Venture Capital Liquidation Preferences – Critical To Your Success | John Colley | Skillshare

Venture Capital Liquidation Preferences – Critical To Your Success

John Colley, Digital Entrepreneurship jbdcolley.com

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12 Lessons (28m)
    • 1. Venture Capital Liquidation Preferences Critical to your success!

      3:50
    • 2. Liquidation Preferences Why Are they Important

      1:18
    • 3. What are Liquidation Preferences

      2:39
    • 4. The Difference between Ordinary Shares and Preferred Shares

      1:21
    • 5. UK SEIS and EIS Schemes and Liquidation Preferences

      1:24
    • 6. Types of Liquidation Preference

      3:43
    • 7. Rights of Conversion to Common Stock

      1:04
    • 8. Dead Zones

      3:18
    • 9. Seniority in Future Financing Rounds

      1:37
    • 10. How Can Liquidation Preferences affect your returns

      3:11
    • 11. Should You Offer Liquidation Preferences to Investors

      1:42
    • 12. Liquidation Preferences Course Summary and Wrap Up

      3:06

About This Class

Imagine you are a Founder and you are negotiating a Term Sheet with an investor, perhaps a Venture Capital investor.

What do you think is the most critical part of the Term Sheet after the valuation?  Right, Liquidation Preferences. 

These sound harmless enough, but what if I called the term, "“How the investor gets all their money back first and you may get nothing”  That would get your attention, wouldn't it.

You ignore Liquidation Preferences at your peril as you define the terms of your exit return when you agree these investment term sheets with investors. 

Don't forget everytime you accept external equity investment, you are giving up part of your exit return to them.  The terms on which you do this are critical to how much you will make at exit

And they are looking to minimise their risk at your expense.

This is not actually unreasonable but you need to be able to understand the issues involved in Liquidation Preferences so that you can negotiate them successfully and get the best possible deal for yourself and your other existing investors.

In this Course we will discuss:

  • Liquidation Preferences: Why are they important?
  • What are liquidation preferences?
  • The Difference between Ordinary Shares and Preferred Shares
  • UK SEIS and EIS Schemes and Liquidation Preferences
  • Types of Liquidation Preferences
  • Rights of Conversion to Common Stock
  • Dead Zones
  • Seniority in Future Financing Rounds
  • How Can Liquidation Preferences affect your returns?
  • Should You Offer Liquidation Preferences to Investors

This is not an issue you can afford to be ignorant about.  If you are, then your new investors will capitalise on your ignorance at your expense.

Nothing in this course offers financial or legal advice.  For this you must go to your own legal and financial advisers.

Enroll today and make sure that you understand Liquidation Preferences!

Enjoy the course!

Best regards

John

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Transcripts

1. Venture Capital Liquidation Preferences Critical to your success!: liquidation preferences critical to your success. Welcome to this course. My name is John Colley. I've been advising technology companies since 1998. Golly, that's nearly 21 years. Seems like an awfully long time. But in that time I've seen most things that are going on on. Therefore, I am well aware off some of the critical issues that both founders and investors need to get on top hope. And I can assure you liquidation preferences is definitely one off these. It is an absolutely critical issue, which is presented normally at the time that term sheets are being negotiated. It's really important that the founders and any holders of common stock really understand what liquidation preferences are all about. Oh, and by the way, is also quite useful for investors if they want to pull one over on the three entrepreneur and the founders. So it it's important that, frankly, both sides really understand what this issue is. Liquidation preferences, at their very essence, determine the distribution of proceeds between different classes of shareholders, particularly at the point where there is a downside scenario. So on exit. If there is a downside scenario, that's the time they these tend to kick in. I'm going to explain all this in the course, but that is why it's so important because they shape the distribution off that rich pie or not so rich by if it's a small one to the different classes of shareholders. Now, in this course, I'm going to cover why they are important Exactly what liquidation preferences are. The difference. So you understand, between ordinary shares and preference shares, I got a little section on, uh, UK investors involving the S E I s in the I s schemes and why Basically, investors who are taking the advantages the tax advantage of these schemes find it difficult to benefit from liquidation preferences. I explained the different types of liquidation preferences on the times at which shareholders preference shareholders have rights, a conversion of common stock and why they would want to do it. I also explain to you what dead zones are don't ways not nothing to do with zombies. But it's a really important concept, and you need to get your mind around it because it's all about the interests between different types of shelters. I talk about the security and future funding rounds really important. I explained to you how liquidation preferences can affect your returns. And actually, I give you a little exercise that you can do on a little spreadsheet model that you can play with to show you exactly how these work. And finally, I discuss with you whether you should consider it, offering liquidation preferences to your investors. So there's a lot in this course, but it's really important to cover everything. The exercise with the spreadsheet shows you exactly how to do it on. I've also got a bonus for you, which is the audio book off the primary content of this course, so you can download it and listen to it offline, as it were so a lot to cover. I've tried to keep it really tight and concise, but it is an issue you need to get your mind around. So if you are a founder or a common stockholder, the question I leave you with this can you afford not to take this course liquidation preferences? They really are critical to your success 2. Liquidation Preferences Why Are they Important : liquidation preferences. Why they are important. Liquidation preferences are probably the most important deal term in a venture capital funding deal, but also one off the least understood after valuation. This part of the agreement has the most impact on how the proceeds of an exit are split between founders, other investors and venture capital investors. For this reason, any founder entrepreneur really needs to make sure that they understand what they are signing up to before the terms have put in front of them. It is also very important that you discussed this issue with the company's financial and legal advisers in advance so that you all know how you're going to argue this with the venture capitalists on their advice is a quick disclaimer. Nothing in this course is intended to offer either legal or financial advice. My purpose here is to explain what liquidation preferences are and to help you to understand them. Beyond this, I recommend that you take appropriate legal and financial advice from your personal and corporate advisers, 3. What are Liquidation Preferences: what are liquidation preferences? A liquidation preference sets out which investors have preference in the event of a liquidation event, such as the sand of the company. This is important because the return on the savor the company may not return the original investments made by shareholders in that event. While the preference shareholders, with the benefit of liquidation preferences, may not get all of their money back, they may get all of the available money from the sale, leaving the other shareholders with nothing even in the event of a successful sale. By getting a preferential position in the distribution of the proceeds, preference shareholders can gain a disproportionate reward when compared to common stockholders. In effect, the liquidation preferences set out what the preference shareholders may receive before any other shareholders are entitled to participate in the proceeds of the sale. Note that only holders off preferred stock are entitled to benefit from the benefits off the liquidation preferences, which is one of the primary reasons that investors rarely want to invest in common stock. Note, too, that these are not the exclusive domain off venture capital. Any experienced early stage external investor will seek to protect their downside by investing in preferred shares and benefiting from additional rights when compared to the holders of common stock, one of the main benefits being liquidation preferences. If a company's investors exit by way of an I PO, an initial public offering on a stock exchange, then liquidation preferences become a non issue, as it is common that all preferred shares automatically convert into the publicly traded common stock. At that point, to sum up, liquidation preferences provide downside protection for early stage investors, including venture capitalists, guaranteeing them a minimum return ahead of other investors, regardless off the company's valuation and exit, whether high or whether the company is going out of business. 4. The Difference between Ordinary Shares and Preferred Shares: the difference between ordinary shares and preferred shares ordinary shares in the event of a liquidation event, a sale of the company, the total amount raised for shareholders from the sale is distributed to the ordinary shareholders equally in direct proportion to the number of ordinary shares that they own. This is known as a pro rata distribution preference shares. In this case, the interests off the preference shareholders are preferred ahead of those off the holders of the common stock. They get their money back first. In simple terms, If the preferred shareholders invested one million in the company on the sale proceeds of five million, then the preference shareholders will be given back their one million first, and then the holders of the common stock would receive their return from the four million. We're going to get into more detail about the terms, but note now that if the preferred shares are participating, then they would also receive a share off the remaining four million. This is also known as double dipping 5. UK SEIS and EIS Schemes and Liquidation Preferences: a word on U. K s C. I s and E. I s Schemes and liquidation preferences. Note that in the United Kingdom, preference shares are not compatible with the S C. I s or E i s schemes so that if an investor is in receipt of preference shares, they will not be able to claim S C. I s orry eyes tax deductions. This is because investors who want to take advantage of the tax benefits of these schemes must accept that they are taking the same risks as all of the other investors in the company. This means that in the UK angel and seed rounds, which are predominantly where you find S C I s and E I s investors. Preference shares are very uncommon. But from Siri's, A onwards thes become more common as venture capital and non S C. I s funds participate in the investment rounds. A way around this has been to issue common stock or ordinary shares with a liquidation priority. This needs to be very carefully set up, and I am not a legal expert. So if this is something that you want to investigate, I recommend that you take the appropriate legal and financial advice 6. Types of Liquidation Preference: types off liquidation preference. There are three types of liquidation preferences on founders need to be clear in their minds what these entail for their interests on those of the other common stock investors. Nonparticipating. These preference shares are entitled to receive the amount equal to their investment in the company or a multiple of it. This means that if the preference shareholders invest £1 million they would be entitled to receive this money back ahead of the holders of the common stock. The liquidation preference. Multiple states What multiple off the original investment is returned, the minimum is one times i e. They get that money back. This multiple may also be 1.5 times or two times to provide an investment return to the preference shareholders if they do not participate in any further distributions. Note that in a downside scenario, it would not be unusual for multiples above one times to result in the entire proceeds of the sale being paid to the preference shareholders ahead off the common stockholders. After this distribution to the non participating preference shareholders, the remaining proceeds from the sale are distributed pro rata to the remaining common stockholders. This means that the preference shareholders do not participate in any further part off the distribution of proceeds. From a founder's perspective, this is the most favorable type of liquidation preference. As we shall see full participating. A full participating liquidation preference means that not only do the preference shareholders receive their original investment as adjusted by the liquidation preference multiple before the other common stock shareholders, they also then have a right to share Perata in the remaining proceeds. This means that effectively they get two bites of the cherry. If the liquidation preference multiple is one times, then this effectively underpins the return of their capital before earning their return. If the multiple is higher two or three times, then they are entitled to return, which will be considerably better than the holders of the common stock who are not entitled to participate in any off the preference share returns. This type of liquidation preference is most favorable to the holders off the preference shares Capt. Participating. The last scenario is best described in this final type of liquidation preference. Capt. Participating entitles the preference shareholders to recover their investment ahead of the holders of common stock. Andi to subsequently participate in the distribution of the remaining proceeds. But this secondary participation is capped to a maximum return, normally calculated on the basis of the original investment as a multiple two or three times. Once this cap is reached, the remaining proceeds are shared by the common stockholders only on a pro rata basis. 7. Rights of Conversion to Common Stock: rights of conversion to common stock. The purpose of liquidation preferences are primarily downside protection. In a situation where there is a successful sale of the company and the valuation is high. Nonparticipating and captain liquidation preferences may result in preference shareholders receiving a lower return than the holders of the common stock. For this reason, it is common for preference. Shareholders toe have the right to voluntarily convert their preference shares into common shares, enabling them to participate fully in the successful sale of the company. Remember, in a funding round, if you offer preference shares to one investor, the other investors in that round are likely to demand the right to the same shares particulate early if the shares offer preferential rights over common stockholders. 8. Dead Zones: dead zones. Liquidation preferences mean that the interests off the preference shareholders on the common stockholders diverge in certain circumstances. This means that under some return scenarios, the preference shareholders have received their maximum return with no further upside and are not incentivized to consider high return valuations. When the sale is being negotiated, they may wish to accept a lower price and close the deal rather than keep negotiating for higher price and risk losing the deal in the nonparticipating liquidation preference. The dead zone appears when the amount of the sale equals the amount that the preference shareholders are entitled to receive, including taking into account the liquidation preference multiple and the point where the common stockholders start to receive their returns above this price. There is no further distribution of proceeds to the preference shareholders, given that these are downside protections, this scenario is most likely to happen when the sale of the company is not going to return . All the money invested to shareholders because the company has not been a successful is planned. Once the preference shareholders conceit e that they will have maximized their return, they will have no interest in continuing the negotiation for a higher price, which might enable common stockholders to receive some return even if it's below the level off their original investment. In the full participating liquidation preference, there is no dead zone. The interests of the two classes of shareholders remained fully aligned. While they may receive different returns, increases in the overrule return will benefit both shareholders and therefore they will both be inclined to try to maximize the proceeds from the sale of the company. In the capped participating liquidation preference, both classes of shareholders remained aligned until the point where the preference shareholders reached the level of their cap. Above this, they are not entitled to further returns on their incentive to keep negotiating for high price disappears. However, if the return from the sale reaches a higher level where it becomes economically beneficial for preference shareholders to exercise their voluntary right to convert into common shares , the interests off the two classes of shares are realigned on the dead zone disappears. Dead zones become increasingly complex with subsequent rounds of funding as each round can result in the creation of new classes of preference shares. Each building on preferential rights over the previous rounds 9. Seniority in Future Financing Rounds: seniority in future financing rounds. When companies go through a series of funding rounds, they commonly end up with several different classes of preferred shares. The's convey vary in their ranking for exit proceeds in relation to one another. This is what is called seniority. Standard seniority is the most common structure in this case. Liquidation preferences are honored in reverse order from the latest funding round to the earliest. This means that Siri's be investors would receive their liquidation preferences ahead off Siri's A investors Perry Pass. Ooh, Seniority gives all preferred investors equal status, which means that all preference shareholders would receive a share of the proceeds based on their respective investments. If the proceeds from the sale do not amount to the total invested by the preference shareholders, then the payments are made proportionate to the amount off the original investment. Tiered seniority is a hybrid off the two types above. Between Standard and Parry pursue here, preference share investors are grouped into tears. Within each tier, they are treated parry pursue, but the tears themselves have different seniority levels 10. How Can Liquidation Preferences affect your returns: How can liquidation preferences affect your returns? Let's take an example of a company that wants to raise a £1,000,000 on a pre money valuation of £4 million. To do this, the company issues preference shares with nonparticipating liquidation preferences. The pre money valuation is the valuation of the company before the investment is made. In this case £4 million. The post money valuation is the value of the company after the investment is made £5 million. To keep things simple, we will assume that the company is debt free and does not issue any further preference shares. In the later funding round after the funding round, the preference shareholders owned 20% of the company. One million divided by five million. Let's take a look at three scenarios where the company is sold for £10 million.5 million pounds, or for only £2 million. There are four alternatives. No liquidation preference, common stockholders, one times liquidation preference most common 1.5 times liquidation preference and two times liquidation preference. Since these are nonparticipating preferences, the preference shareholders need to calculate whether they maximize their return based on their preferential rights or through voluntarily converting their shares to common stock and participating on the basis off their common stock ownership. Investors will always seek the outcome that maximizes their returns. These are shown in the tables in the first table. The returns to the preference shareholders are calculated on the basis that they convert to common stock and receive their 20% of the proceeds of the sale. Under the three scenarios, the second table shows their returns based on their preference shares with nonparticipating liquidation preferences. The third table shows which scenario gives them the optimal return in this scenario is where the company is sold for 10 million or five million. The preference shareholders would convert to common stock and participate on the basis of their common ownership, with the exception that if they had a liquidation multiple of 1.5 times or two times, they do better at the £5 million exit level. To exercise their liquidation preference rights, where the company is sold for only £2 million the preference shareholders receive a higher return, protected by the liquidation preference on the liquidation preference. Multiple 11. Should You Offer Liquidation Preferences to Investors: should you offer liquidation preferences to investors? As I stressed above, this course is not offering advice. The decision toe offer a liquidation preference is entirely down to you and your advisors. If you choose not to offer liquidation preferences, you are asking your investors to take a higher risk on this may make your investment proposition unattractive. As a founder or common stockholder, you must be aware that you are placing preference shareholders in front of yourself and your other common stockholders in the event of a sale of the company, particularly when the exit value is at the lower end of expectations. In the downside scenario, this will negatively effect common stockholder returns. Many venture capital investors will only invest in preference shares rather than common stock that have liquidation preferences. You should be aware of the risks involved in liquidation preferences, and I would always recommend creating a simple spreadsheet, as I have done to understand the implications of what is being proposed. Ultimately, remember that term sheets are a matter off negotiation, and you should decide what you're prepared to offer, concede and stick on before simply accepting the terms set out in a term sheet by an investor who will always be looking to optimize, if not maximize, the potential off their investment 12. Liquidation Preferences Course Summary and Wrap Up: First of all, congratulations on completing this course all about liquidation preferences. And I hope you now understand why they are critical to your future success. My congratulations to you. I really hope you've enjoyed the course. Got a lot from it. And now, having picked up the key points I've tried to get across to you, you really understand where I'm coming from, and it's gonna help you in your negotiations going forward. Just a quick recap on what we covered. I explain to you why liquidation preferences are important. Why they're critical. I explained exactly what liquidation preferences are and also explained the difference between ordinary shares and preference shares because of preference shares benefit from liquidation preferences. As you've seen, we had a quick aside on the UK tax schemes around S C. I s and E I s schemes. If you're not a UK investor, that needn't worry you. I talked about the different types of liquidation preference. I also talked about the rights of conversion to common stock. And when a preferred investor might decide that that was something worthwhile to do. And indeed why they've got that conversion, right? We discussed zed zones. Now you know what dead zones are all about and why you get this difference off interest, a misalignment of interests at different valuations between different classes of investor, really important concept to grasp. We talked about the security in future financing rounds, how you can end up with different classes of preference share, and you've got to get there the pecking order sorted out and clear from the outset so you don't end up with a big bun fight at the end, we explained. I showed to you how liquidation preferences can affect your returns on. Then we discuss whether you should offer them to investors, and I stress nothing in this course is offering illegal or financial advice. You've really got to go and have that discussion with your advisors. Your legal advisers in your financial advice, is. But hopefully, having gone through the course, you'll have some idea about what you're talking about, and you'll be able to have a much more informed discussion. I showed you an exercise. I hope you've taken the benefit of that little spreadsheet where you can play around with it and see how it works for yourself by putting in your own assumptions into the little model, but I provided to you. And don't forget the audio book, which you can download, take away and listen to on the audio or the mobile device of your choosing. I hope you'll find that particularly helpful if you have any questions or issues arriving arising from content in this course, then definitely reach out to me. Wherever you're watching this course, reach out to me and I will do my best to help you. So thank you again for taking the course. Congratulations on finishing it. I really hope you found it helpful. And now I really hope you understand why liquidation preferences are critical to your success.