
Here's Why You Need A Liquidation Preference - rpledge
http://www.avc.com/a_vc/2010/08/heres-why-you-need-a-liquidation-preference.html
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metajack
The plural of anecdote is not data.

How many companies with exits with liquidation preferences didn't make the VCs
money? How many without preferences didn't make the VCs money? How many
involved the founders getting screwed because of these preferences?

I don't object to the preference in general, but any multiplier greater than
1.0 is a red flag for me.

You can find VCs that will do 1x preferences. I don't know what the options
are for deals without preferences.

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cperciva
_The plural of anecdote is not data._

If you're a VC investing $50M in a company, you don't wait for _data_ before
trying to protect that investment.

 _I don't object to the preference in general, but any multiplier greater than
1.0 is a red flag for me._

Personally I think a preference of (1.1)^[# years since investment] would be
more fair (otherwise founders can make money by simply investing in treasury
bonds). But I don't plan on taking funding anyway, so it's a moot point.

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johnrob
_And investing in common stock when the founder controls the company and the
exit is not a fair deal._

Don't tell that to any employees of your portfolio companies.

~~~
fredwilson
they don't invest cash

they get paid a salary and get options on the upside

~~~
johnrob
Do they understand that? I think they believe those options are worth more
than they really are.

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frederickcook
Their stock is the same class as the founders. Everyone who had options in
Slide also made money proportionate to Levchin, which is better than the
investors did, who made nothing. (This assumes early, cheap options. Later
ones may have lost money and be worthless.)

The situation the OP is referring to is when the founder decides not to sell
the company or IPO, or makes a poor decision about when. With the former,
there is no liquidity and stock in a private company with no liquidity or
profit sharing is pretty useless.

If a company takes VC investment, it is basically committing to sell or IPO at
some point (VC wants control to ensure this), ensuring the options will at
some point be liquid. So, technically, having a VC with board control could be
a good thing in some situations to ensure that the founder doesn't get any
ideas about building a "lifestyle" company and that everyone gets a payday at
some point.

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tptacek
Preferences address the problem _opposite_ to "lifestyle companies" (which, by
the way, is a silly term). Preferences cover the case where the founder wants
to ditch the company in a "cheap" acquisition instead of rolling the dice on
the investment return the VC bought into.

~~~
starkfist
"Lifestyle company" now seems to mean any business built without the intention
of making money for a board of investors...

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sx
I am an entrepreneur myself and I think an 1x liquidation preference makes
sense. You cannot get X dollars at a 3X valuation and then turn around and
sell the company for X keeping 2/3 of X and only giving 1/3 of X to the
investor.

I think what most people disagree with are the 2x and 3x liquidation
preference terms that are not uncommon in term sheets. They are a very
effective way, for the investors, to push the founders to a more risky /
bigger potential path so that they can also make money. This works well in the
context of the VC model (for the VCs).

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shin_lao
Can someone explain what a liquidation preference is?

~~~
ulf
It means that when an exit happens, investors can have different rights to how
the money is distributed.

Suppose you own a company and sell 50% of it to VC X for 1 Million Dollars
(2M$ valuation). The VC gets a liquidation preference, which means they will
get paid before you in an exit. If you sell for more than 2 million, that is
no problem. But if you sell for less, the following happens:

Suppose someone wants to buy you for 1.2M$, which you agree to because you
feel like the business is a dead end. According to the shares, you and the VC
should get 600K$ each. But since VC x has a liquidation preference, they get
their money back. So you get just 200K$ as the found. Even worse if you sell
for less than 1M$, in that case you walk away empty-handed...

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amackera
This doesn't really seem fair...

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byrneseyeview
Not really. A liquidation preference is worth something, so if you really
didn't want to give on, you could give up more equity.

But as Fred Wilson once pointed out, it's a great way to handle a situation
where the founder thinks the company is worth way more than the VC does. If
the founder is right, the VC owns less stock than they otherwise would have;
if the VC is right, and the company is bought for a low valuation, the VC gets
a higher percentage of the payout.

Essentially, a liquidation preference can give you "conditional equity"--the
founders own, say, 50% of the company if it's sold for a small amount, and 80%
if it's sold for a large amount.

~~~
adw
I think you'd find a broad consensus among founders and VCs that 1x non-
participating is pretty much entirely fair (and standard!) the whole time.

Other pref structures often mean that either the VC had the upper hand in
negotiations or that there's a big divide in valuation to cross.

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charlesdm
A liquidation preference of 1x seems fair. However, how common are deals where
the liq pref is 2x or 3x?

~~~
sabj
1x is fair as long as everyone knows what's going on and what is expected.
Especially for later investments, when less risk might be expected. I don't
know how common higher preferences are, but they often seem... more unsavory,
shall we say.

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bosch
The tough part about being a first time entrepreneur is stock preferences and
setting them up properly. You want to find a way that the future employees
won't get screwed, but you also want to ensure that your company is an
attractive investment opportunity for possible angels/vcs. From what I
understand there's not really a good balance to keeping things equal unless
one group gets shafted.

Does anyone have any examples of how to setup the stock situation to benefit
both employees and investors?

