There was a good blogosphere discussion this weekend on liquidation preferences during seed and VC investments. Fred Wilson once again has the best thoughts on participating preferred on his blog. It’s a great read for anyone negotiating with an investor for their first fund raising round on what participating preferred is and also links to explanations on liquidation preferences.
Update – Upon rereading my post and being contacted by Gabriel (who I am about to mention) I’d really like to point out that I’m not trying to personally attack him. It sounds like he’s a very, very smart guy who has built a few businesses to the point where he is able to be an angel investor. This is no small feat! Furthermore, promoting entrepreneurship and making angel investments is something that should be celebrated, not attacked. I do have some issues with his post on liquidation preferences in angel rounds, though.
During this discussion I came upon what I thought was going to be informative post on liquidation preferences by an angel investor in PA, Gabriel Weinberg. He links to a few spreadsheets in his post that supposedly make the case that it’s cool to take an angel investment with a 2x liquidation preference. He makes the points in these sheets that as an investor, with a 2x liquidation preference he can make a 15% IRR even if he invests in a company who’s value drops from $3 million at his investment to a $1 million exit 5 years later. That is one of the largest mis-alignments of interest between an investor and an entrepreneur that I can imagine.
He also seems to think that later round investors will be ok allowing him, the earliest investor, to keep his out of whack liquidation preference AND not insist on having one themselves. There is no chance a good investor will allow this. In fact, having out of the norm terms (like aggressive liquidation preferences) have a very high % chance of torpedoing your company’s ability to raise capital from a sophisticated investor. When the VC firms I worked for saw aggressive terms like these in seed investments, we usually passed on the investment right away. This is because it is a sign that you are going to have to deal with an unsophisticated angel investor, and most VCs would rather have a lobotomy than waste time negotiating with an angel who thinks they know what they are doing but don’t.
To illustrate my point that unsophisticated angel investors with large liquidation preferences are dangerous, I’ll share a story of a deal-gone-bad: I saw a company’s angel investors blow up an investment that would have been GREAT for the company and entrepreneur. Basically, the angels would have had to have lost their super-liquidation preferences. The company was cash flow break-even, but could have used my fund’s $10 million investment to grow to potentially be a $100 million plus company – but because the original investors were sitting pretty on a cute little return (very safe at this point, since the company could generate cash by stopping investing in growth) with their preferred structure, so they rejected the investment. Note that this crushed the entrepreneur’s dreams of growing his really great company into a big firm in the next couple of years. And my firm wasted a lot of time negotiating with these investors. I still feel really bad for the entrepreneur.
There are only two times it makes sense to accept over a 1x liquidation preference:
- The investors are letting you cash out at the time of the investment (i.e. the money they are investing is going into your pocket.)
- This is a B or C round and your company is having real problems. VCs will sometimes then insist on punitive terms to try to make up for the fact that they know their initial investment(s) in your company are likely to not produce returns.
VCs for a long time highly encouraged convert investing by angel investors. Angel investors have been clamoring for more respect and believe that they should be encouraged to invest in preferred stock with a valuation, instead of investing in convertible debt that turns into whatever the next round’s structure is at a discount.
Update: There was an issue with the model shared in Gabriel’s post, but he has since removed the problem. I believe it is dangerous to let non-sophisticated investors into Microsoft Excel, and seeing his Google Spreadsheet I’m going to extend that thought to include all cloud-based spreadsheet applications. In the model he shares, he has invested $50k as part of a $500k round in a startup. In his final scenario, he sells the company on the downside for $1 million and somehow gets back $164,167. 16% of the total returns! How the heck is he going to do that when he only put in 10% of the initial investment? Are the other investors in the $500k round going to say, “Hey Gabriel, you get paid first and we’ll just split up whatever is left over?” No. They are going to split the proceeds up according to the % of preferred that was invested, giving him a max of 10% of the return – i.e. he invested 10% of the initial investment so he’ll only get back 10% of the proceeds, since 100% of the proceeds are going to the investors in this scenario.
angel investors should do converts not preferred
I present this as a compelling reason to get unsophisticated angels back into investing in converts.
Update: I was too harsh in my original post. I’ve had an email communication with Gabriel and I think he’s trying to do what is best. I also think he’s trying to help companies grow. His post was intended as a “hey I want to hear people’s opinions” and was not a license for me to be nasty. I was mean spirited in my original version of this post, which isn’t cool. I’d like to apologize to him.
I do very strongly believe that liquidation pref’s are an area where it is easy for entrepreneurs and investors to get out of alignment. I think that strong belief carried over into a morning where I didn’t have my usual cups of coffee at home (due to the boil water order here in Boston). To be clear, while I do think there are times when a multiple liquidation pref works for everyone (see my point one and two above, plus for some growth stage investments) I’m not a fan of it for seed stage investments where the startup will be likely to seek further funding.
May 3rd, 2010 at 3:41 pm
Wow, thx for taking the time to attack me personally without knowing me or really reading my post or spreadsheet closely.
First, the scenario you point to and make fun of me for was not included in the post at all or meant to be taken seriously. I noted three plausible scenarios. The fourth is just meant to play around with.
Second, I never suggested this was a desirable outcome. Of course the opposite! I don't want to invest in anything I don't think has a reasonable chance where everyone is going to make out great, i.e. an exit where the liquidation preference doesn't matter at all. All I'm saying is that new angel investors can make more deals if they get some money back when things go south. In that context, I think a 2x liquidation pref, non-participating can get you there.
Other ways to get to the same place are 1-1.5x, participating, or dividends. Really any of those is fine with me, but as I noted in my post entrepreneurs often have an emotional reaction to participation rights. And dividends can cause accounting headaches.
Third, I never meant to suggest this was desirable in every deal. It is meant in the context of an entire terms negotiation. That is, it is a give and take on valuation, liquidation pref, etc. as Fred notes in his post.
Fourth, I didn't mention this (but should have) that I am doing deals with very small rounds that I hope will not need VC money. So the follow-on issue is less of an issue.
Fifth, I reject your premise that you can tell what is standard and non-standard. Survey 100 deals and see what liquidation preferences, etc. come out. In fact, WSGR already does that:http://www.wsgr.com/publications/PDFSearch/entrep… . Things are all over the map.
But it's worse than that. Each angel group/syndicate has their own set of docs they like to use that have evolved over the years. Each have their own intricacies. Only the past few years have so-called "standard" seed docs emerged. And even then there are currently 4 competing ones, which all have different terms. The series seed docs are simply the latest.
So I ask you this, what is standard? You make it seem like 99% of seed deals have the same terms. That isn't true at all. Each term may have an aspect of it that gets plurality across deals, but that's it. I'd argue hardly any deal looks 99% the same as any other.
May 3rd, 2010 at 3:49 pm
Excellent post, as always. Or, as one of our mentors used to say, "If you want to get funding, don't become a hairball."
May 3rd, 2010 at 5:21 pm
This is the same reply that I posted on Gabriel's blog:
Gabriel, sorry if this came across as a personal attack. That was not the idea. Promoting entrepreneurship and making angel investments is awesome and should be celebrated, not attacked.
I do have an issue with the spreadsheet, which I've gone into. Even if you are not referring to that particular part of the sheet in your post, I'd suggest fixing it. My experience is that someone out there will find your sheet via Google and try to use it, so having anything in there that's off may be an issue for that unlucky soul…
I realize that there is no standard angel investment term sheet. I also don't think there ever will be a single place one can visit to download one. However, this doesn't mean that there aren’t pretty standard terms that can be easily digested by follow on investors. I know that some super-angels/early stage VCs have, over the years, tried to get together a standardized set of documents, but failed. The fact that different sophisticated investors (and ones who often follow angels) keep trying to get some standard docs put together highlights the fact that weird terms are causing pain.
On my blog, you mention in a comment an important point – the fact that you do not anticipate your seed investments needing VC money. If this is truly the case than there is likely not going to be an issue with non-standard terms. However, every “different” term in a seed investment makes it that much harder to do a follow on investment, should the need arise. Deals do not get incrementally or linearly more difficult, they become exponentially harder.
I do believe that there terms that are more standard than not for angel preferred investments. My only experience with this has been as a VC watching my partners walk away from good companies because the angel terms were too out there. The closer an angel investment is to the typical NVCA Series A term sheets the more standard they are (unless they are a clean convert.)
May 3rd, 2010 at 5:25 pm
I've updated the sheet and removed the values in scenario 4
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May 4th, 2010 at 1:02 am
Interesting post. I believe that everyone (well lot's of people) give lip service to the idea that 1x participating preferreds create misalignment, but the fact is that a very large number of investors (including high end VCs) regularly ask for it and regularly get it in early rounds and late rounds. With respect to angel investors, I agree that convertibles are way better than preferred, especially preferreds with preferences.
May 4th, 2010 at 1:14 am
I think you can dig yourself a hole really fast if you are raising a lot of $ with high participation. A high end VC asking for more than 1x participation is a sign they do not like the valuation. I agree that they happen in growth deals, especially when the entrepreneur is taking $ off the table.
May 3rd, 2010 at 11:02 pm
[...] It’s stupid tο ԁο anything non-standard іn уουr seed round | St… [...]
June 9th, 2010 at 3:29 am
Hi thanks for your blog, I am currently preparing an excell document for a start up, that I can present to investors.
Do you know where I can find out more about the details some of the terms of private investors and VC´s, and what I should be aware off, I do not want anything to stifle innovation and global growth.
Do you know where I can get a sample excel template of a good "investment and business valuations spreadsheet" that I can present to investors?
June 9th, 2010 at 2:06 pm
Mark, I don't quite understand what you are trying to present. Is it some sort of a valuation spreadsheet? In the US, startups usually do not present any sort of a valuation spreadsheet to potential investors.