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Liquidation Preferences: What You May Not Know
By Colin Blaydon and Michael Horvath

03/01/2002
Venture Capital Journal
Copyright (c) 2002 Thomson Financial, Inc. All Rights Reserved.

Shortly after a recent exit sale, a CEO called his lead venture capital backer to complain that while he had thought his management team owned 34% of the company, they had received only 5% of the sale proceeds. "How did we get such a bum deal?" he asked. The VC patiently explained: liquidation preferences.

Liquidation preferences ensure that in the event of a sale, investors get a certain return on their money before anyone else gets a cent. This staple financing tool is a must have for the savvy preferred investor. But management often doesn't—or doesn't want to—understand the potentially draconian consequences of preferences.

Those consequences are only getting worse. Recently, liquidation preferences have become particularly aggressive as burned investors seek to protect themselves from future disaster. This is not good news for management. Yet, deals with liquidation preferences can be structured to provide investors with the protection they seek while keeping management from feeling exploited and resentful. In this article, we discuss ways to strike that balance.

What are liquidation preferences?

Liquidation preferences provide preferential treatment for preferred shareholders in the event of a liquidation of the company or a sale of a majority of the company's stock. Essentially, the investor receives a multiple of his original investment as the first money out. For example, a $10 million investor with a 2X liquidation preference would be entitled to receive the first $20 million generated by a sale.

Because liquidation preferences give the VC a guaranteed return on their investment of up to 1X or 2X or, as we have seen recently, 5X! (as long as the sale price matches or exceeds that) they are an attractive way to limit downside loss. But this protection comes at the expense of common and other preferred shareholders without liquidation preferences. They're left divvying up a smaller pie. After the preferences, there may not even be crumbs.

Liquidation preferences come in two shades, participating and non-participating. With a non-participating liquidation preference, the investor receives the liquidation multiple, and that is it. An investor with participating liquidation preferences gets to double-dip, receiving both the multiple of the original investment plus his or her share of the rest of the proceeds dictated by ownership percentage once preferred stock is converted to common.

How do liquidation preferences affect valuation?

As with ratchet clauses, liquidation preferences protect preferred shareholders when a company's value turns out to be less than what everyone ostensibly expected when the investment was first made. But since liquidation clauses are only invoked at the terminal point of a company's independent life, not at interim financings, they receive less attention by company management considering investor term sheets.

Indeed, sometimes management will be more wooed by a deal with liquidation preferences because these preferences can make the valuation of a company upon a financing round look better than it is—or better than the investors really think it is.

Here's why: The effect of a liquidation preference depends on the liquidation or sale price of the company, an unknown at the time of the financing. In the event the company is highly valued in the final transaction, the liquidation preference has little effect on common's share of the proceeds. In a non-participating situation, the multiple is easily matched by the sizeable value of the investor's shares. In a participating situation, the multiple may be de minimus given the whopping total value of the equity.

But if the company is sold at a valuation at or below the liquidation preference multiple times the post-money valuation of the company at the financing round, the liquidation preference effectively grants the preferred shareholders a greater percentage of the company at the time of sale and hence—in hindsight—reduces the implied valuation at the time of the interim financing. (The preference multiple times the post-money valuation represents the sale value at which the non-participating preferred investor would be equally compensated by receiving the liquidation preference amount or the percentage ownership times the liquidation value. At any lower valuation, the investor's liquidation preference would exceed his/her percentage ownership times liquidation value. Hence, effectively, the investor owns more of the company on liquidation than this percentage ownership.)

Even more confusing, a financing round is generally quoted in terms of price per share and the associated valuation is based on that share price. If a financing has relatively few new shares but an aggressive liquidation preference, the apparent valuation based on per share value may appear to be a flat or even up round, while effectively the pre-money value is close to zero and the post-money value is equal to the new investment!

Say, for example, the venture capitalist invests $10 million with a 4X liquidation preference for 10% of the company. Presumably the company is worth $100 million. But if the company sells for $40 million, the VC effectively owns 100% because of the liquidation preference. The post-money valuation then is $10 million and pre money is zero.

This ability of liquidation preferences to distort the ex post valuation picture can be effectively used to an investor's advantage when negotiating around other anti-dilution provisions from an earlier round of financing. An investor can do an investment at the previous round's price but secure a substantial liquidation preference, effectively gaining a larger share of the company at the time of sale, again, depending on valuation.

How about management?

It all sounds great for investors. But how about management? Top executives are usually paid substantially through their shares and so focus more on per share valuation than on nebulous liquidation preferences. But if they later realize that preferences will wipe their money off the table, they may lose motivation . Even if managers are savvy about preferences, they might be unconcerned about them at a financing round when they are feeling optimistic. That sentiment may change as tough realities set in.

Investors, then, should seek ways to satisfy management's needs while protecting their own. We offer three such approaches.

First, investors can offer management a transaction bonus. An incentive to sell the company, this cash bonus aims to make up some for any share of proceeds foregone to the preferences. The bonus needs to be in cash rather than new options, because the whole idea is that after the preferences, shares aren't worth much.

Transaction bonuses are usually done in side agreements, sometimes even verbally. And that's the problem. The message is usually a "we'll take care of you." But if the rules of the game aren't clear, management might not be responsive. Investors won't get the desired enthusiastic response they're seeking, namely, a company sale.

Second, investors can offer management a slice of their liquidation preference. If, for example, they've got a 4X multiple on a $10 million investment, they can offer, say, 5% of their $40 million. Again, such arrangements would be in a side deal. But these slices can be somewhat self-defeating in that they reduce the protection of the preference.

Finally, investors can set up a valuation hurdle at which point the preferences would disappear. This approach aligns management's interests with investors. The message is: You hit a home run, and our liquidation preferences go away.

How high the hurdle? The higher the valuation hurdle to get the liquidation preference to disappear, the less of an impact the liquidation preference would have on preferred's investment return anyway. (IPOs are another story. Investment bankers generally insist that all preferred stock converts to common, and liquidation preferences go away.)

Let's say a venture capitalist invests $2M for 25% of a company with a 2X participating liquidation preference that goes away if the company sells for more than $100M. If the company sells for exactly $100M, assuming no further dilution after the VC invests, his or her return would be $25 million, or 12.5X without the liquidation preference. Had the liquidation preference applied, the investor's return would have been $28 million (4 million + 25% of 96), or 14X. Clearly the liquidation preference is not generating the bulk of the investor's return. A $100 million hurdle for management would not inflict too much pain on the investor.

The problem with hurdles is that if they are structured as a single hurdle, like $100 million in our example, they might be too narrow to achieve the objective of motivating and rewarding management. What if the company sells for $95 million? Then management doesn't get the benefit of its efforts even though they substantially, though not entirely, reached the goal. And management might find itself inclined to pass on market-wise sales that don't satisfy the internal hurdle.

The way around this problem is a "sliding scale" of hurdles, whereby the preferences are reduced by greater percentages as the sale price rises.

In sum, there are several ways for investors to incent management while using liquidation preferences to protect themselves. The key is to address these issues squarely and clearly at the time of financing. If liquidation preferences actually have to come into play, it's generally not because things have gone well. And that's the worst time for more surprises.

Colin Blaydon and Michael Horvath are professors at the Tuck School of Business at Dartmouth. They are also directors of Tuck's Center for Private Equity and Entrepreneurship. They can be reached at pecenter@dartmouth.edu.

This article originally appeared in the March 2002 issue of the Venture Capital Journal.

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