Welcome back to the fourth installment of my series on the Anatomy of a Term Sheet. I hope this series is helpful to startup founders, and helps break down some of the legalese in venture capital term sheets. In this series, I am going through the model term sheet provided by the National Venture Capital Association, which you can find here.
In previous posts, I discussed some basic provisions, including pre-money valuation, the option pool issue, and dividend terms. Today, I will delve into the liquidation preference, one of the signature features of preferred stock. Without further ado…
Series A investors are going to be getting preferred stock, not common stock, in exchange for their investment. Preferred stock gives its holders certain rights that are superior to the rights of the common stockholders (hence the name “preferred”). The liquidation preference is one of those terms that actually describes what it is pretty well. It gives preferred stockholders a priority position over common stockholders if the startup company goes through a liquidation, dissolution, or winding up. Here is what the liquidation preference term looks like in the model term sheet:
In the event of any liquidation, dissolution or winding up of the Company, the proceeds shall be paid as follows:
Alternative 1 (non-participating Preferred Stock): First pay [one] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred (or, if greater, the amount that the Series A Preferred would receive on an as-converted basis). The balance of any proceeds shall be distributed pro rata to holders of Common Stock.
Note the term “non-participating Preferred Stock.” This means that an investor that chooses to receive its liquidation preference will not get to participate pro rata with the other stockholders in any remaining sale proceeds after payment of the liquidation preference. Under this alternative, proceeds of any liquidation, dissolution or winding up are paid out first to preferred stockholders, and to the extent the proceeds are large enough, the preferred stockholders each get their original purchase price per share, and depending on the language, with accrued or declared and unpaid dividends. If the preferred stockholders would get more money by converting their preferred stock to common stock, then they get the higher amount. Essentially, the preferred stockholders are getting their money back, before any proceeds can be distributed to holders of common stock. If there are any proceeds left over after paying the liquidation preference, then the remaining proceeds are paid pro rata to common stockholders.
Also note that the liquidation preference could be a multiple of that original purchase price. For example, in the term sheet it could be a 2X liquidation preference, in which case the preferred stockholders get two times the original purchase price. This will be fairly important in the case of a merger, consolidation, or asset sale, as I will discuss below.
Alternative 2 (full participating Preferred Stock): First pay [one] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred. Thereafter, the Series A Preferred participates with the Common Stock pro rata on an as-converted basis.
The second alternative is for the preferred stockholders to get their liquidation preference, and also participate in the distribution of any remaining proceeds. They participate alongside the common stockholders, receiving any remaining proceeds pro rata on an as-converted basis. As you can see, this form of liquidation preference is more attractive to the Series A investor. They are getting a double dip into the proceeds.
Alternative 3 (cap on Preferred Stock participation rights): First pay [one] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred. Thereafter, Series A Preferred participates with Common Stock pro rata on an as-converted basis until the holders of Series A Preferred receive an aggregate of [_____] times the Original Purchase Price (including the amount paid pursuant to the preceding sentence).
The third variation on liquidation preference is where the preferred stockholders receive their liquidation preference, then participate alongside the common stockholders in a pro rata distribution of any remaining proceeds (on an as-converted basis), but their total participation is capped at some multiple of the original purchase price per share.
Finally, we have this language:
A merger or consolidation (other than one in which stockholders of the Company own a majority by voting power of the outstanding shares of the surviving or acquiring corporation) and a sale, lease, transfer, exclusive license or other disposition of all or substantially all of the assets of the Company will be treated as a liquidation event (a “Deemed Liquidation Event”), thereby triggering payment of the liquidation preferences described above [unless the holders of [___]% of the Series A Preferred elect otherwise]. [The Investors’ entitlement to their liquidation preference shall not be abrogated or diminished in the event part of the consideration is subject to escrow in connection with a Deemed Liquidation Event.]
This crucial aspect of the liquidation preference term is the application of the preference to two other situations – a merger or consolidation (where the startup does not end up as the controlling entity), or an asset sale. If we had just been looking at a liquidation, dissolution, or winding up, there might not be any proceeds to distribute to preferred stockholders or common stockholders, as a practical matter. In the case of a merger or asset sale, however, the proceeds might be substantial indeed.
Let’s look at how this works in practice. First, we assume that our startup is being sold for $60 million, and the Series A investor has $10 million invested for one third of the company, with a 2X participating preferred. The investor gets $20 million off the top (assuming no accrued dividends) because it is a 2X preference, and an additional $13.3 million (one-third of the remaining $40 million sale proceeds). The investor’s total take is $33.3 million, which is more than half the sale proceeds, even though the investor only owned one third of the startup company.
It is for this reason that founders should push for a non-participating liquidation preference, and fall back to participating preference with a cap when negotiating the term sheet. In addition, whatever terms founders agree to in the initial round will influence the terms they get in later rounds, so it is important to push for non-participating liquidation preference at the start.
Thank you for reading, feel free to comment, and next time, I will discuss voting rights and protective provisions.
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