The venture capitalist funding market has lost a lot of its heat since its boom in the year 2015. If the venture capitalist market is somewhat cool and startup founders do not have a lot of options to get their startup funded, then the venture capitalist firms can put some creative terms in a startup funding deal to maximise their profits.
One such term that the venture capitalists abuse are liquidation preferences that are put in the contract when a venture capitalist decides to provide funding to a company. This article is about how liquidation preferences can ruin your startup and why you should negotiate heavily against liquidation preferences during the financing rounds which take place when your business is being funded by a venture capitalist.
What Are Liquidation Preferences?
Simply put, a liquidation preference is an arrangement that is put as a clause in the contract during the financing round of a company by the investors which protects the money invested by the investors into a company in case that the company exits at a price that is less than the amount that was expected by the investors at the time of financing the startup.
In case of any Liquidation Event or an exit that can be voluntary or involuntary in nature, the investors who are holding a preferred stock will be qualified for get out of the returns or resources of the company when it liquidates. They are entitled to be paid earlier and in preference to any circulation of the proceeds when compared to the holders of Common Stock which are owned by the owner of the company and its employees. This way, the investors secure their investment even if it means that the common shareholders get paid nothing.
Components of Liquidation Preferences
There are generally two segments of a liquidation preference, first is a base multiple which identifying with the first speculated value of the business and the other is a cooperation or deficiency in that department which portrays whether the inclination speaks to a base return edge after which everybody gets served proportionally or whether the holders of the preferred stock get paid first.
A straightforward (1x) non-taking part liquidation inclination guarantees that, at the event of the liquidation of a company, the preferred stock holders i.e. the investors get the cash they put into an organization initially came back to them first, before the money that is generated due to an exit or a liquidation is conveyed towards every other person as per proprietorship percentages. In any case, a straightforward one times multiple non-taking an interest liquidation inclination is totally the correct thing when the company is just getting started and are getting funded by venture capitalists.
Anything more than a one time multiple liquidation preference with no interest in any case, is precarious and is not in any case reasonable and full with potential for unintended outcomes. These kinds of liquidation preferences can ruin your startup and you need to negotiate against any such clause during the financing rounds of your startup.
Why Entrepreneurs Should Negotiate Against Liquidation Preferences?
Some startup owners may not be opposed to having one or even more than one liquidation preference clauses in their financing deal. Most entrepreneurs overlook the liquidation preferences in favour of getting a better valuation for their startup especially in the early stages of seed A or seed B funding rounds. But this should not be the case. Startup owners should be aware of what liquidation preferences can do to their company in case things go south for them.
By plan, each liquidation inclination skews the conveyance of revenues in the case of an exit far from the percentages of ownership of the startup owners and the employees. Liquidation preferences work ok in the event of 1x multiple liquidation inclinations where the investors are non-taking an interest, which are unimportant if the leave cost is over the section cost of an arranged financing round. Any other liquidation preferences which have a higher multiple than 1 and has interest provisions can disturb the process of distribution more vigorously, even at higher results.
This, at times results in altogether different motivators in case of monetary matters for the investors of the company versus the owners or the employees who hold an Employee Stock Ownership Plan. This will inevitably result in conflict between the owners along with the employees of the company against the investors.
For example if there is a discussion between the investors and the owners of the startup centered around a proposed closeout of an organization at a value that will enable the investors to make a decent return on investment, yet because of the liquidation preference structure very little would be left on the table for the owners as well as the employees that hold an Employee Stock Ownership Plan.
As we know that the venture capitalism game is centered around getting people to align their interests, an unreasonable liquidation preference will make it harder for the owners and the investors to align their interests. This is why startup owners should always negotiate against absurd liquidation preference clauses during their financing round to protect their own as well as their employees’ interests.