Here's Why You Need A Liquidation Preference

I get a lot of heat every time I mention that I won’t invest without a liquidation preference. People say that it means I don’t want to take a risk. I am happy to take a risk. We do it every time we make an investment. We lose money on some of them and I can live with losing money. It is the price you have to pay for the opportunity to make money.

What I am not OK with is an unfair deal. And investing in common stock when the founder controls the company and the exit is not a fair deal.

Let’s look at who got what from the sale of Slide to Google. From Techcrunch:

 

Max Levchin  – $39mm

Scott Banister who also took part in the series A made $5m from the sale.

BlueRun Ventures, who invested $8m in the series B round made $28m.

The Founders Fund and Mayfield Fund, both investors in the series C, each made their money back.

Fidelity Investments, part of the series D: also made their money back.

The reason Fidelity, Founders Fund, and Mayfield got their money back is they had a liquidation preference. Otherwise they would have lost money in a transaction where the founder made $39mm.

I have no issue with Max making $39mm. He took the ultimate risk, started the company, invested his own capital, and I am sure he created the exit opportunity. He should get the biggest payday. But to suggest that Founders Fund, Mayfield, and Fidelity, who invested a significant amount of capital and backed Max, should not get their money back in this situation is nuts.

#VC & Technology

Comments (Archived):

  1. Harry DeMott

    This is a perfect example of the “heads I win, tails I get my bait back” philosophy of investing in “brand name” entrepreneurs or “hot” companies. It’s like buying scratch off lottery tickets – where 95 times out of 100 you pay $1 and get a prize of $1 – and every once in a while you get $1000 back – and sometimes you get wiped out.It epitomizes the need for the liquidation preference.As I see it from the outside, Slide went through 5 business models – maybe more – and built up a strong team – which Google was happy to acquire. $39M seems a pretty good payday for the founder of a company that never quite got it right – which is exactly why you need that liquidation preference.I wonder if they got interest on the PIK Preferred?

    1. fredwilson

      excellent analysis as always Harry.

    2. adam laikin

      where are you buying your lottery scratchers that 95/100 pay back the $1 cost?

      1. Harry DeMott

        Oh, I wouldn’t say it is that easy. The point is merely that if you invest in a a strong team in a hot sector and do it at a high enough valuation (so that it scares away some people) and are late enough in that the company is not burning tons of cash – your ability to recapture your investment back due to the preferred structure is vastly improved – compared with an earlier stage guy who has a lot of $ on top of him. In Slide’s case – they probably had to clear out $80M of preferences (not exactly sure but I bet I’m not that far off) before the lower down guys started to get returns. The last round guys had to clear out $50M in preferences if what I read is correct – so for them – the question is “will Max Levchin be able to put together a team and or a product that can be sold to someone else for $50M ultimately?” If you believe strongly that the answer is yes – and you don’t believe there is a lot of other financing coming in ahead of you – then your risk is somewhat minimized. At a $500M valuation – your return profile will look like the lottery tickets. A lot of par recoveries – and a few home runs mixed in with a few below par recoveries or outright busts.

    3. ShanaC

      I don’t understand what is possessing Goggle and the market itself to reward the founder. Part of me wants to go “You need to go DIE DIE DIE” in a dramatic way because it might be healthier for the market to not have big companies like google buying small companies which don’t execute.How is that a strong team? He never got his groove. Something went wrong here.

      1. Mark Essel

        If it wasn’t perceived as valuable, it probably wouldn’t have been purchased. Maybe it would have given an advantage to a competitor, there’s a different type of strategic thinking involved when it comes to M&A. It’s not always about bottom lines (although that helps). Even a single relationship can have huge dividends for an acquiring company.

        1. ShanaC

          I’m questioning that judgement call as valuable. I recognize the game is valuable. Is it multimillion dollar valuable? That I question.

  2. David Semeria

    Thanks Fred, you’ve given me the opportunity to hit two birds with one stone.The first is that you can’t prove a general point with a single example. This is why I don’t say LPs are always bad. I say there are certain situations where they can be unfair.Let’s say a bunch of hackers give up their day jobs and self-fund their own startup. They write a lot of code, make a lot of sacrifices, and eventually – but not inevitably – they gain a bit of traction.They go to a VC who invests $X with a modest 1x LP.Things are going swimmingly until one day the big G begins offering a similar product for free. Our noble hackers are shafted – and it’s not really anybody’s fault (fully-operational crystal balls are in short supply).They get an offer to buy their IP for around $X. To keep their reputations they accept.Result: Hard-working, risk-taking hackers lose everything. Hard-working, risk-taking VC gets out whole.Both the hackers and the VC are equally culpable / innocent of not predicting Google’s entry – but their outcomes are very different.An extreme example, I know – but enough to disprove the general point that LPs are always fair on everybody.

    1. fredwilson

      i am in that situation now David on a sale of a company i’ve been an investor in for a long timeand guess what?the founders would rather let the company do down the drain than take nothingso the VCs give up their preferences and/or the founders negotiate a sale bonusas Paul Graham said recently, the balance of power has shifted from the VCs to the founders and you see that play out across the board, including the exitsdoes the buyer want me? nodoes the buyer want the founders? yes

      1. George A.

        Fred makes the correct point. no sale is possible without complicit founders. The LP just gives the VC’s a bargaining chip. Take that away and they really have no seat at the table in a downside scenario.

        1. David Semeria

          Imagine if I every time I bought a publicly-traded stock I asked the seller for a free put option at my in price.If the stock goes up I keep all my upside, if it goes down I get out whole.There is something very unsymmetrical about liquidation preferences which flies in the face of a basic tenet of finance which says you cannot enjoy abnormal returns without taking abnormal risk.

          1. fredwilson

            A private investment is not at all like a public stock. You can’t comparethem. When we make a mistake we lose everything. With a public stock youcan make a very bad investment and sell a month later and get 80pcnt of yourmoney backPrivate stock is illiquid. Until you experience the powerlessness ofwatching your entire investment blow up and not being able to do anythingabout it, you can’t fathom the difference

          2. David Semeria

            We’re very much in infinite force vs immovable object territory here, and I freely admit you have much more experience in all this than me.That said, it’s not true that every time you make a mistake you lose everything. That’s entirely my point!Whilst the ownership split is maintained on a successful exit, preferences mean the same is not true in a fire sale.Below the preference, all proceeds flow to the VC (and that’s why you don’t always lose everything).It’s this lack of symmetry I find particularly galling. You pays your money, you takes your chance.

          3. sweller

            David, I do agree with your point about the lack of symmetry. It does seem unfair. But, it’s a free market and if I am investing money on the behalf of my limited partners, then I will take all of the downside protection that the market will bare. If that causes me to miss out on more exciting deals, then that may force me to rethink my approach.If entrepreneur do not like the terms of granting downside protection to their potential investors, they can shop the deal elsewhere.Also, no one is saying that entrepreneurs couldn’t build in their own downside protection for equity (sweat and otherwise) they have put into the company. They simply need to find a VC in the marketplace that will go along with that structure.

          4. David Semeria

            That’s a very honest answer, Scott.Of course, you can probably guess my reply: if preferences are de-facto then the concept of ‘choice’ strains the definition.As regards a smaller, senior preference for entrepreneur’s sweat equity – yes, I had that idea too. But finding a VC who will agree to such a term is probably harder than finding one willing to forgo the beloved preference in the first place. As you rightly point out, in the long-term market forces will dictate how this will play out.And that’s the way it should be.

          5. Harry DeMott

            AVC is certainly a very founder friendly forum – and many of the angel/seed funds are marketed based on being non-VC like – much more founder friendly.All that said, the basis of all of these arguments is that the liquidation preference protects the VC in a marginal case while the founders and employees get nothing – as opposed to an all equity deal – wherein an edge/sideways case would yield something for everyone – less for the VC’s – more for the founders.The concept that people miss, I feel, is one of implicit leverage that the founders/employees benefit from. Do employees at start-ups often take less than they could earn working at Microsoft or Apple or some other larger stable company? Of course. So why do rational people do this?It is for the implicit leverage that they get when someone comes in and invests millions of $ in their business. They do it for the upside case. They do it for the options. Founders and early employees are getting tremendous value at a low price by virtue of their sweat equity in the business. Someone has given them a chance of getting really rich (if $ are their motivation), or changing the world (lots of that going around), or being independent of the strictures of large companies (who likes big bureaucracies?) They get these things – and a paycheck – for the larger paycheck they give up.None of these are trivial.The VC – on the other hand has no motivation other than making a return on their investment. There’s no changing the world or getting rid of the man. These are tangential benefits of their sole job of returning more to the LP’s who trusted them than they started with. And what they say to the founder is this:” I will fund your dream, and I will give you the capital with which to pursue that dream with whomever you see fit to bring along with you on your team. I will do this for a year or two after which we will sit down and see whether you are making progress toward your goals. If you are, then we will renegotiate and chances are you will have a few more years of pursuing you dream. If you are not, then chances are you will have to fund someone else to fund your quest – and what I am asking in return for this is protection on my investment in case this all doesn’t work out.”This does not seem to be a bad, or unfair trade off to me in the least. Each party gets what they want – and in a success case all is well with the world.What you seem to have a problem with is the unsuccessful case – or edge case.I look at it this way. There are many jobs people could take that are a lot less risky than some sort of tech/internet start-up. And yet there are 14M Americans on unemployment as I write this today. Reasonable companies go bankrupt every day. Lay-offs occur every day. Do these people ask for some level of capital back based on their contribution? If I borrow from the bank to grow the business and end up selling it for less than the loan – does the bank pay over some of the proceeds of the liquidation to the employees?I thin only in the VC world could you even have this discussion – divorced as it is from reality.I come from the hedge fund world (another world highly divorced from reality) but also a world that is ultimately very pragmatic. In my world, if you do not return your investors money – they take whatever is left and move on. Hedge funds, like VC’s, tend to employ a 2% manageent fee and a 20% fee on profits as a construct. Think of a venture funding this way. I put in $5M into your company as an investment. As a founder, you take 50% as a management fee (assuming you burn $200K per month) and you take a 20% carried interest in profits (early option pools of 20% or more are not at all uncommon). So why wouldn’t I want my capital back before splitting any proceeds with you as founder? How is that wrong?Just another – very long winded as I re read it – point of view.

          6. David Semeria

            Thanks Harry, your reply was more than my comment deserved.That said, I have to disagree with just about everything you wrote above (sorry!).First up, I don’t believe that a mediocre exit is an ‘edge case’ – if not, the asset class would not be in the state it is now.More importantly, I don’t buy into your concept of ‘life leverage’ offered by venture capital. You’re right when you say that a VC’s only real goal is to return a decent risk adjusted return to his/her LPs, but these goals are essentially the same as those of the entrepreneur (and if anything the entrepreneur is probably more risk adverse given the implicit diversification enjoyed by the VC).That fact that the entrepreneur has an opportunity to get rich is irrelevant, since – to paraphrase your own viewpoint – there is no real difference in an investor’s eyes between a highly promising startup and long-dated option trading at below it’s implicit value. As Gordon Gekko said “‘It’s bucks that count, kid. All the rest is conversation”.It’s true I have a big issue with liquidation preferences – but only in a very specific set of circumstances. These are when the founders make big, self-funded sacrifices prior to external investment. The professional investor will decide to put money in based on an objective appraisal of the potential of this self-funded work. Nobody bends the VC’s arm to buy, and nobody bends the founders arms to sell. Both sides are rational and well-informed.However, if things don’t turn out as planned, the VC can enforce an asymmetric risk / return profile the likes of which I have yet to see in any other asset class or instrument.I’m surprised you used the example of a bank making a loan. When a loan is made the lender has a senior claim on assets up to and not beyond the value of the principal and interest. The bank gets seniority in return for no participation beyond this sum.Liquidation preferences allow an investor to have it both ways. The investment behaves like debt up to the value of the preference and then behaves like equity thereafter.And before you shout “convertible bond” at me, remember that entrepreneurs do not ‘charge’ (as in the case of a convertible) for the value of the conversion option.One point I will cede is that perhaps the value of the preference can be justified by the size of the pre-money valuation. When I first started looking at VC, I was amazed by two things (i) liquidation preferences and (ii) the valuations given to revenue (and sometimes) traction free companies.I made the point in another reply that perhaps a more sanguine entrepreneur should consider accepting a lower valuation in return for a preference-free investment.

          7. Harry DeMott

            I love the fact that you disagree with every point – makes for good conversation.I think that we are both surprised by pre-money valuations – and remain so – but like the liquidation preference – it is sort of part of the game. You don’t get one without the other to some degree. Perhaps they are the founders way of dealing with the liquidation preference.”Convertible Bond”!!! I’m just shouting it at you.Banks would be ideal sources of funding – except for the fact that start-ups have no assets other than intellectual capital – which banks won’t loan against. I’ve always been amazed once inside growing companies how sacrosanct the preference is to VC. I’ve heard conversations where people were unhappy taking on venture debt – because they didn’t want to create a senior claim (particularly when they were in a senior position) in case things went wrong. They’d rather finance with more senior claims they could put on the company – despite the fact that it would not necessarily do the best thing for the common.Where I really take issue with you is your assertion that the ability for a founder to get rich is irrelevant. Without capital to fund the idea – the idea is worthless. And where else is a 20 year old hacker going to get an opportunity for someone to say – your idea is worth $5M and you can keep a big chunk of that if you are correct? As they say – only in America.Ultimately, this debate really comes down to which side of the fence are you on. Everyone wants the best deal for themselves. I’m sure that sooner or later we will see pure common deals – just as I am equally sure that sooner or later we will see the return of the participating preferred. It all goes in waves – but given the risks that investors are taking – I’m not surprised that the liquidation preference has been sustained.Can you imagine what the typical VC’s return profile would look like without a LP? My guess is that it would look a lot worse – and then they wouldn’t be able to raise money – and with no capital to invest – we would see the return of the participating preferred along with a pledge of the founders blood in order to secure an investment.

          8. David Semeria

            “Convertible Bond!”. Love it!At the risk of you thinking you’re dealing with a bit of a nut case, I actually agree with just about everything in your most recent reply. I still have a small issue with the 20 year old hacker – his new found wealth is an effect rather than a cause – but I think we’re almost there.In what is maybe a first for Disqus, I’m going to link to a comment on the same comment page (it would be quite funny if this got blocked by their new link spam filter).In it I reply to Terry Jones, who, if he were not a real person, could easily be mistaken for a the type of caricature that regularly appears in soppy Hollywood biopics.Terry’s the perfect example of the (not young) entrepreneur who bet the ranch.Perversely, he defends the preference. Go figure.

          9. terrycojones

            Heh ๐Ÿ™‚ Re the preference (see my reply below): if you can’t beat ’em, join ’em!BTW, this goes back to another thing I think is important to strive for: alignment of interests.

          10. doug rivers

            You’re right about the leverage of the VC in a private deal. But, imagine that you’re a founder & you build the company to a reasonable size, bring in a “professional” CEO, and the company then stagnates through multiple rounds, diluting you to next to nothing. Your (vested) common stock is nearly worthless because of huge liquidation preferences.I’ve never heard of this arrangement, but how about having founder (and employee) stock receive some liquidation preference as it vests. You sometimes hear as justification for an investor LP that if the company is sold shortly after an investment, the investor should not take a loss for the sale of their cash. However, this argument has much less force after vesting, since the founder/employees have put in quite a bit of time at sub-market wages.

          11. Mark Essel

            I’d like to share some personal experience with a 100% loss on some margin options on NVIDIA. I thought there was no way it could go lower. The company produces outstanding chips at a large profit and CUDA was just then taking off.Poof, all the value tanked and so did my Ameritrade account. Of course the stock rocketed back up after I lost everything to double or triple what I bought it for.

          12. David Semeria

            Sorry to hear that Mark, but that situation can only occur if you were using leverage – which is, alas, generally a bad idea.

          13. Mark Essel

            It was a good lesson. I should have doubled down when the floor dropped out. I still believed in the company and it’s product, I just ran outta cash. The bank always wins.

          14. PhilipSugar

            With absolute all due respect I think your last paragraph is taking it to a personal level, I agree totally with a 1X liquidation preferenceAs an entrepreneur and a CEO until you experience the powerlessness of watching your entire life blow up because you have a VC flail around (try to replace CEO’s, propose stupid mergers, hire expensive consultants, etc) because they can’t achieve a high multiple exit you can’t fathom the difference from that and having powerless shareholders. (One’s that can’t prevent CEO’s from making $200M windfalls from blowing up companies….ahemmm Bob Nardelli, and every single Wall Street CEO)You can’t compare the two because a dollar is worth a dollar, and if you can buy or sell a share in an instant and receive a dollar its worth a dollar. In a private company I say my share is worth a dollar and there is absolutely no basis for that other than my word. You are wiring money….money that is positively is worth a dollar. If it turns out I was wrong, you get your positively worth a dollar back, and I get whatever is less for my absolutely no basis dollar.

          15. George A.

            this is an excellent point, but I would offer:1. public companies are at a scale where they shouldn’t be reliant upon any single person (franchise is more than a single person or persons). 2. they have the financial profile and the capacity to recruit replacements. Where there is key man risk, investors take note. 3. boards get pressure to have succession plans all the time…succession plans are not something you hear about in startupsnet net, founders have the ultimate veto right in a startup and that simply is unique to a startup.

          16. David Semeria

            I just used the public markets to frame my example.The underlying point is that liquidation preferences can allow you to have it both ways.

          17. Alex Bligh

            If you did that, you would pay for the price of the put option too (for the asymmetrical risk profile), resulting in a higher valuation. So, translating back to VC-land, the alternative is for VCs to come in with ords (or things more like ords) at a lower valuation.

          18. David Semeria

            No, that’s entirely the point.The put option is free, and will remain so as long as liquidation preferences are a sine qua non for VC investment.

          19. Alex Bligh

            Why do you think the put option is free? Nothing is a sine qua non for VC investment, like (nearly) everything else it is negotiable, which is why there are deals done with no liquidation pref, deals done with 1x, deals done with 2x, different PIK preferences, etc., and all those affect other terms of the deal, e.g. price. Even if it were the case that every deal has a liquidation preference (which I don’t believe it is), the VC is paying for it somehow; VC funding is a competitive market palce.If an entrepreneur says to a VC “no liquidation preference”, most VCs, if they want to do the deal, would turn round and say “well, in that case, the round pre-money goes down”. But entrepreneurs are often obsessed with pre-money valuations, and at the time think their company is going to be the next Google, and don’t negotiate the liquidation pref because they pay less attention to downside scenarios.Just as an additional data point, UK Venture Capital Trusts have to put a minimum percentage of their investments in ordinary shares (without any preferences) in order to maintain privileged tax status. Whilst admittedly there are other contributory reasons, they end up picking the least risky, lowest upside deals, and are by no means famed for high valuations.

          20. David Semeria

            Alex, you make a number of excellent points and hit the nail on the head when you point out that entrepreneurs willingly trade preferences for a higher valuationEntrepreneurs – .by their very nature – are optimists. Nobody in a startup is thinking about a future fire sale as they set about buying the office furniture.

          21. Mark Essel

            That’s something you think about only when forced to.If you thought about downsides all the time you’d get a job like the other 75-88% of the world that can find one these days :).Great quality comments today, I’m glued to the pc reading and rereading them.

          22. David Semeria

            It depends on how old you are Mark.Kids in the twenties will chalk their first shafting down to experience (read Mark’s Shuster’s personal experiences, if you haven’t already). However, if you’ve been around the block and have a family to support, you can’t justify dropping 5-6 years for the sake of another life lesson.

          23. John Frankel

            In reality the liquidation preference is also to cover paying the VC’s a tad more on a good exit. It also works fine in a moderate exit. In a poor exit where it might cover only part of the liquidation preference then it really breaks down. In that case one is (naturally) forced to negotiate for what is right, and what is right is that the founders get some reward for their hard work and effort – unless they accept that they were massively incompetent. Bottom line is, as most things in life, liquidation preference does not address every possible outcome and you have to be reasonable in the edge cases.

          24. David Semeria

            Do you not find it ironic that an exit at or around the value of the external investment (what you call an ‘edge case’) represents the very scenario for which preferences were first created?In other words, you’re saying it’s reasonable to renegotiate preferences in the very circumstance they were first designed to protect against.

          25. John Frankel

            Yes. But times have changed, and the central case has now become the edge case as it is easier to raise enough money to get another start up going. The founders have a stronger hand, as Paul Graham and others have highlighted, and an agreement is, at worst, only a legal document and not something that can compel founders to act in the best interests of others. Thus it comes down to working with reasonable, moral people from the getgo.

          26. David Semeria

            Great reply, especially with regard to working with reasonable and moral people.

          27. JLM

            As in any maturing business, the VC business has now become codified enough — and the entrpreneurs have broken the code — that money is just money. It is the reputation and the reality of the people w/ whom you are doing business with that is of paramount importance.

          28. John Frankel

            Totally agree.

      2. David Semeria

        In Italy they say “Success has many fathers, but failure is an orphan”.Sometimes it’s nobody’s fault – but the VC gets downside protection.I would guess many founders work just as hard in struggling companies than successful ones.Whatever happened to caveat emptor?The fact that in your example either the preferences are re-negotiated or the founders get a carve-out merely reflects a fairer split in value.

      3. RichardF

        A 1x LP is perfectly reasonable just as it is reasonable for a founder to try and carve out something on a distress sale if they are in a position to do it. The founders evidently bring value to the sale and therefore there is a deal to be done (unless they mucked up big time on the execution, in which case from a reputation perspective they might want to just ‘do the right thing’). It’s the price a VC has to pay for being able to walk away from the investment with some/all of their investment intact whilst the founders remain locked into the company for a year or two when they would rather be doing something else, probably. Problem is that both parties can get emotional about who is screwing who over

        1. fredwilson

          yup. emotion is bad in these situations. better to remember it is business and move on.

        2. JLM

          Conceptually there is nothing wrong with multiple preferences. A seasoned entrepreneur should be perfectly relaxed about negotiating a “second preference”. This is just a deal structure issue.Don’t get me wrong, because I love simplicity.I have done exactly this.First preference for the investor and second preference for the entrepreneur and then an agreed split thereafter.

          1. RichardF

            I like that idea

          2. Mark Essel

            Pay the investor first, feed yourself second, and then split the difference.How does that work out percentage wise for a simple deal (Charlie’s example was good, 4million pre, 1 million invested, 10million exit)

      4. Jon Smirl

        I’ve seen LPs back fire too. One marginal company I was working with got an offer at 2x the capital invested. It was a marginal business so it was a good offer. But the LPs worked out so that the founders got almost nothing. Investors wouldn’t budge on LPs not wanting to reduce their return. The founding team knew the business was marginal and wanted to sell but not at a zero return. So the company stayed independent hoping for a better offer, It failed about five years later as the founders quit and moved on to new projects. They figured that they were never going to get a decent return and abandoned the company.LPs that automatically decline over time would have solved this case. Start at 100% and take 10% off each year.

        1. fredwilson

          the investors were probably inexperiencedan experienced VC should never make that callit almost always ends badly

      5. Dan T

        Experienced a similar situation. Common had 2/3rd of the stock, preferred had 1/3 with 1X LP. Offer to sell after dot.com bust was 25% less than invested capital. Preferred end up with 2/3rd, common with 1/3rd – deal got done. Without compromise – it would have been lose/lose for all – a Thelma and Louise ending.

        1. Mark Essel

          Smart compromise Dan, no one likes seeing ladies drive off cliffs.

  3. Dan Ramsden

    Early stage investors buy options at full equity value. Entrepreneurs are happy to take in the money at that price. The bells and the whistles in terms and conditions are just an attempt to smooth edges, to make the square peg and the round hole fit a little better. Regardless, the only time everyone is happy is when the success of the enterprise is very substantial… which in a way makes sense, because that was the premise going in. Until then, and for everyone else, the dynamic is one of conflict inherently. It’s how the model is constructed.

  4. CliffElam

    I get your point, but my experience (more limited than yours, obviously) has been that the external market for capital dictates LP. I saw a lot of VC’s who normally insist on it have to leave (with gritted teeth) it by the wayside because there were other VC’s willing to fund without it.Likewise, these days, I am seeing LP’s that are so levered up the founder won’t make money unless someone pays silly money to take them out.I think the first situation is more likely to attract good talent into the startup world than the latter. And talent is the key ingredient.-XC

    1. fredwilson

      there is a market. different investors will buy different things.i’m just saying what i require to get involved and explaining why

  5. Alex Bligh

    Personally (and I’ve been on both sides of the table), I would suggest natural justice says that if the founder makes $39m, the VCs should make at least something on their investment, not just their money back (presumably without even interest).That could be an argument for a higher liquidation preference than x1. But, assuming I’m guessing right at the exit price was between the round B pre-money and the round-C pre-money, it could equally be satisfied by the C and D rounds should have gone in a lower valuation, without a liquidation preference at all (e.g. in Ords).Fred: you comment that you are involved in one company where the founders would rather let the company go down the drain than complete a sale where they get nothing due to the entire proceeds being eaten up in Liquidation Preference, so there is a stand-off and a ‘negotiation’. I am not sure why you think this is a good thing. What it tells me is that the investment structure was not sufficiently well thought out to cope with an eminently plausible scenario (exit at a lower price than the Liquidation Preference total). Further, that the structure has created a situation where founders and investors interests are not aligned. I agree no structure is perfect, but your example appears to demonstrate a flawed structure, rather than a functional one.

    1. fredwilson

      the issue is the company was not successfuland actually the founders are doing the right thingthere is no standoff and no negotiationwhen things don’t work, it is not easy or pretty

      1. Mark Essel

        Things don’t work a third of the time in your experience right. So is there a good and a bad way to spin down a failed venture (returning any capital possible).

  6. Elie Seidman

    I agree with you, the (non multiple) LP should be a given. I won’t invest without one and don’t expect anyone to invest in me without one.

    1. fredwilson

      non multiple non participating – i agreei’ve had entrepreneurs trade higher valuation for participation and i’ve gone for that deal but i don’t like it

    1. fredwilson

      wow. how come i never read your 10 Commandments before?so good, i immediately tweeted them out to >80,000

      1. andyswan

        Thanks. Probably because very few people read what I write.If you liked that post, you would love my teleprompter-free speech on entrepreneurship. Here is the entirety of the powerpoint that accompanies it:http://andyswan.com/blog/20…So fun.

        1. CJ

          I read you all the time…love your stuff Andy. I think our political opinions differ in some things (alike in others actually) but your feed is in Google Reader right next to Fred, Howard Lindzon and The Fly. How’s that for a morning starter?!?!?

        2. Mark Essel

          You’re in my reader Andy, but admittedly I only read your blog once every week or two, the best way to get the older posts is if you pull them together in an ebook format (Anthologize). Certainly dig the Fred Wilson “oprah” effect stats :).What’s the driving difference between andyswan and swantastic?

          1. andyswan

            Swantastic just experimental….my playground. It’ll find itself someday haha

    2. JLM

      Great list — fabulous. Real wisdom. Stronger than an acre of garlic in W By God TX.

    3. ErikSchwartz

      If I had known that you had already invoked Hyman Roth I would not have.

    4. kirklove

      Good stuff… “Hyman Roth has been dying from the same heart attack for the last twenty years.” ; )Love number 9. Always felt a rising tide should lifts all boats is the right way to conduct yourself.

    5. ShanaC

      Truer than I’ll ever know. Why Hyman Roth in the name?

      1. andyswan

        Godfather reference. When asked why did Hyman Roth live to such an old age?”Hyman Roth always makes money for his partners.”

        1. Apearlstein

          And Hyman Roth also said “a smaller piece” when they offered him some of his birthday cake. he was a such generous man, making sure his friends got more cake too.

          1. andyswan

            Good point!

          2. karen_e

            Easy enough with money, difficult with cake. God, I love a good birthday cake.

          3. johnmccarthy

            I always thought he asked for a smaller piece for dietary reasons or to just bust on the waiter. I like your explanation.

    6. Mark Essel

      Crap I need to pull a Cortez #4. I’m leaning on the income from my day job too much.btw, check those stats later, I just submitted this killer list to HackerNews.

    7. terrycojones

      Nice list Andy. I would add to #4 to say “burn your ships in public”. Obviously Cortez did it in front of his men (women?), but it might not be explicitly obvious that you should publicly burn ships. Making it very public sends a signal to everyone, especially people who might consider working with you or investing in you. It shows people you’re committed, and that will help them commit. One criticism of academics getting involved in startups that I frequently have is that they don’t quit their tenured jobs. Wrong signal.I left 3 jobs on my way to making Fluidinfo (http://fluidinfo.com), including over $100K in salary per year (over 3+ years). *And* I sold my own apartment & put all the money into the company. I never get tired of telling people, either ๐Ÿ™‚

      1. andyswan

        Agree! Nice story…love hearing it!

    8. David Semeria

      I like #10 the most.And by the way, I’m Hyman Roth.Seriously.

  7. DGentry

    My fear is that some day the same VCs who will employ 2.5x or 3x liquidation preferences will succeed in preventing an employee carve out by an acquiring company. If would only take a couple prominent examples where the founders and investors make reasonable returns, and employees get $0, to ensure that only mediocre engineers will join a VC backed firm.

    1. Alex Murphy

      Not sure that this will stop people from joining. Just one example like this would put a lot of pressure on future deals to do a 1x valuation to to use the preference for its purpose – risk reduction.There are plenty of examples of people getting screwed by investors, founders, partners etc, it doesn’t stop new people from joining start ups. It makes the next generation a little smarter, I hope anyway.

    2. fredwilson

      i think the days of VCs doing that and getting away with it are gone

    3. Mark Essel

      That would suck, and is something to keep an eye out for. I wonder how many shitty deals happen for engineers each year.

      1. Fred Destin

        I think the worse deals for engineers tend to happen b/c they don’t demand enough equity. Look at Skype and how many folks made real money there. I hear it so many times: “engineers don’t actually get motivated by stock, let’s keep it for the bus dev hire”. I would argue it’s often the Founder / CEO’s who don’t go out of their way early on to generate a decent spread of stock.

    4. Fred Destin

      Dude your real risk is not the ridiculous Liq Pref, it’s the getting recapped at a very low price. The two tend to go hand in hand: raise too much money, burn it, get recapped, say bye to your equity. At least the carveout negotiation does not get polluted by wrong assumptions about how much your equity is worth.Have seen a few 1.5X but not the 2-3X you are talking about, except on emergency bridge loans where they are quite common prior to the bridge converting.

  8. othylmann

    great points already and I am by now more leaning towards an LP but … there always is a but ;).An LP influences the pre-money valuation. e.g. if somebody said that they would want to invest 1 million at 4 million without LP and somebody else would say that they want an LP, then the valuation would go up to let’s say 5 or 6 million. The reason is just the downside protection. You can’t have both. (same would be true if you had one bidder that has the choice of an LP, but yeah, it is all hypothetical)So for me, an LP needs to be simple (I either get my money back or take the part of the sale based on my share but not both) and it needs to allow the founder to keep more shares than she otherwise would. Than it seems to be fair for both, especially considering that you can’t sell without the founders wanting to.

  9. kagilandam

    1X LP is fair and straight. You promised me 10X return on your fabulous dream. I invest in your dream and at the end you don’t get anything means it is your bad dream.This is what exactly happens at funeral. If the father had nothing everyone is at the funeral. If the father had a well written rule with everyone agreed upon then again everyone is at the funeral. If he dies without writing a will and leaves enormous wealth then also everyone is at the funeral. If he dies with only 1-house and without a will then no-one is at the funeral…everyone is at the lawyers house…poor fellow oozes out in the dark.

    1. fredwilson

      where does that funeral thing come from?it’s pretty good

      1. kagilandam

        That was just a analogy that crossed my mind while posting.Closing of a company and closing of a human being.In both cases similar thing happens when the money is split between the receivers. In this case the elder son gets the max (Max gets the max) as per the will (rule) written by the father. The case you were mentioning belongs to the last case…there is little pie and who has to take it… everyone fights for the last piece and leave the company to die and ooze out.

  10. Senith @ Finance tutor

    Excellent discussion. LPs were designed for a purpose. It has some advantages and some disadvantages. As long as both parties understand it and opt for it, its fine. Its the result of each side taking their best offers. If a founder has a better deal he should take it. If he has a good idea, enough traction and multiple offers for funding, he should reject the LP and take funding from the VC who does not insist on it. If he wants to go with a VC who insists on and LP for other benefits like network, brand name, etc, its he call and must accept the LP! Its free market and no one is ‘forced’ into signing the paper!

  11. jmcaddell

    I can’t add anything authoritative to the discussion, but this is a pretty superb dialogue here and I’m learning a lot. Thanks.

  12. ErikSchwartz

    So how will this effect Max’s ability to raise big rounds in future companies? I’m guessing the C and D round guys are not too happy with the profit they made on this deal.To quote Godfather II “Hyman Roth always makes money for his partners.”

    1. fredwilson

      i think Max will be fine

      1. ErikSchwartz

        Max just made a 5X (nearly $40M) on what was essentially an aq-hire, plus he kept that team together using interest free OPM. I think we all agree MAX is fine.The question I have is the next time he goes to fidelity and says “I know we’ve spent $25M already and are still searching for a business, but just trust me, I’ll make you money” will they believe him?On the overall topic I have no problems with 1X prefs.

    2. Elia Freedman

      I always figured there were three levels when dealing with investors:Step 1. Get everyone back their moneyStep 2. Make everyone a profitStep 3. Make everyone huge gobs of cashStep 1 is hard enough and he got to 1 and 2. Max is just fine.

      1. fredwilson

        well not everyone got to #2but we both agree that Max is fine

  13. Adrian Bye

    the problem is the employees will lose out in this deal

  14. Jeff Pester

    Wondering how Max would have come out if the deal had been done at $85 Million and not $185 Million? ๐Ÿ™‚

    1. fredwilson

      the deal probably would not have happened

      1. Jeff Pester

        Precisely. Was thinking about your points to Dave a few hours earlier:”the founders would rather let the company do down the drain than take nothing””so the VCs give up their preferences and/or the founders negotiate a sale bonus””as Paul Graham said recently, the balance of power has shifted from the VCs to the founders and you see that play out across the board, including the exits”

        1. Fred Destin

          Jeff think about it differently: raising a lot of money at a high price puts a massive burden on your shoulders to achieve a high value exit. It massively skews your risk profile up. Everyone is now shooting for the big exit. Max is “lucky” and talented: he made it. In many cases, it ends in tears when raising too much too high. I think Paul Graham is arguing for the opposite: keep the future in your own hands, don’t raise much, keep control. Whilst Max may have engineered a favourable capital structure, he shifted the outcome way out on the Bell curve. Lucky it was achieved !

          1. Jeff Pester

            While I understand your point, I’m afraid I don’t understand how it’s germaine to either my comment or to Fred Wilson’s underlying post. The discussion is around the issues related to liquidity preferences, not relative amounts raised and accompanying valuations (and derivative issues). That in my mind is an entirely separate topic.

  15. Peter Cranstone

    Have to agree with you on this one Fred. Essentially a VC firm is a “Risk Banker” You’re in the business to make a profit – just as the Entrepreneur is. Without a liquidation preference you would be exposing yourself to even greater risk vs. the Entrepreneur. What’s also fascinating from your post is the “C” round. The old saying “Beware the C round” now comes into sharp focus. The Entrepreneur made money (but I have no idea how much he put in) the A round guy made some money (probably a 2x) and the B round made money (just over a 3x). The C & D got their money back so they lost money (IRR).I’ve said this for years now, if you’re going to make money for your LP’s you’ve got to get in early (more risk). The exit is now clearly M&A – Slide was never an IPO play even from day one. Therefore if you’re not in an A or B round eventually your LP’s are going to move on.Bottom line – reasonable 1x liquidation preferences are OK. A & B round guys are making between a 2x and 3x return (5x’s are gone for now) and the C & D round guys are losing on an IRR basis. Anything after a C or D is a total bust.Let’s face it, for VC’s picking the winners (predicting the future) is darn tough, basically just as tough for the Entrepreneurs, and if you show up late for an investment you’re going to lose money for sure.

    1. fredwilson

      i think B and C rounds are OK if they are priced rightin hindsight (which is 20/20) these rounds were not

      1. ShanaC

        Possibly bad question: is the market starting to get bubbly, and Slide is the first sign, considering that M&A and exit exits are tied in theory?

        1. fredwilson

          i don’t think the market is getting bubbly.i think Slide is a Google specific thing. they are trying hard to changetheir DNA when it comes to social. not sure Slide does that for them, butthat’s what it is all about

  16. ckemper

    I actually tweeted about this yesterday and wholeheartedly agreed that liquidation preferences are essential in a venture deal. However, this outcome begs the question as to whether straight preferences are enough? Is it fair for Levchin to make $14M as a founder when investors Founders Fund, Mayfield, & Fidelity made little/no return on their capital?The money that VCs invest on behalf of is generally hard earned savings of people who toiled to accumulate those savings. VCs manage capital for pension funds, endowments, and savings institutions. None of that money that VCs invest came easily and someone worked hard for it. So, although I am very supportive of entrepreneurs (having been one and having been an investor in many startups), I think that if there is a realization/exit, those funds deserve some return for their risk capital if the founder is going to make millions.Levchin certainly took risk with Slide, but so did the investors (our retirement plans) behind Founders Fund, Mayfield, & Fidelity. Why should he reap all the rewards of a mediocre outcome?Interests certainly need to be better aligned. Although not the popular stance, I strongly support liquidation preferences but I also believe that, in addition, an annual accrued dividend makes sense for invested capital. Funds like Founders Fund, Mayfield, & Fidelity should see a minimum return (of 6% or 8% per annum) if Levchin is going to make millions having leveraged their capital.Risk is taken by all. Granted, the risk is different for different parties, but everyone took risk, so everyone should have some sort of return that corresponds to the risk taken.

    1. fredwilson

      don’t cry for Founders Fund, Mayfield, and Fidelitythey agreed to the pricethe hard earned savings being invested by them were protected by theliquidation preference

  17. JLM

    At the end of the day, any financial structure is simply the “cost of money” at a given instant in time.The cost changes constantly depending upon what is happening in the world and the supply of money and the attractiveness of the business.In life, we don’t get what we deserve — we get what we negotiate.I am most comfortable on the entrepreneurs’ side of this discussion and thus I offer the following thoughts:Your ABILITY to negotiate is not an inconsiderable consideration. To create a good framework for negotiation, you have to cast your net wide, find the right investors and try to create just a bit of competiton amongst the investors.Pretty simple concept but one I constantly see entrepreneurs failing to do. These are skills which are dependent upon the quality of your PITCH — Fred’s recent blog post sets a pretty good exemplar — and your experience doing it. Never let the bastards see you sweat.Understand that getting started (the moment of birth) and the big breakout moment (the time of exploitation) are instants in time in which you should lower your guard just a bit because these are very critical junctions in time. In between, be picky.Don’t get greedy on either front. VCs should never let a founder walk away penniless. Give the SOB $1MM. Founders should never let a VC walk away with just his bait if the founder is making a good lick. Give the VC $1MM.Can you imagine the mind f*ck of giving Fidelity Inv $1MM when they did not deserve it? You would become a freakin’ legend! How many tacos can you really eat? $39MM worth? I think not.You are building a long term relationship here. Never get mad at or screw the money. Never get mad at or screw the talent. Be better than you have to be and treat others in a legendary way that you would like to be treated as well.Always be a better and more generous partner than what the “docs” require you to do. It will pay a huge dividend in the future.Business is life. Dare to live it like you love it. Always treat others with the consideration and compassion that you would your loved ones.

    1. fredwilson

      great advicebe generous in exits, both M&A and employee terminations

    2. kagilandam

      That is why they have 3 different words … Man … Gentleman…Bastard. Not everyone is a Gentleman ๐Ÿ™‚

      1. fredwilson

        ha, great comment

    3. Scott Lawton

      Well said. Along those lines: I’d like to see standard terms evolve such that founders get a 1x liquidation preference on the “cash value” of their sweat equity, i.e. roughly the salary they gave up during the bootstrapping phase. Or, if not “market rate salary” at least enough to cover “reasonable living expenses” that they had to dig into savings (or second mortgage or credit cards) to cover.In part, this reflects another aspect of the investor/founder equation that’s highly imbalanced. As individuals (ignoring the limited partners who provide capital), VCs get paid lots of money every year no matter what. Founders often work hard for many years and end up WAY behind.(By the way, Paul Graham’s current essay is very relevant to this discussion.)

    4. Harry DeMott

      Great stuff, as is the comment by Scott Lawton in reply. If everyone’s interests are largely aligned you can get much better outcomes.When I was an investor in Zing the company was going sideways – great product – great team – no market acceptance. The iPod was just too powerful. The CEO – having been through this before – and owning a large chunk of the company along with his founding team did a very smart thing – he decided that rather than fight to the last – he would sell to the benefit of everybody involved.Based on this decision, when it came time to pick the buyer – the board largely deferred to him and ended up taking a lower offer based on where the team wanted to go (okay so they all made a big mistake and went to Dell).the point being was that he certainly forewent potential profits to take care of his investors and employees – and as a result – I think most people involved with him would get right back involved (in fact many of them have in his new company)

      1. JLM

        Here’s the thing about being an entrepreneur — you will have the disease forever. You WILL go back to the well. What you do in building a product, in building a business, in leading a team — does matter.Entrepreneurs trade in other currencies than just money.The great thing is that if you keep getting paid in that weirdd entrepreneurial currency, you will eventually make a lot of money but you will still be insane.The money will never provide the cure. Every time you pass a lemonade stand, you will be thinking — “Hey, I could build that into a powerhouse. And deploy some badass technology!”The saddest people in the world are those who focus only on the money. They are the poorest in the end.Life is a great adventure — take as deep a draft as you can.

        1. Richard Jordan

          Yes it’s impossible to quit – if you’re an entrepreneur you just NEED to do it. That’s why it’s so hard for family and friends who don’t choose this to understand why we do.

    5. Mark Essel

      My chaotic side is in awe of how this spits in the face of contracts.Where the base of my skull meets my spine aches just thinking about this dismemberment of legally binding documents.Bless you JLM, this one’s damn good advice and reminds me, even when in a fairly tight situation to be generous to those who have it a lot worse.

    6. andyidsinga

      I love your point about relationship building :)A good guy I know – Greg Bell ( http://twitter.com/waterthebamboo ) – once told a story to a group of us. Here it is .. roughly..Greg was talking to his wife about how he had come up with this great motivational concept:”we have had the industrial era, then the information era..now we have the relationship era. The relationship era is all about building relationships”.To his great idea, his wife replied: “it has always been the relationship era.”Greg realized the truth of that and agreed….oh, and uh, he’s a much, much better story teller than I am.

    7. CollegeHippo

      Fred’s post was excellent but loved the comment of JLM. Great advice. Thanks for inspiring everyone.!!

  18. Dave Broadwin

    OK, I can’t tell from this post if you think (1) a 1x preference coupled with a participation is “fair” or (2) if you think the preference and the participation should be decoupled. To someone’s point about making money for everyone, I have one unambiguous case in my client base where investors took advantage of a cash shortage to pile on a load of multiple X preferences just in advance of a very nice exit. The entrepreneur is a rock star. The entrepreneur went on to a new venture, had investors standing in line up and down Winter Street and Sand Hill Road to fund the new venture and wouldn’t take money from the people who funded the last venture. As my wife sometimes says, “What goes around comes around.”

    1. fredwilson

      hi dave. good questionit’s clear this is a big question because it has been asked several times inthis comment threadi am against multiple liquidation preferencesand i really don’t like participation either but have seen it work in somesituations

  19. Business Junkie

    Yes – you are right – it should be “Fair.” But, it should be fair to ALL parties.

  20. LIAD

    Would love to know what google saw in slide.Bygone company from a bygone era. Still advertising myspace skins and slideshows on their homepageGot more innovation in my little fingerOne big yawn.

    1. fredwilson

      a team that understands virality and how to engineer it into product?

      1. Aaron Klein

        You hit the nail on the head, Fred. Look at the retention bonuses they paid – 20% of the total deal size. The $182MM to acquire the company almost looks like the price of entry to hiring the team for $46MM. ๐Ÿ™‚

        1. Harry DeMott

          Yeah, I think this was a conversation between Max and the Google boys that went something like this:Larry and Sergey: “Max, so what is it going to take to get you and your team working for us 24/7?”Max: “I’ve already been down that road. I like my freedom and being my own boss. But $300M would probably get it done – at least for a few years.”Larry and Sergey:(After much hemming and hawing) “Well how about $182 plus some some Google options for your team?”Max: “Done”Google certainly is not going to give up on social and they have big plans for gaming and music and other pieces of the social puzzle. That’s a pretty big sandbox for the Slide team. They’re not getting anywhere on their own – at least not to the scale that Max was used to or expected – so why not? Cap gains are at an all time low – he walks with almost $30M after tax – gets a great gig – and can start up again anytime he wants (post whatever lock-in Google has him under)

          1. fredwilson

            comment blogging at its bestthis is the best thing i’ve seen written on the slide deal yet Harry

          2. Aviah Laor

            Actually:L & S: 180?M.L. : 184L & S: 182?M.L.: Done

  21. bramcohen

    What floors me is the insanity of accepting a $500M valuation on a company like that without requiring that the preferences be participating. If the deal had instead been at $1B but the preferences had been participating the investors would actually have gotten a decent return rather than having supplied an interest-free loan.

    1. fredwilson

      damn good point Bram

  22. gregorylent

    the techcrunch article also mentioned the worker bees, who got nothing … hmmm

  23. gregory

    Agree with your post. Just one technicality that’d only make your point stronger re: “Otherwise they would have lost money in a transaction where the founder made $39mm.” Wouldn’t Max have made a lot more if there were no liquidation preference?

    1. fredwilson

      yes. good point

  24. Mike Su

    What I hate about this is all the people who were rich richer but the employees who worked 18 HR days, broke up with girlfriends, took less pay have so little to show for relative to the money folks. While money is important in getting things moving, blood sweat and tears are equally if not more, and seems to be undervalued. Is it possible to setup a liquidation pref for early employees to guarantee they see something meaningful in a sideways exit?

    1. gregory

      According to TechCrunch, “Google has agreed to pay an additional $46m in employee retention bonuses”. Not bad.Any who says any of the employees broke up their girlfriends for Slide? Anyone who took a job there after the series A didn’t have too much of a risk of their paycheck bouncing.

  25. Michael Langford

    A 1x-1.5x liquidation preference makes sense. AKA, you shouldn’t lose money because you invested in this company instead of treasury bonds. However its the 2x and greater ones that scare so many people off.

    1. agree

      Makes sense. Especially when the capital is cheap nowadays (The 10 year treasury is just yielding 2.x%).

  26. Nkannan

    Terrific discussion.As an entrepreneur, I see LPs make VC investments look more like a senior debt with warrants. Probably the early rounds should be structured as such and get exchanged into preferred when the startup is growing its valuation through performance. If we follow the principle of higher risk should reap higher rewards as well as larger share of losses, then entrepreneurs should deal with LPs.I can think of several ways to configure mathematically the split of the pie from an exit below VC’s valuation at investment, that keeps the incentives for Founders to go along with the sale. Symmetrically, if the sale price is above the VC’s valuation at investment, then entrepreneurs should get proportionately higher share of the upside. What is unfair though is the multiple rounds of financing at increasing valuations progressively undermines the upside of the Founders as all the VC rounds with LPs are made whole first. The early round VCs like to see up round follow ons, which works against the Founder’s interest.I feel that initial agreements should spell out clearly the formula for splits assuming success and failure and entrepreneurs should not be holding up a sale and drive the business into ground by neglect. The initial agreement should spell this out.When there is distrust among one of the stakeholders then it spreads like cancer and destroys all motivation to sustain the enterprise. Loss of trust is hard to undo.Nat Kannan

  27. Mike Su

    The other interesting thing about this post is, while this deal is considered to have gone sideways, Max made nearly as much as he made on paypal’s billion dollar sale. There are obviously a myriad of reasons for this, but I think generally speaking entrepreneurs should be aware of just when to go big, and how to structure equity, what it means to get diluted because two very different exits produced nearly the same result for max as an individual. Of course, there were very different results for employees and investors, but just saying sometimes a smaller exit with less dilution is just as good for the founder as a bigger one with more dilution. This has all sorts of implications, but it’s fact and basic math.

  28. Beto Juarez III

    Great post. We certainly want folks like Mayfield Fund and Founders Fund to keep investing on plays like these. I should hope that Max Levchin agrees with your premise as well.

  29. Alex

    This post seems to forget a very important detail.Levchin invested $7m. He’s not just a founder, he’s also an investor. So, we really need to describe this differently.The numbers should read more like:Max Levchin (founder) : $14mMax Levchin (angel) : $25mAnd the lore you hear around town is that if Max Levchin wants money, Max Levchin gets money. So, let’s not go by the belief that Slide was a typical deal. The founder wasn’t young & hungry and the investors were investing in the team not the product.I think these are important points with respect to the liquidation preference issue.

  30. Mark Essel

    This looks like an exit thats beneath the last strike price. So what happens to earlier investors in a down round, do you lose equity?

  31. William Mougayar

    Can an existing liquidation preference be changed in a subsequent round by a more substantial investor?

    1. sweller

      As a wise person once told me, anything is possible when the right money is involved. ๐Ÿ˜‰

  32. terrycojones

    A point for entrepreneurs: if you’ve taken cash from seed investors or friends & family, you can suggest that those folks also get a liquidation preference when arranging a more serious financing. That’s what I just did & am happy with it. After all, cash is cash, and it seems only fair (to me) that if one set of investors think they should have protection for their cash in the form of a liquidation preference, why shouldn’t the others too? I have a blog post in me about how it’s in everyone’s interest that incoming investors should want and expect to be treated like existing ones. Because in the next round the ones coming in now will then be existing investors. Not everything has to be (or can be) equal, of course, but I think that’s a healthy perspective / aim. On top of which, your incoming investors should be reassured to see you fighting to protect your existing investors. Similar comments could be made for new hires, and the standards you set – potential employees will later be existing employees, and you want them to have confidence in some similar ways. I have a rule of thumb for this, but this comment is long enough already……

    1. Mark Essel

      Oh hey the more serious financing hunt worked out well, congratz! Would love to hear about the details if/when it’s ok

      1. terrycojones

        Thanks – next time I’m in NY!

  33. Vivek

    This is a special case with the founder having his own capital. And in this case it does make sense. The usual reason that people dislike a liquidation preference is the situation wherein a founder has to grow his company to a huge size to get even a paltry payday. And I think thats the more common situation.

  34. benjamindblack

    I would love to know what common received on a price per share basis. As a buyer in the secondary market, I had the chance to buy a couple of times but passed to due to price expectations north of $200M, which the sellers thought looked cheap next to those high priced Series C&D rounds. Slide is off Sharespost now so I don’t know the prices at which common was actually sold. Secondmarket has buyer bids at $1.20. Even with healthy discounts, I sensed they were having a hard time finding buyers at the time, but who knows … However, if there were common stock buyers at those prices, they lost a good chunk of money.

  35. alain94040

    Fred, it’s unusual for you to forget to argue your position… Where is the reasoning?You conveniently downplay the fact that the founder also invested a serious amount of cash. It’s almost misleading.I liked one of the comments, saying that while VCs invest their cash, so do the early employees who forfeit higher paying jobs. How do you account for that? It’s money too.

  36. Michael O Church

    Isn’t this somewhat of a

  37. Michael O Church

    Isn’t this somewhat of a false enemy? As far as I can tell, no one has a problem with liquidation preferences per se; a 1x liquidation preference prevents founders from screwing investors. It’s multiple liquidation preferences and participating preferred (which are objectively scummy) that people hate.

  38. Benjamin Wayne

    I see this as a case of an unusual scenario being used to justify an industry practice which generally forces forces entrepreneurs to shoulder a disproportionate share of downside risk.In most cases, what VCs negotiate is not simple preference, which would enable them to protect their investment in a downside exit, but participating preference, in which they are paid first in any liquidation, and then get to share in the proceeds, a form of double-dipping which enables them to both protect themselves on the downside as well as rewarding themselves on the upside.If the goal is to mitigate downside risk, investors should receive preference, but not participation. This enables them to protect their investment in a downside case, but forces them to convert to common where they participate on a pro-rata basis in any upside scenario.If the goal is “fairness”, a challenging term to define, we should consider what happens when liquidation value does not clear preference. In these cases, the entrepreneur typically gets either nothing, or a token carve-out which is usually wildly disproportionate to the value returned to investors.The VC argument for this is typically a golden rule argument (whoever has the gold makes the rules). An institutional investor will argue that they are writing the checks, and since they have money at risk, while the entrepreneur is only providing sweat equity, they should be treated disproportionately in any downside liquidation preference.This is a somewhat disingenuous argument. Institutional investors are rarely investing their own money, they have diversified risk where entrepreneurs do not, and they don’t have to suffer the financial trade-offs, midnight sweats, stress, challenges, and brutal workdays of the entrepreneur.A better system might be a pro-rata distribution of proceeds under downside scenarios which fail to clear preference, so that both investors and entrepreneurs receive some return on their mutual investment in a venture. This would better align goals of management and board in challenging environments, and reward equally the risk and sacrifices made by both parties.

    1. terrycojones

      Hi BenjaminI’m very sympathetic to the entrepreneur’s POV, but I think your summary is a bit one sided.Fred wasn’t commenting on participation or not – in fact IIRC, he recanted on participation quite recently.I don’t have any problem with liquidation preferences (non-participating). The entrepreneur is out there selling, claiming they have the Next Big Thing, etc. If they’re totally totally wrong, it seems fair for the investor to be able to ask for their money back (cf lots of deals in the non-VC world – yes, you’re maybe an idiot to believe the seller, but if their claims are completely off base and they manage to convince you nevertheless, should you be forced to suffer? I don’t think so, there should be some recourse).Also, I’ve met many extremely stressed out VCs who work very hard. In my (limited) experience, raising a VC fund is *much* harder than raising money from a VC, and takes *much* more time. If VCs want some kind of protection for their investors, isn’t that understandable – you want some protection for yours too (I’m talking of friends & family & seed etc). And finally, IMO the consequences of bad failure as a VC are much worse than they are for the entrepreneur. The friendly and healthy “oh, your company flamed out, well failure is good & healthy & normal, why not have another go, here’s some more funding” climate of the entrepreneurial world has yet to permeate the world of the VC and their LPs. The stakes are much higher, it’s much less forgiving, and the consequences of failure can easily include looking for an entirely new kind of career.I’m a 4 time entrepreneur BTW, never been on the other side of the table.

      1. David Semeria

        Hi Terry Big Balls !!Whilst I admire your moral stance on liquidation preferences, I’m sure you’re aware they fly in the face of basic finance: no risk – no return.If a friend or family member sold you a raffle ticket, do you think you should ask for (all) your money back if you don’t win?

        1. terrycojones

          Yo David!Right, but I think there’s a very big difference between a pure lottery (which is extremely transparent, in terms of price and expected reward) and many other situations, and that the VC/entrepreneur sale/purchase does not fall particularly close to the lottery end of the scale.From my POV, the VC/entrepreneur sale/purchase is more opaque (despite due diligence, despite representations & warranties) and is a much harder sell. And note that a (non participating) liquidation preference only kicks in if the entrepreneur is totally wrong in their claims about the value of what they’re trying to sell you. It’s pretty common, even in much less murky transactions, that if the seller’s claims are *totally* off base the buyer can ask for their money back (and a liquidation preference doesn’t even give that protection).Someone has to stick up for the VCs around here. They’re an endangered species – in spite of their highly begrudged measly liquidation preferences :-)And… it’s a negotiation, after all. If you don’t like liquidations prefs, negotiate them out, or don’t take the deal. To me they don’t seem unfair.

          1. David Semeria

            OK, Terry. I really hope you take what follows in good spirit.When I argue against preferences you’re exactly the type of entrepreneur I have in mind. You and Esteve have been working on Fluid DB for how long? Ten years? You sold your apartment, limited your purchases to essentials, and, in your own words, are living living proof that “you can’t overdose on Corn Flakes”.And lest anyone thinks this type of existence is any why romantic or cool, I hope you don’t mind me recalling you saying how hard it was at times not being able to give your kids many of the things their friends have.But I’m sure you’d be the first to say that it was your choice, that nobody made you do it.Right. Here comes the tricky part.Lets say that a few years from now, Oracle unveils its (hitherto secret) universally writable and structureless database. Fluid DB is up the creek.Who’s fault is that? Did you misrepresent your product or the scale of the opportunity? No. If anything Oracle’s entry only validates your claims. But you’re still shafted anyway. The same way that anybody small who competes with any of the big boys is shafted. Especially when they make their product free so as to gain a bit of traction.So what happens?You get a trade offer which amounts to the sum of your preferences. You take it. At least Aunty Maude will be made whole.And where does that leave you? You’ve worked your cojones off, made inestimable sacrifices and what do you get? Zero. Precisely zero.Who took the real risk? Who made the real sacrifices?The golden rule of investing is to only put in what you can afford to lose. There is no equivalent rule for entrepreneurs.Liquidation preferences make it possible for a company in which an entrepreneur has invested his heart and soul be sold for good money and yet the founder doesn’t see a single penny.Tell me that’s fair?

          2. terrycojones

            Oh David…. of course I take it in a good spirit – you make me smile. Plus, I’m too old to do anything else, and I know you too well, etc.I think everything you say is pretty much correct. I took lots of risks, *including* assuming the risks that come with the investment and agreeing to the presence of a liquidation preference, etc. I would and (hopefully) will again.BUT, I also have a liquidation preference on the cash I put in, my wife has one on her cash, and so do all the friends & family seed investors (for a total of roughly $540K). That was part of the negotiation, and I’m happy with it.Please don’t hesitate to speak your mind! ๐Ÿ™‚

          3. David Semeria

            Surely liquidation preferences are like nuclear weapons – when everyone has them, there’s no longer any point….

          4. terrycojones

            Another comment is that liquidation preferences and all other terms are not negotiated in isolation. There are many aspects of a deal getting done, and the different sides (and their lawyers) will have different sensitivities, priorities, etc. For example, my investors do not have a board seat. What would you choose: liq pref & no board seat, or board seat and no liq pref? When I saw the liq pref, my first reaction was “ok, that’s going away” and when I was told “no it’s not” I said “ok, then the existing investors should have one too” which was met with immediate approval. I ended up with very favorable terms, and the during the negotiation both sides were generous and accommodating, and we found reasonably simple ways (like with the liq pref) to give & take. The liq pref is hardly a nuclear weapon, and if you *really* think it’s important, I’d say there’s more doubt in your mind than there should be ๐Ÿ™‚ Nuclear weapons are things like veto rights such as “you can’t sell the company unless we approve” or “you can’t raise more money unless we approve” (terms that I had removed), or full ratchet anti-dilution (which seems to have gone the way of the dodo). Liq prefs were the least of my worries!

          5. David Semeria

            Two points:a) Have you worn out your Enter key?b) Who owns the common?If I’m not mistaken, “todos cabelleros” is a Spanish phrase, yes?

          6. terrycojones

            I still have an Enter key. I just don’t use it here, as I think it’s better to let the browser wrap the lines. Try narrowing your browser window? :-)The common is owned by people who did early work for the company, including me. The people who put in seed cash got a class of stock (S) with a liq pref. The new investors got a new class (A) with a liq pref, plus additional rights.No-one gets their time and effort and sweat back (neither people who worked on FluidDB, nor the many investors who spent time evaluating us – including one Fred Wilson), but all cash has a liquidation preference. I don’t think I could have gotten a term in there saying I get all those years back if things don’t work out ๐Ÿ˜‰

          7. David Semeria

            Well, it all boils down to your ratio of pref vs common (which I don’t want to know).Your situation is clouded by the fact that your cash is ‘defended’ by a preference, whereas your sweat equity is open to the four winds. Why should your cash be valued more than your time?More importantly, you used your Enter key two, if not three, times in your latest reply.

          8. terrycojones

            The liquidation preference deals with cash cause it’s the thing coming in in a liquidation event (my favorite entrepreneurial term – always makes me think of wet dreams). Cash is tangible. Cash went in, cash is coming from liquidation, cash can be returned. The liquidation preference on each preferred share is set to an amount that reflects the amount of original cash that share represents. It’s all very concrete and unambiguous.The time I put in was worth much more than the cash. But there’s no way to get it back. And if an investor puts money into the company and we go bust, can they recover the cost to their reputation? Their time? The opportunity cost? Unfortunately those kinds of things are sunken intangibles, and everyone knows up front they’re not coming back. If you’re not into taking those kinds of risks, you presumably do something else. I love the risk, it makes me feel alive.

    2. David Semeria

      It’s not that simple Benjamin.A non-participating preferred also affords upside participation as well as down side protection.In the event of a good exit, the preferred stock just converts to common and shares in all the upside pro-rata.

      1. Benjamin Wayne

        Yes, as I mentioned quite clearly above.

        1. David Semeria

          Yes, you did. Guilty as charged.

  39. Vijay

    Well what you do not talk about is the deals in which the founder does not see a dime while the investor has a liquidation preference with more than 1X return. So he not only sees his money back but also makes a little bit more while the founder is left with nothing for his work, time and effort.At this it may be easy to say that the investor deserves it as the founder was running the show. But even that is not the case the investor significantly influences the direction of the company.

    1. fredwilson

      I have never seen that outcome in 25 years in the business because thebuyer wants the team and doesn’t want the vc

  40. Erik

    Hey Fred, I think you’re a bit off-base here. For early stage deals like you normally do, liquidation preferences are usually pretty fair. But as you know, late-stage deals are a different animal entirely. I’d argue they are closer to public company investments than early-stage VC deals. In public companies, you can get a liquidation preference, but you have to pay for it – it’s called a put. Now I realize you can argue that although Slide’s valuation was $500 million, it was still “early stage”, but if that’s the case, that’s the investors fault. My point is, investors are welcome to negotiate a liquidation preference and existing shareholders are free to agree to one, but there should be a price associated with it. In reality, that’s the case with any liquidation preference anyway, since it’s all part of the same negotiated deal and any “price” for a liquidation preference is probably baked into the valuation.

  41. PhilipSugar

    I want to summarize my thoughts.I think its about $1 being worth $1.$1 in cash, wire, bank check is worth $1$1 in a companies stock that I can immediately trade is worth $1$1 in a private not tradable company is worth my word…..so I have promise its worth $1$1 of preferred stock in which I want a 2x guarantee is worth 50 cents$1 of participating preferred is worth 0 I get it all back and then participate as if it was worth $1

  42. geophile

    What I am not OK with is an unfair deal. And investing in common stock when the founder controls the company and the exit is not a fair deal.This strikes me as a very one-sided view.I’ve been a founding engineer or 1st employee at several startups, (one IPO, three acquisitions). I have had very little direct contact with VCs, but the idea that the board has no control over the exit is at odds with what I have observed. And if the board does have that sort of control, then I don’t see how LPs can be construed as “fair”. Such LPs greatly reduce the VCs risk at the expense of the earliest employees.Unlike the VC, the employee doesn’t have a portfolio. He is devoting his expertise, experience, talent, dedication, and a significant chunk of his most productive years, (to say nothing of his personal life), to that one company. LPs can reduce a life-changing payout (e.g. college for his children) to just about nothing (maybe a nice vacation). To me, that’s unfair.I’m your mirror image. I won’t work at a company that does have liquidation preferences (once I realized what they were, at my first startup).

    1. fredwilson

      Well I guess we won’t work togetherThat’s too badFounders and management control the exits because they have to workfor the buyer and the investors do not

  43. Kaptan

    Hi, Well said. Along those lines: I’d like to see standard terms evolve such that founders get a 1x liquidation preference on the “cash value” of their sweat equity, i.e. roughly the salary they gave up during the bootstrapping phase. thank you very much. good job.Kaptan

  44. vcinvestor

    Fred, I feel the operative phrase is deal symmetry. Not equality in deal terms but symmetry – the balancing of interests in each material deal factor so that, in the end, the parties feel that the deal papers reflect a reasonable sharing of risk, income and control. So, for example, If Union Square takes straight equity in a deal perhaps more attention needs to be paid to director control factors to get the balance right. In any case, it ends up being a balancing act across risk, income and control.Leon

  45. lordaragorn22

    Tim has lowered the Street’s expectations of AOL to such a degree that, at this point, a “less bad” quarter (e.g., lower sub losses on a percentage basis on the access front) will be spun by this optimistic, not fact-driven market into an AOL win!Zayฤฑflama Lida Fx15 Biber Hapฤฑ zlfvbh

  46. Justin

    There is a good example on how these terms can affect a deal at http://vcexperts.com/vce/ne…. It also demonstrates the true “cost” at issue.

  47. Alex Bligh

    D funding came in Jan 2008, allegedly at a $500m pre. The question I’d ask is not whether it was put to use, but whether it was committed and at risk (i.e. if, without the liquidation preference, they’d have walked away within very little).

  48. andyswan

    Thank you. On a side note, I find your taste in writing to be superb!

  49. Julien

    Get a room =D

  50. fredwilson

    these two were fighting like brothers a couple days ago

  51. fredwilson

    i am not a fan of multiple liquidation preferences. i’ve learned the hard way that they don’t work as intended.i am also not a fan of participation but i have bought participating preferreds on occasion. i’d rather get a lower valuation and a straight preferred

  52. JLM

    What goes around comes around. Life is a closed loop.A slight given is scratched in sand, a slight received is chiseled in stone.Everybody gets even.The loss of 5% of a founder’s enthusiasm can be the difference.

  53. Mark Essel

    That was until Charlie decided he could use Andy’s gift for writing to boost his own startup ;). There’s always an angle.

  54. Mark Essel

    Good example, thanks Charlies. My instinct would have been 20% equity based on the 1million in.Breaking it down simply, 4 million is pre money valuation1 million is investedA sale for 10million, returns 1 million up front and then 20% of the 9million dollar remaining value.So it’s like a loan of 1million for 20% equity, wicked.

  55. Justin

    A good example can be seen here http://vcexperts.com/vce/ne…And one can also see what the true “cost” is at the time of the deal, based on those terms applied.

  56. terrycojones

    Hi Mark. The above is only the case with participating preferred. In the more entrepreneur-friendly version, the investor has a choice: take the liquidation pref amount ($1M) or convert to common and take your 20% ($2M), not both.

  57. Mark Essel

    Danke schรถn