
"Three Things You Must Have" - Chirag
http://www.avc.com/a_vc/2010/11/miltons-three-things-you-must-have.html
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davidu
There is a missing piece from Fred's post, as I often find the case to be. I
know Fred's smart, so I'm not sure why he omits key pieces of the discussion.

In this case, he is leaving out his views on participation rights. What this
means is that if you have a 1x liquidation preference (you get your money
back) do you ALSO then convert to common stock and participate pro rata in the
distribution of remaining proceeds? If yes, that is unfair to the entrepreneur
and you are double dipping. If no, then a 1x liquidation preference is
entirely reasonable.

Here's an example: Let's say someone invests 1mm with a 1mm pre and a 2mm
post. So they own 50% of the company. Now let's say that the company has an
offer to be purchased for $3mm. With participation rights and a 1x liquidation
preference the exit looks like: 1mm money returned to investor, 2mm remaining.
Then the investor converts to common and the remaining 2mm is split 50/50
since the investor owns 50% of the company. That gives the investor 2mm and
the entrepreneur 1mm. Is that fair? I don't think so.

Once you know that converting to common will net you a positive return above
and beyond your original investment, you should convert. If that were the case
here, the return would be 3mm split 50/50, so 1.5mm to the investor and 1.5mm
to the entrepreneur. To me, this is fair. Everyone had an exit. Nothing
amazing, but it accurately reflects the cap table of the company.

Finally, while I am comfortable with a 1x liquidation preference in any
company I start, there are a lot of strong arguments about why a 1x pref is
not appropriate. The most common reason is that "we're all in the same boat.
You bring the money and I bring the idea and execution and if we win, we all
win, and if we lose, we all lose, all equally."

I don't buy that argument, but that's the one people try to make.

~~~
joshu
[http://www.avc.com/a_vc/2010/05/an-evolved-view-of-the-
parti...](http://www.avc.com/a_vc/2010/05/an-evolved-view-of-the-
participating-preferred.html)

~~~
davidu
Bingo. Fred should link to this in his post today.

And furthermore, Fred's points of when it makes sense to have participation
rights are dead-on and exceptionally well articulated.

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Swizec
I agree with the commenters, liquidation preferences only really make sense as
protection when they are 1X. Higher than that and it starts smelling an awful
lot like greed.

And personally, I would prefer a liquidation preference over the investor
tying my hands too much. They invested in me, they should put their mouth
where their money is.

~~~
fredwilson
yup

above 1x is a huge red flag on the investor. entrepreneur beware.

and i also agree that the elegance of the liq pref is that it is an economic
deal and does not impose governance on the entrepreneur

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unexpected
I agree with the basic principle of a liquidation preference, but his argument
sounds like a bit of a strawman.

If he invests 20% for $1 million - he's validating the idea at $5 million
dollars. Presumably, the investor has to due enough due diligence to say, "you
know, this idea is really worth $5 million". If that's the case, if they sell
for $2.5 million later on, the founders take a loss too - just because they
don't have that much cash invested doesn't mean that they lost out as well.

~~~
gyardley
Ideas aren't worth anything, and early startup valuation is just voodoo. The
numbers balance the venture capitalist's need for a certain stake, the
company's need for capital, and the founders' desire to avoid excessive
dilution. They don't actually reflect what anyone would be willing to pay for
the company at that stage.

~~~
unexpected
Ideas are certainly worth something - they're just not worth anything unless
they're actually implemented. If a VC truly believes that early startup
valuation is voodoo, then he shouldn't invest. His willingness and want to
invest early is shown in the amount of risk he carries, but VC's need to
remember that risk carries both ways.

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waxman
These "must haves" will be challenged by the rise of super angels, who
typically don't demand board seats, nor the same types of liquidation
preferences.

I think the board seat requirement, in particular, will be rendered obsolete
soon. But then again, the whole VC industry might be obsolete soon.

~~~
fredwilson
that is clearly a risk, but ..

i'll bet ten years from now these are still must haves and the current crop of
"super angels" will be crusty old VCs just like me demanding them

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bconway
_i invest $1mm in your company for 20% -- the company is six months old and
this is the first investment of outside capital -- a week later you sell the
company for $2.5mm -- you get $2mm for six months work -- i get a $500k loss
does that sound fair? -- no it does not -- that is why there is a liquidation
preference -- to protect investors from that happening to them_

A founder selling a $5+ million company for $2mm probably has a reason for
trying to get out (like catching the start of the spiral before there's
nothing left). Would you prefer the company be scuttled and a $1mm loss
instead?

~~~
gfodor
You need to realize early stage valuations are basically a guidepost for
negotiations, not a real monetary amount people have committed to pay for a
company. By comparing your valuation to other valuations of companies at
similar stages, both parties can be sure they are getting a fair shake. This
has little to do with the idea of the company being sold, in full, for that
amount.

If you're a founder, and you are getting some traction, it might very well be
that you can raise money at a $5mm valuation with little more than a prototype
and a few initial adopters. However, if you all of a sudden have a chance to
turn your fledgling startup into $2mm in the bank, after only a few months,
many would take it and use that money for the next startup.

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alexwestholm
This is a great list of the essentials. Without a liquidation preference, you
can lose while the founders win; without the ability to participate pro-rata
in future rounds, you can't control your exposure to dilution; and without a
board seat, your effectiveness as both an investor and advisor are
compromised.

Where do you go from there? What else winds up in a lot of your term sheets?

