How To Tell If Your Startup Ecosystem Is Sick

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.

Startup Financing Is Not A DIY Project

There are projects that are easy enough for a smart startup founder to take on, and then there are projects that are simply too complex, and which require the help of an experienced lawyer. Financings, such as a seed round or convertible note financing, are definitely not DIY projects.

Several years ago, I bought a townhouse in Berkeley. There was no disposal in the kitchen, so I decided to install one. I went to Home Depot, and picked the one that had “Easiest To Install” printed on the box. It was about $65, so the price was right. Well, I learned that “easiest to install” does NOT mean “easy to install.” First, I couldn’t detach the drainpipe from the sink drain, and not being an experienced plumber, I didn’t know how much brute force I could apply without destroying the sink. So I called a plumber, and he took care of that, and installed the disposal under the sink. Then he pointed out that there was no electrical outlet for plugging in the disposal. I called an electrician to install a new outlet, and finally, two professionals and $300 later, my disposal worked. What I thought was an easy DIY project, because of what the box said, turned out to be not so easy or cheap after all. The problem was, I didn’t know what I didn’t know.

When it come to securities and corporate finance, the overwhelming majority of startup founders don’t know what they don’t know. Today I had a discussion with a very smart acquaintance about “friends and family” rounds. I pointed out that there’s no special exemption under securities laws for friends and family, and that when a startup raises money from them, generally the startup is violating the securities laws. Not only might the startup have to return all the investors money, but there could be civil and criminal penalties, as well as problems with later financing rounds. This was all news to him, and I bet it’s news to most startup founders.

Convertible note rounds aren’t simple, either. If you don’t understand all the moving parts, it is really easy to screw up. Do the startup founders read the reps and warranties in the note purchase agreement? Do they know why those reps and warranties are there, or what may happen if a rep turns out to be false? If the convertible note has a valuation cap, do you know about the liquidation preference overhang problem? Do you know how to fix it? Are you willing to pay me a few hundred dollars to save yourself a few hundred thousand dollars? How many startup founders know that they have to file a Form D with the SEC, as well as with the states where the startup and its investors are located, when doing a convertible note round? I imagine very few. There are even some startup lawyers I know of who routinely do not file a Form D after a seed round for their clients.

The bottom line is, when you are facing something where you might incur civil or criminal penalties, and which, if done wrong, can screw up your later attempts to get investment, you should invest in a good lawyer, and let him or her do it the right way. Because some projects, like investment rounds, are simply not DIY.

Anatomy of a Term Sheet 4 – the Liquidation Preference

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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