This is part 3 of our discussion on financing with our example capitalization and ownership spread sheet. Part 1 is here; part 2 is here. In this post, we will dig into two important terms: Liquidation Preference and Participation. Also, here is the link to our Example Series A Term Sheet. This “typical” term sheet is a hybrid that I created from 3-4 different, but very real, term sheets from various investor sources around the country.
A quick bit of background: Almost every investor will require preferred stock when they invest. Basically, investors get special benefits (preferences) in their class of stock in exchange for the benefit of using their money (to grow your company). In much the same way that there are benefits for companies that loan money — such as access to the collateral you put up against the loan — investor’s preferences provide them some additional security relative to other, common shareholders.
For now, note that Preferred stock holders can, at any time, and at the option of the holder, convert their Series A Preferred into shares of Common Stock. This is a “conversion right” that we can cover in more detail later but is spelled out in our Example Term Sheet. When would investors want to do this? We will see below.
Three of the most important (if not THE most important) terms in a Preferred stock investment are valuation, Liquidation Preference, and Participation because they most directly affect how assets are distributed upon the liquidation of your company. We’ll save the valuation discussion in a subsequent post and focus on Liquidation Preference and Participation in this post.
Put simply, Liquidation Preference is the right for an investor to choose, upon liquidation of the company, between the greater of (a) the amount they invested; or (b) the amount that would be returned based on their ownership.
Importantly, the liquidation preference is triggered when there is a sale (or other liquidation) of the company where (1) cash is used; (2) the combined share holders of the company end up with less than 50% ownership in the new entity (greater than 50% ownership means your company is doing the acquiring); (3) or the company is wound down and liquidated.
The following language is taken from our example Series A term sheet and it describes the Liquidation Preference Term. As you can see, the language is somewhat dense:
Liquidation Preference: In the event of any liquidation, dissolution or winding up of the Company, holders of the Series A Preferred will be entitled to receive in preference to the holders of Common Stock or any other stock ranking junior to the Series A Preferred an amount for each share of Series A Preferred (“Liquidation Amount”) equal to 1.0 times the Original Purchase Price plus any declared and unpaid dividends. If the assets of the Company are insufficient to permit payment of the full Liquidation Amount to all holders of Series A Preferred, such assets will be distributed ratably to the holders of the Series A Preferred in proportion to the Liquidation Amount each such holder would otherwise be entitled to receive. After payment in full of the Liquidation Preference Amount to the Series A Preferred holders, any remaining assets shall be distributed to the holders of the Common Stock on a pro rata basis.
The following is a much simpler version that says largely the same thing for our example:
Liquidation Preference: In the event of any liquidation, Series A investors will receive their money first. The amount of money will be at least 1.0 times the amount they invested.
If there not enough money to repay the original amount invested, sell the company’s assets and give Series A holders that money proportionally to their ownership of Series A stock.
The above version is considerably more straightforward; however, our simplification is not quite complete because the original language actually has an additional, important term tacked on to the end of the Liquidation Preference section (italicized text) that describes the form of Series A share holder Participation. Participation, in addition to liquidation preference, is a Preferred Term that represents another way for investors to share in the proceeds from a liquidation event.
The original liquidation preference language above describes non-participating Series A stock which means, simply, that the series A investors do not participate in asset distribution after the liquidation preference amount has been paid. There are three varieties of participation: full participation, capped participation and non-participating. Capped participation is full participation up to a certain “capped” amount of returns; we are not going to cover this option in our spread sheet.
Fully participating stock means that after Series A holders receive their liquidation preference amount, they continue to participate in asset distribution on a pro-rata basis. To change the original non-participating language to fully-participating, you would use this language: After the payment in full of the Liquidation Preference Amount to the Series A Preferred holders, any remaining assets shall be distributed ratably to the holders of the Common Stock and the Series A Preferred on a common equivalent basis.
Walking Through Our Spread Sheet
First, there are a number of changes to this third version of the spread sheet:
- all variables are in RED; anything in RED may be changed in the spread sheet and the effects will ripple through the rest of the calculations.
- I have eliminated the investment by Founder #3 in Series A because it made the spread sheet more complicated for them to own two classes of stock (common and Series A Preferred). We can make this work later; for now, changing the red “amount” in cell G24 simply adds to Founder #3’s common ownership – not preferred.
- Added the concept of “outstanding shares” – the number of shares, in concept, was hidden behind the “percentage ownership” numbers in previous versions.
- In the “Seed Investment” column, I’ve added a third column to show the number of shares based on each share holder’s percentage ownership. In general, it makes sense to break out the actual number of shares calculation because it’s easier to see how certain things work. For example, when investments happen, the company creates NEW shares “out of thin air” for the purpose of selling to the investors. In this way, any individual’s number of shares never goes down…but the total number of shares that exist (outstanding shares) goes up. Therefore, the “dilution” is simply effect of the denominator increasing in the ratio between the number of shares you own and the total number of shares that exist.
- Take a look at Series A: The total number of outstanding shares is the same as after our Seed Stage investment: 10.5 million. Because the company has been afforded a $1m pre-money valuation, the price per share is $0.10 per share and we know that 5.25m new shares are required to sell $500k worth of new Series A Preferred stock to Investor #1. We leave Series A with 15.75m total shares outstanding in both common and Series A Preferred stock. By the time we liquidate the company in our example, we have 22,640,625 total shares outstanding.
- Bookmark for future discussion: total outstanding shares versus total outstanding, fully diluted shares. basically, this has to do with how you count the number of shares in the option pool that are carved out in the pool but not yet issued to employees.
- At the end of the entire calculation, we must still take LTCG taxes out of the final amount – just reduce the value by 15%. I have removed it from the spread sheet because it adds little value to the “terms” discussion.
First, you can see that there are two new variables above the main spread sheet: Liquidation Preference (set to 1.0 by default) and Participation (set to 0=non-participating by default). This tell us that, at a liquidation event, our investors have the right to get their liquidation amount out first and then not participate in subsequent asset distribution. To see the effect of fully-participating stock, just change the Participation cell (C8) to “1” – it makes a big difference. You should also change Liquidation Preference to 2.0 or something larger to see how that ripples through the calculation – we know by adding up the total preferred investment that the total amount of Preferred investment is $4m – a 2x liquidation preference would mean that there is $8m in preference “overhang.”
Looking at the end result, you may think that it looks like a pretty good deal to simply distribute out the liquidation amount and be done. Remember that the Preferences are designed mostly for down side protection and our spread sheet describes a pretty good outcome: $15m liquidation. This is absolutely a case where the holders of Preferred Stock would choose to convert to Common Stock ahead of asset distribution. In our spread sheet, you can see what this looks like by setting Liquidation Preference to zero (0, because we’re converting to common) and Participation = one (1, because everyone is in common stock and assets are distributed based solely on ownership).
You can see that the new distribution allow the investors to capture their share, based on equity ownership, of the total liquidation amount. The Liquidation Preference of 1.0 and Participation terms do not come into effect in this example outcome because the Preferred investors would unquestionably convert to common stock.
Experiment with marginal and/or negative cases by setting the liquidation amount close to or less than the total amount of money raised by the company in Series A and Series B. And then use a 1.5 or 2.0 Liquidation Preference or set Participation to “Fully Participating” – these will be the more challenging scenarios that you should fully understand.
What is a Good Number for Liquidation Preference and Best form of Participation?
A friend just pointed out that there is a high-level point that is important to make right up front in this discussion: Entrepreneurs agreeing to investor friendly terms in the early rounds may not seem like a big deal (because the amount raised is low and, there, the preference overhang is as well). However, the early rounds — and the Series A round in particular — set a critical precedent for later investors who typically piggyback on the earlier terms. So, once the precedent is set for investor friendly terms, it is pretty difficult to get them out of future deals because no one wants other investors to have a sweeter deal. Very import to get these terms right early so they don’t carry forward in later rounds and burden the company and entrepreneurs.
1x liquidation preference is basically the right target multiple in most cases because, all other things being equal, it’s the most “fair” to both investors and entrepreneurs. It can go as high as 10x but that is rare and there is likely some underlying reason for such a significant liquidation preference. Recently I have seen 2x and 3x liquidation preference in a few term sheets and investors have their reasons when the multiples go up; if you get a term sheet with a larger Liquidation Preference, talk about it and understand the investor’s motivation and concern. Non-participating stock is a bit more common (and better for the common share holders) in my experience but a capped fully participating Preferred stock isn’t unheard of these days.
ask questions…point out any mistakes…let’s make this as clear a discussion as possible. next up: the next tier of Preferred Terms.