Brad Feld has added two more excellent entries on term sheets to his growing collection. The second in the series is on liquidation rights, which he calls the "second most important 'economic term' (after price)." In venture capital parlance, "liquidations" include not only the must-sell-everything, going-out-of-business scenario, but also very desirable mergers and acquisitions, so this is an important class of transactions for most portfolio companies.
The liquidation preference itself is straightforward. When the company is "liquidated," the venture capitalists receive a payment in preference to the holders of common stock. (This is one reason we call their shares "preferred stock.") The size of these preference payments is specified in the contract, but in the current market, liquidation preferences usually equal the initial amount of the investment. This is called a "1x liquidation preference." But Brad observes, "For many years, a '1x' liquidation preference was the standard. Starting in 2001, investors often increased this multiple, sometimes as high as 10x!" I have seem exactly one liquidation preference that high, and it was a situation in which the venture capitalists appeared to be taking advantage of the entrepreneurs in many ways.
The most interesting part of Brad's discussion has nothing to do with the preference, but with the participation provisions (which in my recent study appear in about half of all venture deals). These rights can be tremendously valuable for the venture capitalists if the portfolio company is acquired at a premium. The combination of a liquidation preference plus a pro rata participation in any remaining assets can provide venture capitalists with a very handsome return.
If my conversations with Silicon Valley venture capitalists have not lead me astray, these provisions first appeared in the late 1980s. Venture capitalists argued that they played a role in creating value for many of their portfolio companies, and they should share in the wealth through participation. Of course, they also had the right to participate in the success of the company by converting their preferred shares into common shares, but this would require the sacrifice of the liquidation preference, which is not a feature of common stock. Some people argue that venture capitalists receive more than their share of the value created when they obtain both a liquidation preference and a participation right; as a result, the participation right is often capped.
All of this becomes more complicated when the portfolio company has accepted multiple rounds of venture financing. In this circumstance, the contracts must not only mediate between the venture capitalists and the entrepreneurs, but among the venture capitalists. Whether the venture investors should be treated the same or subject to some priority ordering is hard to determine in the abstract. As Brad observes, "Determining which approach to use is a black art which is influenced by the relative negotiating power of the investors involved, ability of the company to go elsewhere for additional financing, economic dynamics of the existing capital structure, and the phase of the moon."
Posted by Gordon at January 13, 2005 10:37 PM | TrackBack