Liquidation preferences

Startups are receiving ever higher valuations. Some of this has to do with fundamental reasons pertaining to the startup’s successful execution. However, part of it is simply financial engineering.

When a startup and an investor can’t agree on a valuation, the right action is to simply walk away. There may be another investor willing to pay the requested price, or if the startup needs money to survive it will be forced to lower its expectations across time. However, rather than simply walk away, I’m increasingly seeing investors offer startups the headline valuation that they want coupled with a high liquidation preference multiple in order to bridge the gap.

This is how it works in practice. If a company is raising $5M and believes that they should be valued at $15M pre-money, but an investor is only willing to value them at $10M pre-money, the investor simply requests a liquidation preference multiple of 2X. This figure is hypothetical to show the directional effects of liquidation preference multiples greater than 1X. The actual figure will depend on the investor’s assessment of the probabilities of the startup achieving different exit outcomes.

So rather than get $5M / ($10M + $5M) = 33% ownership, the investor accepts $5M / ($15M + $5M) = 25% ownership while guaranteeing themselves a minimum 2X * $5M = $10M exit value before any other shareholders receive exit proceeds.

If the company is sold for more than $10M / 25% = $40M, this doesn’t make a difference. The investor gets at least 25% * $40M = $10M so the liquidation preference doesn’t come into play.

However, if the company is sold for less than $40M, say $20M, then the investor gets their $10M liquidation preference rather than 25% * $20M = $5M. This leaves the remaining $10M for other shareholders rather than $15M.

We can appreciate the full risks of such an approach by taking an extreme example. If you apply a 100X liquidation preference multiple on a specified valuation, since very few companies are actually going to produce a 100X return on a given entry valuation, this effectively gives the investor 100% of the economic value of the shares of the company. In other words, it doesn’t matter what the actual headline valuation is or what the actual cap table looks like.

Our startups have received offers with liquidation preference multiples ranging from 2X to 5X. We strongly oppose such offers which boost a startup’s short term ego while damaging their long term cap table. It’s much healthier to accept a realistic valuation with a 1X liquidation preference which is necessary for the reasons outlined in my earlier post.

Startups should focus on building a valuable business, not financial engineering. Whenever an investor proposes such complex structures that distort a startup’s cap table, startups should recognize that agreeing to play this game will place them at a competitive disadvantage.

Although you could model out your returns in the presence of a high liquidation preference multiple based on the probability which you assign to different expected outcomes, setting out on this path is likely to only serve to help you justify gambling your startup’s future. Your startup’s future is your future.