Liquidation preference has long been a staple in Venture Capital funding, serving as a financial safeguard for Investors. While it addresses real challenges around risk and financial returns, it’s far from a panacea. The very structure that aims to protect Investor capital can become a breeding ground for conflicts between Venture Capitalists and Founders, and even among Venture Capitalists. The rising complexity and scale of Venture Capital deals further magnify these challenges, exposing the imperfections of this time-tested mechanism.
In this post, I dive deep into the mechanics of liquidation preference. I begin by explaining why liquidation preference exists and the different types that are commonly used. The core of the article focuses on unpacking the potential conflicts it can cause—both between Venture Capitalists and Founders, and among Venture Capitalists. Finally, I will outline some best practices for mitigating these conflicts and fostering more harmonious relationships in Venture Capital deals.
In This Post
- Understanding Liquidation Preference
- How Liquidation Preference Creates Conflict in Venture Capital
- Illustration: The Trados Case Study
- Liquidation Preference Misalignments: Bridging the Gap
- Conclusion: tl;dr
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Understanding Liquidation Preference
This section comprehensively explains what liquidation preference is, how it functions, why it exists, and the different types.
What Is Liquidation Preference and How It Works
Liquidation preference is a critical but often misunderstood term in Venture Capital agreements. It establishes the payout order in the event of an exit, commonly called a “liquidity event,” ensuring that Investors receive their investment returns before other equity holders.
This term is usually contractualized in the term sheet and later included in the investment documents, typically the shareholders’ agreement, specifying how the payout is structured. Read the post below for more details on term sheet clauses and governance in VC.
The parameters often dictate that the Investor receives their initial investment back, or a multiple thereof, before any proceeds are distributed to other equity holders such as Founders and employees. For example, a 1x liquidation preference means that the Investor would get their initial investment back out of the exit proceeds before any other distributions occur. Higher multiples like 2x or 3x are less common but can also be negotiated, indicating that the Investor would receive two or three times their initial investment before others.
If there’s money left over after the Venture Capitalists have received their liquidation preference, the remaining funds are typically distributed among other equity holders according to their ownership percentages. This distribution can either be straightforward or involve more complex calculations based on participation rights or other special conditions outlined in the investment agreement, detailed below.
Why Liquidation Preference Exists
Historically, liquidation preference was introduced to safeguard the interests of Venture Capitalists in “downside case” exit scenarios, i.e., when the startup would get acquired or go public at a lower valuation than initially anticipated. There were instances where, due to their “sweat equity” (defined below), Founders could walk away with millions even in such exits, while Investors incurred losses. Liquidation preference serves as a mechanism to ensure that Investors recoup their initial investment, or a multiple thereof, before the distribution of any remaining proceeds.
Additionally, liquidation preference gives Venture Capitalists leverage at the negotiation table, particularly in strategic exits. In cases where an acquirer might be tempted to offer a low upfront price to the Founders and compensate with a sizeable earn-out package, Venture Capitalists could find themselves excluded from these earn-outs. A liquidation preference ensures that Venture Capitalists are accounted for in such arrangements, helping to align the financial incentives of all parties involved.
Over time, liquidation preference has also evolved to serve as a counter-balance to high valuations. In competitive markets, startups often command high valuations, increasing the risk for Venture Capitalists who come on board that their return will come in low. A liquidation preference clause can partly mitigate this risk by “wiping out” the high valuation when the exit does not materialize as anticipated.
Go Further: Watch the webinar for detailed illustrations and calculations on liquidation preference
Participating, Non-Participating, Capped
Understanding the types of liquidation preferences can be crucial for both Founders and Venture Capitalists, as they strongly impact their payout.
Non-Participating Liquidation Preference: In this scenario, the Investor has the choice to either receive their liquidation preference or convert their preferred shares into common shares and partake in the distribution of remaining proceeds. They don’t get to do both.
Participating Liquidation Preference: Here, the Investor receives their liquidation preference and also participates in the distribution of any remaining proceeds according to their ownership percentage. This can be particularly advantageous for Venture Capitalists but potentially detrimental for Founders and other equity holders.
Capped Participating Liquidation Preference: Sometimes, a cap is placed on the participating preference to limit the upside for the Investor. Once this cap is reached, the preferred shares convert to common shares, and the Investor participates pro-rata with other common shareholders. It is sometimes called a “kick-out feature.”
Unlike a liquidation preference which is rarely negotiable with a VC, a participation preference is almost always negotiable.
Brad Feld – Foundry Group (Source: Feld.com)
In some cases, the preference is calculated as a multiple of the initial investment that the Investor made. For example, a 2x liquidation preference would mean the Investor gets back double their original investment before any other payouts. These structures are more common in pre-IPO rounds.
In other cases, the Investor demands a minimum “guaranteed” return (there is no guarantee in VC, where capital can be entirely wiped out) expressed as a compounded interest rate or IRR. Term sheets denominate it as a “cumulative dividend.”
Each type of liquidation preference has its own pros and cons and can significantly impact the financial outcomes for both Venture Capitalists and Founders. Understanding these types is crucial before entering into any Venture Capital agreement.
How Liquidation Preference Creates Conflict in Venture Capital
While it aims to balance risk and reward, liquidation preference can create conflict between Founders and Venture Capitalists, and even among Venture Capitalists. In the following section, I describe the root causes of these conflicts, drawing from academic research, real-life case studies, and my experience as an Investor.
Misalignments between Founders and VCs
There are at least two potential conflicts between entrepreneurs and their financial shareholders.
Flat Spots
The first layer of tension arises when an exit doesn’t look as promising as initially expected. In such cases, Venture Capitalists might be motivated to expedite the exit process at a price that ensures their liquidation preference is fully paid out. This situation may occur at the end of a fund’s life, when GPs might be tempted to rush a sale to close the fund.
The urgency often leaves Founders and employees, who typically own common stock (sometimes alongside early Angel Investors), in a precarious situation where they may walk away with little to nothing. The misalignment between the two parties’ financial incentives can result in rushed decisions and sometimes even lead to the failure of negotiations with potential acquirers.
Having a large amount of liquidation preferences sometimes creates “flat spots” where some investors become indifferent to the ultimate price you sell your company between wide ranges of outcomes.
Mark Suster – Upfront Ventures (source: His Awesome Blog)
Mark Suster’s quote perfectly illustrates the complexities and potential conflicts arising from liquidation preferences in Venture Capital deals, particularly when there is a “flat spot.” In Suster’s scenario, a pre-existing Investor can be more inclined to sell the company at $30 million rather than $50 million because, due to the liquidation preference and the associated “flat spot,” they stand to earn the same amount of money in either case.
Watch the webinar for a numerical example illustration of flat spots in VC.
Disincentives
Another conflict comes into play when liquidation preferences stack up too high. Founders often find themselves disheartened as they realize they might never reach an exit price that allows them to make money above the liquidation preference.
A cornerstone of entrepreneurship motivation is the concept of “skin in the game”—the Founders’ personal commitment to the new venture, typically measured in financial terms. Most Investors expect that entrepreneurs who are financially committed to their startup are more likely to roll up their sleeves and do the hard work when the going gets tough.
The concept found backing in academic research. A recent study of over 1,200 U.S. entrepreneurs found that while the absolute dollar amount invested before launch does not significantly impact firm creation, the proportion of personal funds invested relative to the entrepreneur’s net income positively affects venture success and persistence in the venture creation process.
Entrepreneurs who invest larger amounts as a proportion of their net income are more likely to succeed and are less likely to disengage from the process.
Frid, Wyman, & Gartner, 2015 (Source: Academy of Entrepreneurship Journal)
For many entrepreneurs, this investment is not in the form of cash but instead in the form of time, effort, and skills contributed to the company’s development. The term “sweat equity” signifies hard work and dedication, emphasizing that this type of equity is earned through personal input rather than financial contribution.
However, even in Silicon Valley’s “go big or go home” culture, there are limits to how far one can push. When Founders lose the incentive to aim for a big exit, the Venture Capitalists themselves face the risk of diminishing returns. This dissonance creates a situation where neither party feels they are likely to benefit from any impending exit, making the journey forward fraught with tension and skepticism.
Inter-VC Conflicts
In a multi-round funding scenario, conflicts can arise among Venture Capitalists from different rounds due to differing liquidation preferences. All preference holders are regrouped in what is commonly termed a “preference stack,” leading to a complicated pecking order for payouts upon exit.
Why Late-Stage VC Firms Need Protection
The friction occurs when later-stage Investors demand a stronger liquidation preference, via a higher multiple or priority payment, to offset the higher valuation and perceived risk, thus disadvantaging earlier Investors.
In a recent exchange on LinkedIn after I first published this article, Alex Mans, President of Flyr Labs (a startup that raised close to $200 million with Peter Thiel and WestCap), shed light on the nuanced roles liquidation preferences play at different stages of a company’s growth, even when all VCs have the same conditions on their liquidation preference.
He emphasizes that while early-stage investors benefit less from liquidation preferences, these financial structures become critical in later stages, especially in funding rounds north of $50 million. Late-stage VCs (Series C onward) must protect their downside due to a higher cost of capital and lower return expectations from any individual investment. The power law plays less in their favor as they typically invest in much higher valuations than early-stage Investors.
You need long-term supporting check writers around the table willing to value things well above where early stage investors came in. These late-stage investors need protection due to their returns profile.
Alex MAns – Flyr labs
Alex Mans also pointed out that without liquidation preferences in place during later-stage investment rounds, Founders may lack the motivation to push for a company valuation that surpasses the total amount of liquidation preferences owed to Investors.
Exit Proceeds: Pari Passu vs. LIFO
VC firms agree to one of two mechanisms to divide the preference stack between them, depending on their bargaining power:
Pari Passu. In a pari passu arrangement, all Venture Capitalists are treated equally in the liquidation preference, irrespective of when they invested. Every Investor stands in line together, sharing proportionately in the liquidation proceeds. While this seems equitable, it can also create conflicts if later-stage Investors have invested at a higher valuation and yet find themselves on equal footing with earlier Investors, who arguably took higher risks by investing early. Note: this liquidation preference type is sometimes called “blended.”
Last-in, First-out (LIFO). Although not traditionally called LIFO in Venture Capital (lawyers refer to it as “stacked liquidation preference”), this approach essentially means that Investors in the last round are the first to get their share of liquidation preference. Later-stage Investors who invest at higher valuations often negotiate for a more favorable position in the liquidation hierarchy to mitigate their higher risk. This structure, however, can be disadvantageous for early Investors, potentially causing friction among Venture Capitalists from different funding rounds.
1x non-participating and pari passu. This is a particular case. The pari passu feature works up to the total preferred amount. After that, some preferred shareholders may convert to common stock and take their pro-rata of the proceeds, given their lower entry price. Charles Yu illustrated this point with Palantir’s prefs.
Illustration: The Trados Case Study
The tale of Trados encapsulates the dilemma of liquidation preferences in Venture Capital and serves as a cautionary tale for both Venture Capitalists and Founders alike. Despite a seemingly successful $60 million exit, common stockholders were left with nothing and decided to sue the VCs, accused of running a botched sale process.
The Trados case is far from rare: a company fails to yield the high returns anticipated, and the liquidation preferences set in place create a disproportionate distribution among shareholders. The litigation peeled back layers of the company’s inner workings, providing rare and invaluable backstage data on boardroom dynamics, decision-making, and the actual impact of liquidation preferences.
This case sheds light on the complex interplay of interests that defines Venture Capital deals, offering vital lessons on the importance of equitable shareholder treatment and the intricate balance of power within a startup.
Trados: A Typical Middle-Case Scenario in VC
Founded in 1984, Trados became a $14-million software company by 2000, selling desktop solutions for document translation. Trados decided to raise funds in the Internet Bubble frenzy, aiming to accelerate growth ahead of a planned Initial Public Offering. Despite strong growth, subsequent funding rounds over two-and-a-half years didn’t yield Investor-pleasing results. By then, the Internet Bubble had burst, and the VC landscape had transformed. Many cash-strapped VC firms were looking for liquidity.
In 2005, Trados’s financial shareholders orchestrated a sale to SDL, a UK-based competitor, for a reported price of $60 million. The exit left investors relatively unscathed due to their preferred shares, while common stockholders received zilch. The ensuing lawsuit questioned the fairness of the sale, alleging that the board had authorized an exit detrimental to common shareholders.
The plaintiff contended that instead of selling to SDL, the Board had a fiduciary duty to continue operating Trados independently in an effort to generate value for the common stock.
Final opinion dated August 16th, 2013 (Source: Delaware Court)
What’s most enlightening about the Trados case is the concept of “liquidation preference waterfall,” which describes who gets what in Venture Capital based on classes of stock and other contractual arrangements like Management Incentive Plans (MIPs). In this specific case, Venture Capitalists held both participating and non-participating preferred stock, rendering the type of liquidation preference moot since nothing was left once the preferred amount was paid.
According to Court documents, the Trados liquidation preference waterfall, illustrated below, had only two beneficiaries. Ultimately, the Venture Capitalists pocketed $49.2 million, far more than their total investment of $28.3 million, leaving common shareholders in the cold.
The Trados Waterfall
| Beneficiary | Amount Perceived ($ million) |
|---|---|
| MIP (Management) | 7.8 |
| Contingency & Fees | 3.0 |
| Financial Investors | 49.2 |
| Common Stockholders | 0.0 |
| TOTAL | 60.0 |
Although the Trados case can be considered extreme, such a structure is typical in Venture Capital transactions.
Management Team: Incentivized to Exit
As the table shows, three managers made $7.8 million on the sale: the CEO, the CTO, and the CFO:
- The CEO had been appointed in mid-2004 to improve operations and negotiate a potential sale of the company — which he did pretty effectively.
- The CTO was Trados’s co-Founder, the only one remaining. His shares had little chance of having any value in a sale. He owned common stock, as Founders generally do. The MIP ensured he remained committed.
- The last beneficiary of the MIP was the CFO, who had been hired at the end of 2003 to tidy up the house in preparation for an exit.
It is common for VCs to carve out some value for a company’s top management team ahead of an exit or an I.P.O. This allocation is often referred to as a Management Incentive Plan (MIP). The intention behind a MIP is to motivate the management team to work towards a successful exit, which typically aligns with the VC’s goal of a profitable return on their investment.
Venture Capitalists: Liquidation Preference Protection
How could VCs make more than their initial investment in Trados while common stockholders got nothing? The cumulative dividend mentioned before explains it.
Trados’s VCs owned preferred stock with 1x liquidation preference and an 8% cumulative dividend. It means they had to make an 8% return (or Internal Rate of Return, IRR) before any money could go to the common stockholders.
Founders often underestimate how quickly cumulated dividends compound, ballooning to significantly higher sums over time. For instance, VC firm Wachovia Capital Partners saw its $5 million Series A Participating Preferred Stock investment grow to $7.5 million due to these dividends, a 50% increase in five years. (Wachovia was then called First Union Capital Partners and is now Pamlico Capital).
Liquidation Preference Waterfall ($ million)
| VC Firm | Initial Investment | Allocated Proceeds | Multiple |
|---|---|---|---|
| Hg | 14.3 | 18.9 | 1.3x |
| Wachovia | 6.0 | 8.1 | 1.4x |
| Invision | 4.0 | 4.3 | 1.1x |
| Sequoia | 3.8 | 4.4 | 1.2x |
| Mentor | 0.2 | 0.2 | 1.0x |
| Other? | na | na | – |
| TOTAL | 28.3 | 35.9 | 1.3x |
According to the Court’s documents, the total liquidation preference on the preferred stock, including accumulated dividends, amounted to $57.9 million at the time of the SDL acquisition. I couldn’t reconstruct that number with the information contained and assumed it was the right amount.
I could trace back only $35.9 million out of the total $49.2 million payout. It is still much more than the $28.3 million invested between March 2000 and August 2003. (It includes the stock-for-stock acquisition of Uniscape, backed by Sequoia, but excludes the secondary buyout realized by Hg in September 2000 for $2.3 million.)
Employees & Common Stockholders: The Losers?
Employee stock incentive schemes are often structured with common stocks to align the interests of the employees with the company’s long-term success. These incentives motivate employees by offering them a stake in the company’s future growth. However, in the event of a merger or acquisition, common stockholders, including employees with stock incentives, can be disadvantaged, particularly when liquidation preferences are in play.
The Trados case exemplifies such a scenario. It began with a former Trados Inc. employee, Marc Christen, who filed for an appraisal action after the SDL acquisition was announced. Christen held a substantial amount of stock and was purportedly upset to receive no share of the sale price.
Trados teaches us that a disgruntled employee can come back to haunt his old employer. Had Christen felt differently about his termination, he might never have sued for an appraisal. Good employee relations are always worth the effort.
Edward McNally – Morris James (Source: Website)
This action revealed that insiders (in this case, the VCs) may have breached their fiduciary duties during the acquisition process. This discovery sparked a class action to recover damages for these breaches. Despite the Court’s ruling that the acquisition price was fair and that no damages were owed, the plaintiffs’ attorneys managed to secure a $4.5 million settlement in a post-verdict mediation—of which Christen is reported to have perceived 7% or $315,000.
The Court also awarded Christen an additional $100,000 fee for his significant and verifiable contributions to the case over its 11-year duration, despite objections from the defendants.
The Trados Ruling: Liquidation Preference Holders Owe Duties To Common Stockholders
The Delaware Court of Chancery’s ruling in the Trados case was complex, reflecting the intricate nature of corporate governance and fiduciary duty in Venture Capital-backed companies. The Court addressed several key issues.
Fiduciary Duty: The Court looked into whether the Board of Directors had breached its fiduciary duty by failing to consider the interests of the common shareholders. The directors of a company must act in the best interests of the corporation and its shareholders as a whole. In the case of Trados, there were claims that the Directors appointed by Venture Capitalists prioritized the interests of the preferred shareholders over those of the common shareholders.
Fairness of the Sale Process: The Court examined the sale process and evaluated whether it was conducted fairly. The Court had to consider whether the sale maximized Trados’s value for the benefit of all shareholders or if it was structured primarily to satisfy the preferred shareholders’ liquidation preferences.
Outcome for Common Shareholders: The Court acknowledged that the common shareholders did not receive any proceeds from the sale due to the preferred shareholders’ liquidation preferences. However, the Court had to determine if a viable alternative would have provided a better outcome for the common shareholders.
In the end, the Delaware Chancery Court found that, in fact, there was not a fair process in place for the sale of Trados, yet the price was fair because the shares held no economic value. It’s a bit of a “no harm, no foul” kind of outcome—except that it took about eight years of everyone’s life, not to mention lawyers’ fees, to get there.
Priya Cherian Huskins – Woodruff-Sawyer
The Court ultimately ruled that while the Directors had indeed breached their duty to consider the best interests of all shareholders, the plaintiffs (common shareholders) failed to demonstrate that the breach of duty had caused a financial loss. The Court concluded that, under the circumstances, no better alternative would have provided an economic benefit to the common shareholders.
Therefore, while the directors were found to have breached their fiduciary duties, the plaintiffs were not awarded damages because the breach did not result in a loss to the common shareholders, according to the Court’s findings.
Scott Kupor, managing partner at Andreessen Horowitz and a veteran of Venture Capital, offers a treasure trove of insights concerning Trados in his book, “Secrets of Sand Hill Road: Venture Capital and How to Get It.” A lawyer by training, Kupor delves into the complexities revealed by the case, such as fiduciary duties, shareholder alignment, and the unintended consequences of liquidation preferences.
Well, it turns out that Board members do not owe fiduciary duties to the preferred stock. […] After all, nobody should have to worry about protecting the big bad VCs.
Scott Kupor – a16z (Source: Secrets of Sand Hill Road)
His takeaways from Trados are particularly enlightening for Founders and employees of startups, offering a cautionary tale on the need to understand the fine print of Venture Capital terms and the long-term implications these can have on their ownership stakes and the company’s future.
To ensure a fair process, Kupor recommends hiring bankers, being cautious with MIP adjustments near a deal vote, considering the allocation contributions to MIPs, potentially setting up special committees to represent common shareholder interests, and possibly allowing for a separate vote by disinterested common shareholders.
Above all, Kupor stresses the need for the board to recognize potential conflicts, discuss their implications, seek conflict mitigation strategies, and document these efforts thoroughly in Board minutes. These steps are crucial for demonstrating due diligence and the Board’s commitment to upholding its fiduciary duties, ensuring that all shareholders’ interests are considered in the acquisition process.
In Trados, Venture Capitalists protected their investments through liquidation preferences but at the cost of common stockholders and perhaps ethical considerations. It’s a stark reminder that when Venture Capitalists and Founders negotiate terms, attention to detail and long-term impact should be at the forefront. The Trados case serves as a guide for what can go wrong when such aspects are not carefully negotiated and understood by all parties involved.
In the last section, I present some remediation to this classic misalignment of interests introduced by liquidation preference in Venture Capital.
Liquidation Preference Misalignments: Bridging the Gap
Fairly using liquidation preferences is crucial for maintaining a balanced relationship between Venture Capitalists and Founders. Properly structured liquidation preferences can ensure that Venture Capitalists are adequately compensated for their risk while not disproportionately disadvantaging Founders in the event of a sale or liquidation.
More Transparency
It’s imperative for Founders to thoroughly understand the terms they agree to in Venture Capital deals, particularly concerning liquidation preferences. These terms directly impact the financial outcomes for Founders. A lack of understanding can lead to unfavorable conditions, potentially resulting in significantly reduced returns for Founders despite their company’s (relative) success.
However, as the Lightspeed Ventures / Snapchat debacle demonstrated, VCs should drive transparency and educate Founders on the intricacies of term sheets—including, but not limited to, liquidation preference.
When Lightspeed made its early investment in Snapchat, the terms included giving Lightspeed the right of first refusal to invest in a future round of funding and the ability to increase its share of the company in that round. These terms effectively gave Lightspeed veto power over future investments in Snap and made Snap less attractive to other investors.
I’m obsessed with this idea of “no standard terms”. Ask why, and why, why, and why until your understand them.
Evan Spiegel – Snap (Source: ET Now)
The Founders of Snapchat, Evan Spiegel and Bobby Murphy, later realized the extent of these terms and their impact on the company’s ability to attract other investors. This realization led to dissatisfaction and a drive to reassert control over the company. As a result, Snap’s Founders struck a deal with Lightspeed to remove these onerous terms in exchange for allowing Lightspeed to buy a limited number of Snapchat shares at a discount.
This experience influenced Snap’s approach to future investment rounds and governance. Spiegel and Murphy implemented measures to retain overwhelming voting control and avoid preferential treatment to investors in subsequent deals, culminating with their dual-class share issue at Snap’s IPO.
The story highlights the need for Venture Capitalists to educate Founders about the terms of their investment and for Founders to comprehend these terms fully. When the negotiation heavily favors one side, it can sour the relationship and lead to significant changes in company policy and governance, as seen in Snap’s case.
Fairer Terms
Contrary to what many VCs seem to believe, fair liquidation preference terms also benefit them.
When Founders face a large stack of preferred shares atop their common equity, they are less incentivized to perform if they don’t believe an exit will generate sufficient proceeds to over the liquidation preference. Consequently, Founders might be less motivated to drive the company towards successful outcomes, as their share of any potential upside is significantly reduced.
Worse for Investors, such dynamics can foster moral hazard. Founders may be inclined to persuade Venture Capitalists to continue funding the company, even if its prospects are bleak, to maintain their status and perks as entrepreneurs. This situation is not just detrimental to the Founder’s motivation but also poses a risk to the Venture Capitalists’ investment, as continued funding in a faltering venture can lead to more significant losses.
Equitable liquidation terms are crucial for maintaining Founder motivation and protecting the Venture Capitalists’ interests by aligning incentives towards the company’s success. Here are some practices and mitigants that offer a more equitable approach.
Stick to the 1x Non-Participating Liquidation Preference: Although the temptation is high in bear VC markets to revert to double-dip preferred, VCs should stick to the 1x non-participating pref. As I highlighted in the webinar using Excel simulation, there is no defensible argument for the participating liquidation preference.
Put a Cap on the Liquidation Preference: In cases where 1x may not be acceptable (for instance, in pre-IPO rounds, where Investors typically pay a high entry price), consider capping the preference at a reasonable return multiple. Beyond a certain point, Founers and common stockholders should be able to participate in exit proceeds.
Founders Catch-Up: Implementing a catch-up mechanism allows Founders to receive a larger share of the proceeds after the Venture Capitalists’ preferences are met. This approach compensates Founders for their contributions and risks, ensuring they are not left with minimal rewards after Investors have recouped their investments, promoting a more balanced distribution of exit proceeds.
Founders Priority: An alternate structure is a waterfall where Founders receive priority in exit proceeds up to a certain amount before liquidation preferences are applied. It ensures Founders remain incentivized and retain skin in the game. Such “First-In-First-Out” schemes are rare but may be adequate dependingon the deal’s parameters—for instance, when Founders’ invest alongside VCs is subsequent funding rounds.
The last suggestion to smooth liquidation preference misalignments is much more radical: Eliminate it altogether.
Use The Carrot, Not The Stick
Eliminating liquidation preferences is a daring yet real alternative to minimize the misalignments of interest described in this article. Some VCs, especially early-stage ones, only invest in common shares. An added benefit is that later-round Investors may be less tempted to use “structure,” a common term to describe liquidation preference.
Liquidation preference is poison from the start. We only do common shares. Keep it simple and stupid.
Marc Wesselink – Contrarian Ventures
However, some VC firms may struggle to forgo structure altogether, arguing for the need of an extra incentive for Founders to perform. To find alternative paths, we need to remember why liquidation preference was introduced in the first place. In increasingly Founder-friendly markets, Venture Capitalists gradually agreed to higher valuations set by Founders to avoid losing deals, but with the inclusion of liquidation preferences as a counterbalance.
This approach effectively makes the high valuation less impactful, as liquidation preferences ensure a minimum return for Venture Capitalists before any proceeds are distributed to the Founders.
Watch the webinar for detailed calculations and a numerical demonstration of this point
Removing liquidation preferences is a way to simplify the investment process and align the interests of Founders and Venture Capitalists more closely. Without these preferences, the focus shifts back to the company’s actual valuation and performance, rather than on mechanisms that guarantee some return to Investors if Founders underperform. This change can lead to a healthier investment environment where both parties are incentivized to work towards the same goal: increasing the company’s value.
Venture Capitalists can take a cue from Leveraged Buyout (LBO) financings by implementing management packages to reward Founders as their investment performance improves.
In LBOs, management teams often own very little of the company’s equity. They are often given equity-based incentives to align their interests with the Investor’s performance in an exit. Such practice is rare in Venture Capital, as Founders start with 100% equity ownership, and incentive plans are reserved for employees.
However, offering Founders performance-based equity packages can create a win-win proposition. As the company meets certain milestones or achieves specific financial targets, Founders can earn additional equity, paid out of VCs’ dilution. This approach not only motivates Founders to drive the company towards success but also aligns their interests with those of the Venture Capitalists.
Watch the webinar for more detailed explanations.
Conclusion: tl;dr
Conflicts in Venture Capital arising from liquidation preferences are multifaceted and can significantly impact the relationship between Venture Capitalists and Founders, and among VCs.
While liquidation preferences serve as a protective measure for Investors, they can create misaligned incentives, potentially disincentivizing Founders and complicating exit scenarios.
Addressing these conflicts requires transparency, fairer terms, and novel approaches prioritizing alignment of interests and mutual success.
