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Is Liquidation Preference Fair?

I’ve submitted a talk for the next Ignite Seattle about some common terms in venture capital financing deals.  I’ll be talking about why pre-money valuation is not nearly as important as most entrepreneurs think it is when considering a VC term sheet.  I’ll explain how things like liquidation preference and cumulative dividends can have just as much impact as valuation on who gets paid in the end.  I’ll touch on one point here, but for the full 5-minute explanation, come to CHAC on August 8th.

Briefly, liquidation preference is the idea that when a company becomes liquid (generally through acquisition) the venture capitalists get all the money up to a certain point, at which point they start sharing it with everybody else at the fraction determined by the number of shares.  Shown above is an example of the payouts if the VC has 25% ownership of the company by shares, but liquidation preference on the first $30 million dollars.  At low to moderate valuations, the VC’s take a disproportionately high share of the company’s value.  But if the company is wildly successful, the entrepreneurs take the lion’s share of the company’s value, consistent with their fractional ownership of the company’s shares.

Some may question whether liquidation preference terms are fair or not.  I argue that without such terms, professional investors would not be willing to take the huge risks associated with venture investing, and so the funds would simply not be available to entrepreneurs.  I believe this also extends to early-stage investors such as friends and family since their interests are completely aligned with those of the entrepreneurs.

This is assuming that all parties are completely informed.  I know that often entrepreneurs sign up with venture capitalists without fully understanding the implications of the agreement.  I believe that the VC’s have an ethical obligation to explain the terms, especially terms like liquidation preference which are important and might be surprising.  Let’s explore this further with a digression into ethical economic theory, using sweat-shops as an example.

Free-market economic theory assumes that all business transactions are engaged in willingly by both sides.  All deals should be mutually beneficial, and if both sides understand what they’re getting into, then the deal will be.  Taxes and other government mandates are not free-market based, so the logic doesn’t apply.  On the other hand, sweat-shops might seem horrible to us, but to somebody who’s
alternative is subsistence farming, working hard for guaranteed pay is
great, so the sweat-shop is a good choice for them. 

For all private transactions, I argue that if both parties are fully informed, the deal is moral because both sides think they are benefiting.  Realistically, it’s impossible for people to be fully informed because there’s just too much information.  A more realistic condition is that of "empathy" — if each party were to switch places, would they still take the deal knowing what they know and what they think are the conditions for the other side.  If the sweat-shop job involves breathing toxic fumes that the factory workers don’t understand will give them cancer in 5 years, then the deal is immoral because the factory owners would never take such jobs themselves, even if the alternative was subsistence farming.

Applying this theory to liquidation preference is interesting.  If put into the entrepreneur’s shoes, a VC would certainly take a financing deal with a liquidation preference term.  This is because they know this is how the game works, and also because one trait entrepreneurs share almost universally is optimism — they’re thinking about the far-right part of the graph much more than the left-hand side.  So by the empathy condition, liquidation preference terms are moral.  But questions of ethics are often blurry, and I think this is such a case.  A VC who knowingly hides the implications of a term-sheet could certainly be more upstanding.  So ultimately the fairness of liquidation preference terms depends on how informed each party is, and how completely they communicate with each other what is going on.

  1. Leo, I had a fairly long set of comments on this post, so I replied with a post here: http://rlucas.net/blog/vc/vc_liquidation_preference_response_to_dirac.html

  2. Geoff says:

    Interesting, Leo. As I mentioned to you, there is an interesting parallel to what you call a "fair" deal and the game of poker. David Sklanksy, a poker writer, uses the following as a "fundamental theorem of poker":

    Whenever your opponent does the same thing he would do if he could see your cards, he wins. Whenever you get him to do the opposite thing he would do if he could see your cards, you win.

    This is pretty much the essence of poker. From what you write, poker is the antithesis of a "fair" deal, as it should be. Funny, though, that it appears you and Sklansky have stumbled upon opposite sides of the same issue independently.

  3. Leo this is a great post though I felt you were oversimplifying the moral implications of capitalistic transactions. Many poor people, for a modest payout, will agree to *breathe toxics* and *risk death* even after they understand all the implications. Huge current disparities of income and biz wisdom make ethical transactions problematic even if you apply your golden rule.

  4. Lars says:

    One thing that needs to be considered is that the incentives for a VC and an entrepreneur are very different when it comes to liquidity. Looking at the given example, imagine that the hypothetical company gets a buyout offer for $30 million. The entrepreneur is highly motivated to reject the deal or wait for a better one to come along. For a sale of 30M, the entrepreneur gets virtually nothing.

    The VC, on the other hand, is highly motivated to sell at 30M. They have little incentive to wait and negotiate for a larger buyout as the additional payout for a sale above 30M is a fraction of that below 30M. Additionally, they may be under pressure to close the fund and payout their investors.

    The same is true of real-estate agents. They could work harder to sell your $300k house for $320k, but as the fractional increase in value of their commission on $20k is small, they are better off to close the deal at $300k and spend their time selling another $300k house than working to sell yours for more. As the owner, on the other hand, that $20k is very valuable.

    I’ve read about a number of entrepreneurs with “successful” startups with liquidity events where the VCs walked away happy and the founders make 20k or less.

  1. […] talk about Venture Capital Term Sheets that I mentioned earlier has been accepted for the next Ignite Seattle which is tomorrow night at the CHAC.  If […]