startups often use
equity as a significant part of the compensation package. But, roughly
speaking, the better for the angel or VC the preferences are, the less value
any given offer of % equity will have to the employee. So, unless the employee
is a sucker, better terms for the angel or VC mean more % equity or up-front
salary you'll have to offer the employee to compensate.

~~~
anamax
> So, unless the employee is a sucker, better terms for the angel or VC mean
> more % equity or up-front salary you'll have to offer the employee to
> compensate.

Great point.

Since equity has to sum to 100 at every point, that "extra" is fairly
expensive.

If it translates to more salary, it adds risk to the biz.

------
pge
I disagree with this approach for angels. I'll approach it from two angles, an
investor willing to think through and modify terms, and an investor that wants
a boilerplate set of terms for every deal. In the first case, it's important
to think through the shape of the entire return curve. If a company is 100%
common stock with no liquidation preference, and you own 20%, your return is
linear, $0.20 for every dollar of sale value. As soon as you add preferences,
participation, caps, etc, that line is no longer straight. A 2x preference,
for example, strongly weights the low value exits (the curve is steeper from O
to the 2x amount, then reduces in slope). In the negotiation between the
investor and the management team, each side has views of what the ultimate
value may be (or what a probability weighted view of potential exits might
be), and each side can manipulate the shape of that curve to match his
expectations. For example, if the investor is worried about a low priced exit,
and the management thinks the company is worth a lot more, a 2x liquidation
preference and a higher valuation works for both parties. Investors get more
of the exit value at a low price, and management gets more on the upside
(because of the higher valuation results in more percentage ownership for
them). If both sides understand how these terms work, creative use of
preferences, participation, and caps can help everyone get to a deal that
works. If, however, one wants a standard set of terms for every deal, I would
recommend sticking with straight up 1x non-participating preferred and
reducing the number of variables to one: valuation. 2x is usually perceived as
not founder friendly and raises unnecessary concerns (whether real or
perceived). It also sets a bad precedent for subsequent institutional
investors, who will likely ask for 2x as well in order to be on the same
ground. If the institutional financing is substantially larger than the angel
round (as is usually the case), the angels end up losing by the precedent they
set. With the institutional financing in place, the return for the angels is
(almost always) better when both institutional and angel investors have 1x,
than if both have 2x. Whether or not it is justified, institutional investors
are often going to seek "fairness" by having terms on par with (or better)
than angels. Setting a precedent with 2x for the angels will lead them to go
for 2x as well, which doesnt help the founders and doesn't help the angels.

------
anamax
FWIW, all of Weinberg's arguments apply to early employees as well.

Perhaps they should ask for 4 weeks of severance. Of course, since startups
are risky, the best way to do that is to pay them a month in advance.

