More comments from A_VC blog (yes I am an avid reader). And referenced by Fractals of Change

Fixing Venture Capital

Venture Capital – An Entrepreneur’s View

The problem with liquidation preference is not its existence but its magnitude. If the liquidation preference is only “designed to protect the VCs from having the company sold by the entrepreneur at a price that gets the entrepreneur a good return, but results in the VC losing money” (and not for any other reasons), then the highest liquidation preference that a VC should be able to JUSTIFY is 1X (and nonparticipating preferred).

Most reasonable entrepreneurs would agree that VC’s should be protected from situations in which an entrepreneur raises a round with a pre-money $5M valuation with $4.9M investment ($9.9M post), and immediately sells his company for $9M, thus pocketing ~$4.5M (~50% of stock) while the VC loses ~400K (4.9M-4.5M) immediately. In situations where VC’s own more the 50% of the company and control of the board, I’m not even sure if common stock holders can sell the company w/o board or VC approval. (someone can enlighten me on this).

Kevin Laws has a great post on this . .

Snidely Whiplash And The Liquidation Preference

Given that liquidation preference in the valley ranges from 2-3, I’m not sure how the “protection from entrepreneur” argument holds. The truth is that VC’s are using the liquidation preference as a financial engineering tool to guarantee themselves some baseline level of IRR or simply to increase their IRR. Don’t get me wrong, there is nothing inherently insidious with liquidation preferences if VC’s simply call it for what it is.

Entrepreneurs needs to realize that similar to warrants and options, the liquidation preference term in a term sheet has “value” and is a source of dilution to his or her equity stake. (I wonder if there is any academic research on how to “price” this type of “security”)

Furthermore, I call for fellow entrepreneurs to also realize the true potential and valuation of his/her business and what is the preferred exit strategy. If the entrepreneur is looking to sell his/her company, be extremely cautious of typical VC advice of “never turn down any money” and “raise as much money as someone will give you.” With a high liquidation preference and volatile market conditions (causing volatile valuations for your venture) it is highly likely that you are digging your and employees’ common stock a huge hole to climb out of. Simply put, you could be holding “extremely out-of-money options” and not even know it. Of course, the decision must be evaluated on a case by case. In the end, stick to the fundamentals (and clichés, also doled out by VC’s ). . . treat VC’s money as your own, don’t waste money, make every penny count. . . for many ventures, $10M should get you to profitability or even a IPO. In which case, you wont have layers and layers of liquidation preference to worry about.

Below are comments I posted on A_VC a while back in regards to Fixing Venture Capital.

Not terribly current but I’m trying 1) archive some of my longer comments 2) learn to use wordpress. So pardon me as I ramp up on the application.

Also for those that dont know, carveouts are additional cash or equity given to employees (most likely just CEO and a few VP) of a company when the company gets sold OUTSIDE of their stock options and employment agreement. Its like a “job well done” bonus for making the VC’s money. A lot of times the employees are required to sign an employment agreement with the acquiring firm as part of the carveout package.

great post Danny, many people (from previous comments) assume that the market is efficient and that any negotiated term by definition is “fair.” I believe this is only the case where there is no information asymmetry. The market was inefficient in the past, because sellers of equity did not have all the information required to properly “price” the value of their equity and terms in the financing. Today, blogs like this one are reducing the information friction between entrepreneurs and VCs, which will help created more “fair” financings EVEN IF the terms stay exactly the same. (simply stated, know what you get yourself into)

While on my soap box A previous comment from part I of the article mentioned that “carve outs” compensates the management team in the case that the liquidation hurdle is not met in an acquisition. The key here for entrepreneurs to understand is that the “CURRENT” management team is essentially cut into the deal in order to convince them to stay through the transition processes. In most cases, those entrepreneurs that are no longer active part of the management team will not get a penny. There is a lot going on here than what meets the eye.

1) Selling below liquidation preference means that the company at one point probably did not perform to expectation, as a result, founders are most likely out of the company
2) The existing management team is most likely recruited by the VC and are experienced veterans in the industry. Thus, VC’s have an inherent interest to keep a good long term relationship with “powerful” executives in the industry, AND owes them a “favor” for promising riches when first recruiting the management team.

So what does this mean for the entrepreneur?

1) Don’t count on the carve out when negotiating the termsheet
2) When the VC’s ask you to step aside, if you don’t have confidence in the new management team, don’t walk away quietly especially when the company is doing well, stay involved in an operating role

Because the financial interests of the entrepreneur and VC are not aligned, conflicts often rise in a startup. This is the reason why you see entrepreneurs fighting with VC’s to stay on with the company. While VC’s claim that more experienced management team is needed to take the “company to the next level,” (completely valid argument!) founders have the financial incentive to fight to stay on because there is a probability that the new management team will make some money while he or her will not make a penny. I’m not making judgments on whether a management team changes is good (it’s a case by cases thing), but just that the entrepreneurs need to realize the full economic impact of the events that are taking place. Of course, there are plenty of startups where founders deserve NOT to make any money and deserve to be force out of a startup.