The Valuation Trap – Part 1: Liquidation Preference

Ondřej Fryc

December 7th, 2018

Reflex Capital → Blog → The Valuation Trap – Part 1: Liquidation Preference

I remember it as it was yesterday. In 2007, in my own startup, we received a Term Sheet with stellar valuation. It was so high, that we were blindfolded for the other “legal language”, such as … liquidation preference. “That’s not important, we’re not gonna liquidate our company and even if it does go down the tubes, two times zero is zero anyway,” I recall us thinking.

Liquidation preference is, however, related to any “liquidation event”, which – surprise, surprise – includes exit of the business as well. Then those stakeholders with higher liquidation preference are higher in so called “liquidation waterfall” and are entitled to get not just what their then-current shareholding is, but what their liquidation preference says. Only after they are fully satisfied, remaining proceeds are distributed to others.

Not long ago I’ve seen a startup signing a Term Sheet with $5 investment at a whopping $50m post money valuation. Competitive bids came at around $30m. The catch was, that there was “participating 3x liquidation preference” fine print in the seemingly better Term Sheet. The “participating” word is even another slyness. It means that after such investor gets his 3x investment, he still participates on the pro-rata distribution. With the more usual and fair “non-participating”, the investor can choose to get either liquidation preference, or pro-rata distribution. So, in practical terms, what can happen:

The company gets sold at $100m: Investor gets his 3×5=$15m a then 10% of $85m, i.e. total of $23,5m (23.5%) for his 10% stake. Compared to the investor, who’d invest at $30m without these “features” (who’d get 5/30*100=$16.7m), he receives 40% more, although his stake was 66% smaller (!). And now imagine things do not go so well and the company gets only sold at $15m: The 10% investor gets everything and founders get nothing.

Do you still consider the valuation as the most important part of a term sheet?

In the coming weeks we will elaborate on other twists relating to high valuations. Have you heard of full-ratchet anti-dillution protection? Or the lock up your company would face if things do not go so well and you would need to raise a downround? Or consequences of different conversion times of convertible notes? We’ve been there and learned the hard way. We are aware that we won’t be liked by other investors, as we are uncovering their dirty practices. But we are and always will be on the founders side.

Stay tuned 🙂

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