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Issues with VC Term Sheets: Liquidation Preferences

David Young is a partner at DLA Piper (http://dlapiper.com/). You can watch more content here on Docstoc.

Upon sale, the initial cash goes back to the investors. What happens after that?

  1. Participation. Investors get their money back and then shares with percentage ownership with the founder.
  2. Non-participating. More favorable to the founders. The first three million goes to the preferred stock investors but beyond that they have to convert to common stock, so if you sell above initial valuation, everyone shares based on percentage, liquidation preference goes away.
  3. Participating up to a cap.

So when negotiating a term sheet with venture capital investor, the most important issue is obviously valuation. Immediately after that, the key issue really is the structure of liquidation preferences.

And it’s generally a given with preferred stock and venture capital financings that upon sale of the company, the initial cash goes back to the investors. If they’ve invested $3 million upon sale, that first 3 million goes back to the investors.

But the key issue that people (haven’t focused) enough in liquidation preferences is how it’s structured and what happens after that. And there are 3 general types of liquidation preference.

One is called participating liquidation preference or participating preferred stock, where the investors get their $3 million back but then after that, they share based on percentage ownership with the founders. So if they own half of the company, they get their first 3 million and then everyone shares 50/50 after that.

The other alternative is called non-participating preferred, which is more favorable to the founder and to the company, where the liquidation preferences really just downside protection. The first 3 million goes to the preferred stock investors, but to get anything more than that, they have to actually technically convert to common stock. So if you are able to achieve a sale above the initial valuation, everyone just shares based on percentages. Liquidation preference basically goes away.

And then the third alternative, is just sort of hybrid of the two, which is participating up to a cap. And it’s very important to negotiate this issue because it makes a very real economic difference on any sale of the company and the three types. We are generally seeing about 1/3 and 1/3 and 1/3 across venture capital financing so it’s an issue where there’s a lot of flexibility for negotiation.