How to Avoid Hidden Liquidation Preference Multiples
- Lighter Capital
- Jul 15, 2015
- 5 min read
Updated: Oct 2
Many early-stage startups are raising money from angel investors through convertible debt—it’s easy and well-understood, right? Well, mostly. There are a couple problems with convertible debt that have emerged as it has become a popular early-stage funding method (it wasn’t always the security-de-jour). Entrepreneurs should be aware of perhaps the most hidden and misunderstood issue: hidden multiples on liquidation preferences.
Liquidation preference multiples
A liquidation preference tells you how much investors get paid before common shareholders (you, your team, employees) when the company exits (through a sale, merger, or liquidation). A multiple significantly increases the amount investors get back before common shareholders see anything, which means more dilution for you.
.
1x liquidation preference: Investors get back exactly what they put in (their original investment) before anyone else shares in the proceeds.
2x, 3x, etc. liquidation preference: Investors get two or three times their original investment back first, before common shareholders get paid.
Though a convertible debt deal may suggest a standard 1x liquidation preference, a valuation cap can produce a significantly higher liquidation preference multiple at exit. This is ultimately coming out of founders’ pockets and can even mess up later rounds of equity financing.
For a deeper explanation, check out The Silicon Hills Lawyer. José Ancer did a great job of summing up the problem of what he calls “liquidation overhang” in the post The Problem in Everyone’s Convertible Notes.
An Example of Liquidation Preference Multiples/Overhang
Let's walk through the math in an example so you can see how and why early investors may get a larger payout than expected.
Investors like convertible debt because they get in on a (hopefully) good deal early. With convertibles, they don’t have to haggle with the entrepreneur much about terms, like they would leading a priced equity round, and they get to piggy-back on a VC or other lead investor setting the terms later (typically for Series A preferred stock). Early investors typically want more upside if your company does well and your valuation soars. Enter the valuation cap.
USEFUL DEFINITIONS
A liquidity event is an event that triggers a payout to investors. It could be an acquisition, an IPO, etc.
Liquidation preferences determine who gets paid what—and in what order of priority—in different liquidity events.
Let's assume the following for this example:
$500K seed funding round with convertible notes carrying a $2.5M valuation cap
Series A has a $10M pre-money valuation, resulting in a per share price for new money of $4.00
The Series A has a run-of-the-mill 1x participating liquidation preference. This means that the Series A has a per share liquidation preference of $4.00
The $2.5M valuation cap means the notes convert at $1.00
Under the above example, the $500K in notes will convert, ignoring interest, into 500,000 shares. ($500,000 / $1.00)
If the notes convert directly into the same Series A preferred stock as “new money” investors get (which is what most notes require), their aggregate liquidation preference is $2 million (500,000 shares X $4.00).
So those investors paid $500,000, but they have $2 million in liquidation preference. In other words, they effectively got a 4x participating liquidation preference.
Let’s face it, you’d never knowingly give a VC a 4x liquidation preference. So why give it to convertible debt holders?
Fortunately, this is easy to fix before finalizing the convertible debt docs.
Fixing it later can be painful. You’ll either have to go back to early investors and ask them to give up some of their rights (never popular), or you’ll end up with a messy cap table. And the mantra for your cap table should always be: “Cleanliness is next to godliness.”
How to Keep Liquidation Preferences in Check on Convertible Debt
A first priced round will often be for Series A Preferred Stock. VCs insist on preferred stock for a variety of reasons: one is that they can structure a liquidation preference, meaning they get their money out before any money goes to the common stockholders. That’s all fine and normal.
Though terms may seem relatively entrepreneur-friendly, you want to make sure that your investors' liquidation preference is limited to 1x the amount of money they put in. They get their money out, and that’s all.
Again, this is common practice for VC investments. There’s no good reason why convertible notes should be any different. They have a valuation cap on the convertible debt to ensure they get the valuation increase if the company goes way up in value, so getting a “bonus” 4x liquidation preference is really double-dipping.
From a legal standpoint, there are several ways founders can protect themselves against liquidation preference overhang. We’ll review a couple of strategies briefly here, but ultimately, you need a savvy startup lawyer that has dealt with this exact issue before.
1. Specify in the convertible note what the liquidation preference will be when the note converts
In his excellent post, One Simple Paragraph Every Entrepreneur Should Add to Their Convertible Notes, Mark Suster offers a suggestion in plain English of what you should include:
“If this note converts at a price higher than the cap…your stock [will] be converted such that you will receive no more than a 1x non-participating liquidation preference plus any agreed interest.”
2. Issue sub-series of preferred stock
Another way founders can protect themselves against hidden liquidation preference multiples is to write into the convertible note a clause that explains a special sub-series of preferred stock that will be issued to the seed-round note holders—if and when the notes converts. In other words, it's a special sub-series that is designed specifically to protect against artificially-inflated liquidation preference.
This is the approach advocated by Ancer. To extend the earlier example, instead of issuing 500,000 shares of Series A to [seed-round] note holders, you issue them 500,000 shares of Series A-2.
Series A-2 would just be a series of stock that is exactly the same as the Series A in all respects, except for the liquidation preference. The Series A would have a per share liquidation preference of $4.00 per share, and the Series A-2 would have $1.00 per share.
Problem solved.
The Devil is in The Details
Obviously, investors love the upside of this hidden liquidation preference—even if they didn’t know they had this benefit before, it’s hard to ask them to give it up once they understand it. Heck, they took a big risk on you!
But it’s good to remember that it’s a practice that’s long been frowned on by VCs for being egregiously greedy and messing up incentives. Early investors are supposed to be appropriately rewarded for their risk by the conversion discount and valuation cap.
When you’re an entrepreneur struggling to secure funding for a new startup, it’s easy to let what seems like a minor detail slide. We see it all the time! But those details can literally cost you millions of dollars later on, so it pays to get a good lawyer on your side before you start the process and make sure you ask about this so the appropriate verbiage is in your documents.
Looking to explore new fundraising strategies?
If you're curious about capital solutions to grow your business so you can get a leg up on the competition — and you don't want to give up equity to do it — be sure check out The Startup Financing Playbook: A Practical Guide to Raising Capital for Sustainable Startup Growth.
