How To Tell If Your Startup Ecosystem Is Sick

June 8, 2017

I had an interesting lunch with some fellow lawyers the other day. I know, “interesting” and “lawyers” shouldn’t be used together in a sentence, but bear with me. We were discussing venture capital deal terms we had encountered with various startup financings we had worked on. One of the other lawyers mentioned that in two deals he had worked on recently involving local Midwestern startups and investors, the investors had insisted on a 3X participating liquidation preference. I was really taken aback by this. In a Series A financing I had worked on a couple of months ago, involving a startup and VC firm that are both in the San Francisco bay area, there was a 1X non-participating liquidation preference. The VC didn’t even try to get something more.

To understand why this is important to startups and to the health of a startup ecosystem, let me explain what a liquidation preference is, and how it works. A liquidation preference is money that the investors take off the top, when a startup they have invested in goes through an exit. For example, suppose a startup is being acquired by Facebook. If a VC that has invested $3 million in the startup has a 1X participating liquidation preference, that means that the VC takes the first $3 million off the top, leaving less money for everyone else. Since the liquidation preference is participating, the VC then gets to share in the remaining proceeds with the common stockholders, pro rata. Essentially, the VC gets to double-dip. In a small transaction, this could be devastating to the founders. For example, look at what happens if Facebook is paying only $5 million for the startup. The VC gets $3 million off the top, leaving only $2 million for everyone else. Because the liquidation preference is participating, the VC may also get a share of that remaining $2 million. And that’s just with a 1X liquidation preference.

Typically, the VC may only use the 1X liquidation preference in a smaller exit transaction, as it protects his downside. In a larger exit transaction, the economics may favor converting the preferred stock to common stock and sharing in the proceeds that way. A liquidation preference greater than 1X, however, may skew those decisions.

Now let’s look at how a 3X participating liquidation preference would impact the deal. Suppose the sale price of the startup is $10 million, and the VC invested $3 million. Now the VC gets $9 million off the top, leaving $1 million for everyone else. Because the liquidation preference is participating, the VC will get a share of that $1 million, too. The founders and any employees holding stock and/or stock options get screwed, to put it politely.

What are the implications of this for startups and a startup ecosystem? When you have a vibrant ecosystem with lots of strong startups and many angel and VC investors, you have competition for deals. As a result, the deals tend to be fairer to the startups. A strong startup has some bargaining leverage when seeking financing, and investors are eager to invest in such companies. When the investors have to compete for deals, they offer more favorable terms to the startups, lest they miss out. FOMO is a powerful force.

You see this at work in Silicon Valley, which has a well-established startup ecosystem with many VC investors and some of the most promising startups. In the Fenwick & West Silicon Valley Venture Capital Survey for the first quarter of 2017, only 16% of the deals involved multiple liquidation preferences. This is actually a steady rise over the past year; in the first quarter of 2017, the number was about 7%. Of those multiple liquidation preferences during 2017Q1, two-thirds were in the 1X to 2X range, and one-third were in the 2X to 3X range. Also, for 2017Q1, only 22% of the financings provided for participation; the remaining 78% were non-participating.

In smaller and new startup ecosystems, you don’t have a lot of strong startups, and you may only have a handful of investors operating. This is frequently the case in some of the emerging Midwestern startup ecosystems, like Louisville, Indianapolis, Columbus, Pittsburgh, and Cincinnati, where I’m located. As a result, the investors feel more emboldened, or more risk-averse, so they demand terms that are way out of the norm for places like San Francisco and New York. I emphasize the word “demand,” because that’s what these investors do – they demand these terms, with a “take it or leave it” attitude. If you don’t like what Investor A is offering, good luck with Investor B – they probably are offering the same terms. There is no Investor C.

As long as this persists, these smaller ecosystems will be weak. In order to improve and strengthen the ecosystem, you need stronger startups to attract more investors who will offer fair terms. These weak ecosystems, however, risk losing the best startups to more favorable ecosystems. Also, startups have to be prepared to look outside their community for funding. If you are a startup in a place like Cincinnati, and you aren’t trying to raise funds from investors in Chicago, New York, Austin, San Francisco, and LA, you are putting yourself at the mercy of your local investors. You may say that you can’t afford to fly all over the country seeking out investors, but the truth is that you can’t afford not to. Your obligations are to the shareholders, to produce the highest returns. If you give away a 3X participating liquidation preference to a local investor because you didn’t seek out investors in stronger ecosystems, you are basically taking the money out of your pocket and putting it in your investors’ pockets.

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