The End-Zone: How Startups Do or Die
In Part 2 we learned about different types of shares, dilution, preemptive rights, the ‘power law’, ESOP, debt vs equity considerations and anti-dilution protection. Your company is now mature enough to consider a couple of exit opportunities.
Your company has caught the keen eye of a market incumbent that is interested in acquiring your technology. The board is excited about the M&A, and you and Fran, young entrepreneurs, will finally see liquidity. The net price tag is $20M (after deducting fees for your banker, lawyers, accountants and ambulance chasers).
[Note: We're deliberately using a low exit value to display how the preferences work. If the company sold for, say, $200M, all shareholders will convert to common shares, waive their preferences and just take their pro-rata piece of the pie.]
You and Fran look at the cap table. Firstly, the unallocated ESOP can be ignored and retired. This was that component of the ESOP that was earmarked for future talent, or to retain key staff, but was never actually issued. These shares (some 553 thousand) are ignored.
Liquidation Preferences enable investors to receive a multiple of their original investment amount back first, before any distribution of proceeds flow to other share classes. If senior share classes have a liquidation preference above 1x their investment, they will actually make a profit before any other investor will even receive a penny. For a senior share- class investor, this means that the total value of a company’s proceeds at exit only has to be as much as their overall investment amount in order to break-even on the deal, whereas if this were tied strictly to ownership percentages it would take a much bigger outcome to break even on the investment.
There are two types of preferred liquidation preferences: Non-Participating (most common, our scenario example) and Participating (not very common, ‘double-dipping’ on the part of the investor). Participating Preferred can be further sub-categorized as fully participating or capped, explained below.
The investor will only receive an amount equal to the greater of his/her pro-rata ownership of the company or the preference stipulated in the investment. In our case, as the Preferred B/B-1 shareholders hold 36% of the company (1,129,242/3,134,626 shares), an exit at $20M should result in a $7.2M return for the investor class. However, as the 2x preference will yield a higher return of $10.1M ($5.05M investment (including the CLA but excluding the accrued interest) x2 – assuming that this was the term of the CLA conversion shares), the Preferred B class should automatically receive their preference amount of $10.1M. This is the totality of their return, and the B shares are no longer considered in any distribution calculations.
Oftentimes, there is an added layer of complexity, as shareholders invest in multiple rounds (i.e., different share classes), and their overall interests needs to be computed. However, typically, to approve an exit, the company will require the majority vote of each share class. In our example, due to their high ownership stake in the company resulting from investments in previous rounds with lower valuations, both Mike and Ever Line Ventures will prefer to forego their preference, convert to common, and take their participation amount. However, as Dire Straits Capital hold the majority of the Pref B class (58%), they can force the entire class to convert.
The remaining ~$9.9M will next be distributed to the Preferred A shareholders, in accordance with their 1.5x liquidation preference. As the Preferred A shareholders hold 30% of the residual company (605,384 / 2,005,384 shares), proceeds of $9.9M should result in a $2.98M return for the investor class. However, as a 1.5x preference will yield a higher return of $4.5M ($3M investment x1.5), the Preferred A class should automatically receive their preference amount of $4.5M. This is the totality of their return, and they too, will no longer be considered in any distribution calculations.
Although Mike and Ever Line Ventures are invested in the same share class, they have very different interests. Mike would prefer his participation whilst Ever Line Ventures would prefer the preference. It is because of Ever Line’s majority holding of the class that they can force the preference outcome. $5.4M now remains for the common shareholders.
As Mike holds 17.9% of the residual company (250,000 / 1,400,000 shares), remaining proceeds of $5.4M should result in an additional $964K return to him, and Fred and Fran will each take $1.9M home – far less than their originally anticipated return of $2.7M.
The total return to investors and shareholders is as follows:
Employees in the company may be disenfranchised by the relatively small amount allocated to them. But it’s important to remember that an acquiring company will usually issue additional restricted stock units/ESOP to key employees who stay on with the company.
While this concept isn’t relevant to our current example, it’s important to understand anyway. This structure exists to both limit the downside and enhance the upside on an investment. On the upside, a participating preferred structure allows an investor to initially receive his/her preference and then to further receive his/her pro-rata of the company. Hence the ‘double dip’ comment above. Obviously, this is not great for common shareholders.
As previously mentioned, there are two types of participating preferred structures:
- Uncapped Participating Preferred: Participating Preferred without a cap provides that after the investor gets his/her liquidation preference on the preferred shares, the investor then shares in the balance of the sale proceeds with the common shareholders on an as-converted basis (meaning that preferred stock will be treated as if they converted their shares into common shares even after receiving its preference).
- Participating Preferred with a Cap: The “cap” (also known as a “kick-out”) sets a limit on the multiple of return on invested capital that a preferred shareholder can receive before his/her participation feature is cancelled. For instance, if the cap is set at three times (3x) invested capital, the shareholders would participate up until they receive three times their investment in that class, after which they would not receive any further proceeds from the liquidation.
However, holders of this preferred share class have the option to convert their preferred shares to common shares ahead of the close of the transaction if they decide that they are better off converting to common shares. In other words, if they would receive a greater than 3x return multiple on their invested capital if they convert to common shares and give up their participating preferred rights. This is important to note as some people mistakenly believe that the cap feature is a fixed cap for the total return a preferred shareholder can receive no matter what the overall outcome. This is not the case, and these holders are not limited to the cap if their ownership percentage of a company would result in a return that is greater than the capped amount.
The purpose of the cap is to set a return threshold above which the additional proceeds received from the participating feature disappear. The reasoning behind this is that if the overall return to an investor is above some multiple of invested capital they should no longer receive proceeds that exceed their actual percentage ownership in the business. I.e., in order to avoid excessive double dipping.
The Zone of Indifference
Preferences introduce a fundamental problem – they create a zone of indifference / "dead zone” in which the investor gets the same return across a range of exit values. If we recall the waterfall, we will remember that the first ~$10M go to the Preferred B/B-1 shareholders, followed by the next first $4.5M that go to the Preferred A shareholders, followed by the residual to common shareholders. If we look at the Preferred B/B-1 shareholders, as an example, we can quickly see that any exit above $10M, and all the way up to approx. $29M, won’t actually result in any change to the Pref B shareholders return, because after their 2x preference there are other shareholders waiting their turn for a distribution before the Preferred B class can take a second handout.
A VC’s Decision Tree On When and How to Vote In Favor of an Exit
There are multiple factors, maybe for another post, but two of which I want to specifically mention:
- Escrow holdbacks: Typically, in an M&A, the buyer will demand that some substantial piece of the consideration be held in escrow either until the passing of a certain amount of time (e.g., 18 months), or until particular milestones are achieved (e.g., annual sales of $1M). This is the acquirer’s way of mitigating the post- transaction risk that the founder and team don’t come back to work the next day after receiving their pay outs. For example, if a VC is more interested in immediate liquidity (higher IRR – see here) than a cash multiple (all else being equal), they may decide not to convert an outstanding CLA into equity, which will then be subject to a holdback, even though the dollar value may be higher.
- Fund lifetime: If the VC fund is coming to the end of its lifetime (usually 8-10 years), the fund managers may be interested in quickly wrapping things up, taking their cash off the table, and starting their next fund.
Other cap table features:
- Warrants: These are derivative securities that give the holder the right to purchase equity from the company at a specific price within a certain time frame. Warrants are often included as a "sweetener" to entice investors to invest their capital. Similar to call options, warrants allow the holder to lock in a price per share, despite future fluctuations of the share price. Typically, if the warrant exercise price is below the share price (ie, the warrant is “in the money”) then the holder will exercise the warrants. If, however, the share price dips below the warrant exercise price (ie, the warrant is “out of the money”), the holder will simply let the warrants expire and pay market value for an additional stake in the company.
- Share split: A share split is a nifty trick that increases the number of outstanding shares in a company by dividing each share into many shares but actually has no impact on a company’s valuation. Rather, there is a direct correlation between the company’s share count and share price. For example, in a 2:1 share split, every shareholder with one share is given an additional share. So, if a company had 10 million shares outstanding before the split, it will have 20 million shares outstanding after the split. On the other side of the equation, the share price is halved in such a scenario such that the valuation remains constant. Reasons for share splits include:
- Aligning a company’s share price with other industry players in order to be perceived as competitively priced.
- By executing a share split (and therefore reducing the share price), stock is perceived as being cheaper, and therefore more affordable. This is a common tactic to increase short term demand around a company’s stock, usually around times of difficult fund raising.
- As a psychological tactic to appeal to shareholders on the basis that they hold an ‘impressively high’ number of shares. Of course, the number of shares is meaningless when viewed independently of their underlying value.
- Share merge: This is the opposite of share split.
Too many entrepreneurs place their focus on the cap table at face value without running through the financing terms and impact on the waterfall, in the hope that their company will successfully IPO, all preferred shares will convert to common, and all liquidation preferences will disappear.
Realistically, this is not the case. Usually, in the event of a successful exit, liquidation preferences will matter.
I recently met with a young company where the founders were at a junction and had to decide whether to take additional VC investment (which will come with the usual dilution and liquidation preferences) at a significantly higher valuation, or to sell out immediately at a much lower valuation. When the founders ran through the waterfall it became apparent that to equate their personal exit pieces between the two scenarios, they would have had to sell the company at an almost unrealistic price down the road if they did decide to take the additional financing. The result isn’t important here, but going through the exercise was very meaningful.
So what’s the take home from all of this?
- This is really the crux: Instead of focusing on the sticker price or 8-digit valuations, realize that the financing terms are going to be much more significant for you and your investors. Of course, negotiating these terms is easier said than done.
- Diligence your investors. Know who you are getting in to bed with. Investors, who are preferred shared holders, are not necessarily going to be economically motivated in the same way as you are. Further, your company has become your life-sake. Many entrepreneurs leave cozy jobs to get their ventures off the ground and oftentimes have tied their families and friends in the venture with them. VCs operate differently. They have large portfolios and will write off many of their investments – your company may be one of them.
- Get professional help from experienced industry players. Saving a few hundred bucks on a good lawyer upfront will only come to hurt you down the road. Your brother-in-law who is a great divorce lawyer doesn’t count.
- Start your fund raise early. The later you leave it, the worse the terms will be.
- Lastly, build a company. Don’t build around an exit. If, as an entrepreneur, you can build a company that is customer-centric with a great product that people need, the exit will take care of itself.
If you have any questions or comments, feel free to leave a comment or be in touch.