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.
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.