NOTE: This is the fourth post in our series about standard terms in early stage equity financings. These posts refer to the model Series A Term Sheet put out by the National Venture Capital Association (NVCA) and available for download here.
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We continue our discussion of the Charter provisions with the liquidation preference, which is the most important economic term in the term sheet after the valuation because it establishes the relative rights of the investors and the common stockholders with respect to assets available for distribution when the company winds up its business. While the term “liquidation preference” suggests the provision applies only if the company goes belly-up, in reality there is likely to be little to fight over if this happens. The real impact of the liquidation preference comes into play when there is a “Deemed Liquidation Event,” such as an acquisition by another company, which generates cash or other assets (ex. stock of the acquiring company) to be divided among the stockholders.
The model term sheet includes three alternative provisions for the liquidation preference. They are (1) non-participating preferred stock (most company favorable), (2) participating preferred stock (most investor favorable) and (3) participating preferred stock with a cap. In all three alternatives, preferred stockholders are entitled to receive a “preference” – typically some multiple of their original investment (1x-3x) plus any accrued and unpaid dividends – before any payment is made to the common stockholders. “Participating” preferred stockholders are also entitled, after payment of their preference amount, to share with the common stockholders, on an as-converted-to-common basis, in the distribution of any remaining proceeds (this is called “double dipping”). If there is a right to participate with the common, the right may be capped at a multiple of the preferred stockholders original investment. It is important to note that investors will always have the option to convert their preferred stock to common stock if it would result in a larger payout, which could be the case with non-participating preferred and participating preferred with a cap if the amount available for distribution exceeds the preference amount or the cap, as applicable. Thus, investors will never receive less in liquidation than they would have if they simply owned common stock.
As with dividends, the economic impact of the preference and the participation rights depends on the company’s eventual fate. When evaluating a term sheet, it’s a good idea to do some quick math to determine what the different groups of stockholders (common and preferred) would take home if the company were sold for different values (for this exercise, assume the entire proceeds of the sale go to the stockholders). Then see how changing the proposed preference and participation rights impacts these results.
Entrepreneurs should note that investors may find it counterproductive to impose a very investor-favorable liquidation preference on a company for two reasons. First, it reduces the founders’ economic incentive to build the business. Second, later investors will likely want similar terms, which would leave the earlier investors negatively impacted by the same terms they imposed on the company. Don’t be afraid to raise these points (particularly the first one) in negotiating the liquidation preference, but also be prepared to make tradeoffs: if your potential investors insist on having a participation right, focus on pushing down the liquidation preference and adding a cap on participation; if the potential investors want a big liquidation preference (say, 5x), say no to participation.