Employee Equity: The Liquidation Overhang
We're five posts into this MBA Mondays series on Employee Equity and now we are going to start getting into details. We've laid out the basics but we are not nearly done. I am just starting to realize how complicated the issues around employee equity are. That's not good. It's like paying taxes. Everybody does it and nobody but the tax accountants understand it. Ugh.
Anyway, enough of that. Let's get into the issue of liquidation overhang.
When VC investors (and sometimes angels) invest in a startup company, they almost always buy preferred stock. In most startups, there are two classes of stock, common and preferred. The founders, employees, advisors, and sometimes the angels will typically own common stock. The investors will typically own preferred stock. The easiest way to think about this is the "sweat equity" will mostly be common and the "cash equity" will mostly be preferred.
For the sake of this post, I am going to talk about a simple plain vanilla straight preferred stock. There are all kinds of preferred stock and it can get really nasty. I am not a fan of variations on the straight preferred but they exist and they can make the situation I am going to talk about even worse.
First, a quick bit on why preferred stock exists. Lets say you start a company, bootstrap it for a year, and then raise $1mm for 10% of the company from a VC. And let's say a few months later, you are offered $8mm for the company. You decide to take the offer. If the VC bought common, he or she gets $800k back on an investment of $1mm. They lose $200k while you make $7.2mm. But if the VC buys preferred, he or she gets the option of taking their money back or the 10%. In that instance, they will take their money back and get $1mm and you will get $7mm.
In its simplest (and best) form, preferred stock is simply the option to get your negotiated ownership or your investment back, whichever is more. It is designed to protect minority investors who put up significant amounts of cash from being at the whim of the owner who controls the company and cap table.
Now that we have that out of the way, let's talk about how this can impact employee equity. Anytime the value of the company is less than the cash that has been invested, you are in a "liquidation overhang" situation. If a small amount of venture capital, let's say $5mm, has been invested in your company, it is unlikely that you will find yourself in a liquidation overhang situation. But if a ton of venture capital, say $50mm, has been invested in your company, it is a risk.
Let's keep going on the $50mm example. It comes time to sell the company. The VCs own 75% of the Company for their $50mm. The founders own 10%. And the employees own 15%. A sale offer comes and it is for $55mm. The employees do the math and multiply 15% times $55mm and figure they are in for a $8mm payday. They start planning a party.
But that's not how the math works. The VCs are going to choose to take their money back in this situation because 75% of $55mm is roughly $41mm, less than their cash invested of $50mm. So the remaining $5mm is going to get split between the founders and employees. The investors are now "out of the cap table" so the final $5mm gets split between the founders and the employees in proportion to their ownership. The employees get 60% of the remaining $5mm, or $3mm. The party is cancelled.
This story is even worse if the company that has $50mm of investment is sold for $30mm, or $40mm, or even $50mm. In those scenarios, the employee's equity is worthless.
I know this is complicated. So let's go back to the basics. If your company has a lot of "liquidation preference" built up over the years, and if you think it is not worth that amount in a sale situation, your company is in a liquidation overhang situation and your employee equity is not worth anything at this very moment.
You can grow out of a liqudation overhang situation. If this hypothetical company we are talking about decided not to sell for $55mm and instead grew for a few more years and ends up getting sold for $100mm, then the liquidation overhang will clear (at at sale price of $65mm) and the employees will get $15mm in the sale for $100mm.
So being in a liquidation overhang situation doesn't mean you are screwed. It just means your equity isn't worth anything right now and the value of the company has to grow in order for your equity to be worthwhile. But it also means that a sale of the company during the liquidation overhang period will not be good for the employees. As JLM would say "you won't be going to the pay window."
This issue is front and center in the minds of many employees who worked in tech companies in the late 90s and early part of the 2000s. The vast majority of companies built during that period raised too much money too early and built up large liquidation preferences. Many of them were sold for less than the liquidation preference and the investors lost money on their investments and the employees got nothing. That has hurt the value of employee equity in the minds of many.
We are in a different place in the tech startup world these days. Many of our companies have raised less than $10mm in total investment capital. And the ones that have raised a lot more, like Zynga, Twitter, and Etsy, have enterprise values that are 10x the lquidation preferences (or more). This is the gift of web economics. It doesn't take as much investment capital to build a web company anymore. That has made investing in web companies better. And it has made being an employee equity holder in web companies better.
But liquidation overhangs still do exist and when you are offered a job in a startup where equity is being offered, it is worth asking a few simple questions. You need to know how many options you are being offered. You need to know where the company thinks the strike price will come in at (they can't promise you an exact price). You need to know how many shares are outstanding in total so you can determine the percentage ownership you are being offered and the implied valuation of the strike price. And finally, you need to know how much total capital has been invested in the company to date so you can decide if there is a liquidation overhang situation.
Just because there is a liquidation overhang doesn't mean you shouldn't take the job. But it's a data point and an important one in valuing the equity you are being offfered. Figure this stuff out going into the job. Because standing at the pay window and finding out there's no check for you is painful. Don't let that happen to you if you can help it.
Excellent coverage, and I feel a little more comfortable with the topic after reading comments here and elsewhere about participating preferred etc. Your example of a job at a startup with a liquidation overhang made me realize how far I am from an ideal position. If the right guy or gal was standing at the bottom of a cash crater and asked me to help fill it up, I’d grab a shovel and start building a mountain. Thank goodness for non-linear work transitions.Bonus points for pay window references
i am going to try to use the term “pay window” as much as i can!
I think we need a guest post from JLM devoted to the “Pay Window”
i asked JLM once to elaborate on what he meant by the pay window – his response his here – http://bit.ly/cG2LIm
Fred, I’m a little confused. Most VC’s get participating preferred stock, so don’t they also get a dividend on their investment as well as pro-rata on the amount above their initial investment? In your initial example, the VC would get more than their initial $1M back, no?
i don’t think most VCs get participating preferredi haven’t seen it in a term sheet in years
fred, are you saying you have ONLY seen straight preferred deals “in years”?That is, you have not seen any deals in years other than straight preferred?Scott, “dividends” is a completely separate issue from whether investor stock is “straight preferred” pr “participating preferred”. In some deals (some very egregious delas, IMO) investors get both — preferred stock with or without participation, PLUS accruing dividends (which essentially always are only paid out in an exit)
i see it a bit in europe, but not in the US these days
Steve – I find participating preferred is still fairly common, particularly in businesses with deep IP where the company has real salvage value even if things don’t take off and so there is a meaningful economic difference for the VC. In web 2.0 businesses, I see it less because if things don’t work, there’s very little salvage value. In the end, it’s a point of negotiation between the VCs and the founders. I’m not personally religious about it. I know others who are on both sides of the equation (and that’s a whole separate blog post in and of itself).
Jeff – thanks for that clarification – my experience has been to see participating preferred, but the companies I’ve been with have been mostly enterprise software, so that jives with your point and clarifies why Fred doesn’t use it given their web 2.0 bent.
Steve – understood regarding dividends, I was just looking at all the ways money goes to the investor(s) before it gets to mgmt/employees. While Fred’s example is very easy to understand, my experience is there are usually other things that take money off the table before distribution to common shareholders. I’m not sure how common it really is to do straight preferred with no dividend, even though it seems it is standard for USV. It sounds like you agree.
Interesting – over here in the UK the good early stage VCs are definitely going to a 1x preference (i.e. money back or share of proceeds – rather than both) but are generally insisting on a low dividend (around 4-6%) which only serves to raise the exit hurdle (or the liquidation overhang, as you call it), to guard against a poor exit after several years eroding the preference.I’ve also recently written about some of the metrics we’ve seen in early stage deals in the UK here in case you’re interested: http://bootlaw.com/2010/10/…
Some data on the subject:http://vcexperts.com/vce/ne…
Fredlanders, Off the topic question.We had a PE firm investing $3.6mm (equivalent in our currency ‘rupee’) in three trenches. After investing the first 1.2mm now they are running short of cash and have asked us to go for funding from elsewhere and are ready to take back their 1.2mm without any strings attached (spelt out clearly in email).The question i have isi) Should we take a separate document signed with the problem mentioned above before going to other investors (to avoid any LP clauses in the original document we signed).ii) How would the next investor will take it … will there be a negative impact on the confidence of company performance (we are still in pre-production stage). But we are sure we should get better offer because of recent developments in alliances and orders from multiple vendors (local and abroad) for our system.To give some background … we are medical devices company (radiology) and have pilot units (20) installed and clinical validated+UL+ISO certified.
Here’s what you need to do1) amend their deal to provide that they will not invest more capital andare not entitled to any more ownership2) do not agree to get them their money back. That may make it harder tofinance the business3) take an option to buy them out at their cost for the next year. If youcan raise enough capital at a high enough valuation to make this work, thendo itIn my mind they reneged on a contract. You don’t owe them much other than totreat them fairly as a shareholder going forward
Thanx a lot Fred. I will pass on the same advice across to our board tomorrow.
Thanks for this post. In your examples, you assume the liquidation preference is 1x, right? But can’t it be higher in reality – 2x, even 3x? Does that mean that the investor first gets 2-3x his investment out, and the rest gets shared prorata?If the exit is huge, like the examples mentioned, that might have less of an impact on employees. But if it isnt (as in most exits) then employees still might walk away with with nothing even if there is an ROI for investors.Would this be a question employees should ask too therefore – i.e. what is the liquidation preference? – and is this something a company would be expected to share?
I said in the post that I was talking about straight preferredThat is the most common type of preferredI haven’t seen a 2x or 3x preferred in over a decadeThey do exist but not in the term sheets of good early stage VCs
Actually, Charlie, “straight preferred” is 0X (zero X) — as Fred indicates, investors get EITHER their capital returned OR their pro rata share of the gross proceedsFred, do you never see 1X? Where investors get BOTH their capital returned AND their pro rata share of the NET proceeds (the balance proceeds after investor capital is returned)? My info is, 1X is still pretty common in venture dealsAlso, Fred, I am a huge fan of your posts on these topics — so lucid and simple and so valuable to entrepreneurs to get this education! I would challenge you to go one step further: why not use your Flatiron and USV portfolio companies to provide real world data (rather than conjecture)? Of course, only aggregate or anaonymous data, no need to name names. That you could provide very real market and deal and outcome data, but do not do so, has always struck me — why not do this?
it takes work on our partand we are busybut it’s a great idea and we should do that
By the way, a couple of California law firms put out helpful quarterly studies on certain VC deal terms, including Fenwick West (i.e., http://www.fenwick.com/publications/6.12.1.asp?vid=14), which includes quarterly stats on the use of participating preferred and liquidation preference multiples (as you’ll see in that linked study, 35% of the deals they looked at in Q2 had participating preferred and 17% had multiples>1x). As far as I know, there isn’t a similar study on the east coast (there was a Boston firm that monitored deals in their coverage area several years back, but I believe they stopped). Anecdotally, in the mid-atlantic/Southeast, I would say participating preferred is in the overwhelming majority of venture deals (and angel deals where the angels use preferred), sometimes with a cap, but multiple preferences aren’t used by reputable investors, except in special/distressed situations to deal with a specific kind of concern, and is more prevalent in follow-ons in down markets.
I have a question – since web companies have become so inexpensive to build are you taking larger ownership stakes for the same amount of investment than you would have say, 8 years ago? i.e. Does $5mm investment buy you a bigger share of the company now than it did in the past? Does it follow that early-stage companies have decreased valuation because the startup costs are less (implies low barriers, etc.)?I had a situation in which my employer refused to tell me the # of shares outstanding. I guess because he didn’t want me to figure what the co was being valued at (or what I was being valued at). Finally I got it out of him. After signing the papers. Didn’t know any better then.p.s. Don’t know your policy on making edits post pub but I noticed two typos: 9th pp 1st sen. now –> not; 2nd to last pp, wrong “there”.
Thanks for the tips on the typos. My policy is that I love it when readershelp me copy edit. I’d love it even more if you could do the correctionwhile reading subject only to a quick approvalAs to you question, valuations have gone up and ownerships for investorshave come down. But returns have gone up because we have less 50mm blowupsthe kill all the returns On Oct 25, 2010 8:19 AM, “Disqus” <>
That would be a nice browser extension. “CrowdEdit”, maybe…
yes, i’ve been suggesting someone build this for years
loving the phrase “the gift of web economics”makes me feel warm and cuddly. like I’m in an open source house, surrounded by creative commons furniture, lying on a cloud bed wrapped in a zero marginal cost duvet
That’s what it isAnd I am a beneficiary
perhaps not financially, but every web user worldwide is a beneficiary of the gift of web economics.
Sounds like a Startup Employee Equity Value Calculator is needed. Similar to the standardized simplified seed docs that have come into being. Might be tough to capture all the weird financing scenarios that people come up with but I think most of them could be reasonably generalized into a few types. Include a warning, “if it’s too weird for this calculator to capture don’t take the job!”
This is absolutely crucial.
Hi FredYou said: “ends up getting sold for $100mm, then the liquidation overhang will clear (at at sale price of $65mm) and the employees will get $15mm in the sale for $100mm”.at 65mm with the VC owns 75% will result : 65 * 0.75 = 48.75 close to the 50mm invested but still with a loss. Have i misunderstood something ?
you did the math right. i approximated the $65mm. it’s a tad higher
I know you don’t like them- thematically, this seems related to convertible debt (either equity or payback). How do you know if the payback is worth it? (fair valuation in both)How do you know if you are an employee how negatively diluted you are? What are you calculating against after all of this- shares outstanding, liquidating preferences, any other mystery?
Thanks Fred, these posts are really helpful. MBA Mondays would make a nice book.
A little off topic I know, but what is considered to be a “typical” employee stock option package? Meaning, how much of a percentage in the company is offered to the first few employees in a tech startup?And along similar lines, for a company that’s bootstrapping (with preferably $0 outside investment) do you recommend C-Corp, S-corp, or LLC?Please anyone feel free to chime in.
we covered corporate entities back in the early days of MBA Mondayshttp://www.avc.com/a_vc/201…there is no typical but the first few employees generally get >1% and less than 10% each, particularly if they are key developers
Thanks!I read that post, my mind seems to have blanked for a moment.
That would have been helpful to know years ago.
Fred – one of the things I suggest all of my companies do is periodically calculate the “liquidation waterfall” across all classes of shareholders. When they “follow the waterfall”, employees get a very clear sense of the impact of the liquidation overhang in black and white. It’s amazing how few CEOs and CFOs do this as a natural course of business.
that is a fantastic suggestion Jeffi will start making it myself
Agreed. Too many company founders still don’t understand the affect terms will have on their stake in the company. While many would argue this is the attorney’s job, why not do it yourself.http://pedatacenter.com/ped…
Doing attorney job probably will not only save the cpendings of the company but also increase the job for yourself?
The problem is that people do not like to disclose this to their employees. Since the more information you control the more asymmetrical the bargaining position between you and the potential and current employee. The founders who know do not tell to lower bargaining costs/positions. I can completely understand this but then they can’t complain when good talent(which is not me) bargains heavily for heavy cash present value implicit compensation which they are reluctant to deliver and try to obfuscate with equity option plays where you do not really know where your standing.Its like a game theory play between two people and that’s how it is.My feeling is that talent even mediocre talent got wise to it and it is not due to the experience in the 90s and 2000 as Fred has implied. I do like what he posted today because its a more realistic picture of how things are but does not change the way the game is played. I am not against how it is played just do not like the implied expectations that you as an employee should opt to play within the framework presented to you instead of creating your own bargaining position.
As a current employee (read: not founder/CEO) in a startup I see two huge benefits from these posts.-Better CEO’s and more transparency for a very sticky topic. So thank you for developing better leaders.-Like McDonalds marketing to children via TV ads, Fred is creating a future market of entrepreneurs for USV to work with.Smart. Very smart. I know you are thanked often but this community greatly appreciates your efforts.
Awesome post. Congrats!
Great post from a descriptive, mathematical perspective, but what does it mean in prescriptive terms? i.e. at what point does a company whose employees are facing a large liquidation overhang (and having read this post understand what that means!) need to think about taking some action to restore employee incentives?
Fred – thank you for walking through the mechanics of employee equity and liquidation overhang. Over the last few posts, I couldn’t help but notice how pro-VC the tone was. You made it seem like VCs are entitled to get their money back, which is tough to swallow from the entrepreneur’s perspective. I understand that preferred securities have that right, but is it philosophically a good idea?Let’s remember that the price of exits it largely determined by exogenous factors: stock market prices, how well the economy is doing, etc. However, the timing of the exit is controlled by VCs, since they control most of the company. The mistakes of overpaying or forcing a poorly timed exit are made by the financial entity (VC) but the consequences are largely borne by the founders and employees. Doesn’t this seem unfair? It would seem so to me, especially given the promise of value-add by VCs.I don’t mean to be hypercritical of VCs here. They take risk and deserve to be rewarded for that. But it appears that using a preferred deal structure could burn a lot of goodwill and push a lot of talent away from future entrepreneurial endeavors. Of course, this whole issue could be arising from entrepreneurs, not the VCs.Why not just sell the common equity for less and have everyone on the same page?
would you do that with your own money?i would not and i would not expect anyone else tothese are super risky venturesa good number crash and burnwhen there is an exit that gets the founder a payday, i want to knowthat at a minimum i am getting my money back
It just depends on the tradeoffs, right? Imagine you a VC was presented with (or made the pitch) to do a deal for either 30% preferred or 40% of common at the same price. VC gets more upside and more downside. Entrepreneur gets less upside and less downside.For an entity like a VC that wants to concentrate and silo risk as much as possible, this would make sense. For an entrepreneur, taking a few eggs out of the basket. It sounds like a potential win-win. Or does the complexity of investing with multiple VCs prevent this? We as observers get to see that deals get done, but with little insight on terms or investor and founder perspectives.
Ahhh… but it isn’t your money – it is your LP’s money. However, for the founders and the employee’s it really IS there money.
yes and noi have a ton of my own money invested in our funds
I would love to ad a ton of great additional insight, but you have done a great job Fred!I would simply say that your simple example makes things understandable, but people should realize that in smaller companies finalization of the purchase may be contingent on specifics of the agreement and the final division of funds to investors, founders and employees may take years (and may be even less than assumed worst case scenarios.Keep of the great education. It helps everyone involved with these programs.
Isn’t this actually a disincentive to work for a startup that raises too much money? If so, is it the same impact for earlier rounds as well as later rounds of funding?
Preferred stock is not a well balanced deal for entrepreneurs. The rationale is based on the large amounts of money VCs invest in the company. But, how do you define “large”? Most probably it should be not an absolute measure but a relative one, ie: entrepreneurs sometimes put all of their savings and property at risk, which makes their investment “larger” than VCs.IMHO, in an overhang liquidation scenario, proceeds from the sale should be split between VCs and entrepreneurs in proportion to the money invested in the company plus an arms lengh valuation of the hours spent at the company.What do you think?
This is great post, Fred especially for startup employees to be aware and do their research in selecting right startup to work for based on their risk appetite.However, I find things strange in India. Hardly employers disclose ‘total stock outstanding’, not even ‘total money invested’. This makes employees just do wild guess on how the startup is based on the product they are developing and the team they have.I hope as more and more seed and early stage investments happens…such things would become more open to discuss with potential early stage employees.
Fred:I find that I really understand things best in the context of their historical development.How about a history post that traces the evolution of VC financing/capitalization structures from the days of Fred Terman to the days of Fred Wilson? :)I am sure this complicated picture of all sorts of interlocking instruments that manage risk in interwoven ways for multiple classes of stakeholders did not evolve overnight. So can you (or a guest poster) explain the major developments and the specific historical trigger events that caused evolution in the instruments? Is convertible debt, for instance, an old instrument coming back in fashion, or an innovation? Has more ‘quant’ analysis capability changed the sophistication of instruments in common use as it has on Wall Street?This would especially valuable given the big shifts in VC markets that seem to be happening (the predicted overall shrinking, and the restructuring due to the emergence of superangel/micro VC). Are the current events unprecedented in magnitude, or did similar seismic shifts occur in the past? Was it a smooth evolution or a jumpy one?Or if there’s a book about all this, I’d appreciate a reco.
start with this bookhttp://www.amazon.com/Creat…
Fred,Another consideration for (potential) employees: the liquidation math you highlighted isn’t set in stone in a sale scenario. Buyers are going to be interested in retaining the key people, particularly in cases where a company is sold near the value of preferences — a sign that business hasn’t gone to plan and the company is being acquired for people and technology vs. cash flows. In those cases, buyers may tilt consideration towards employees by either requiring a rewriting of the cap table (eg waiving preferences) or carving out a significant chunk of consideration for employee retention. Shareholders don’t have to agree to this, but if the offer is their best outcome, they likely will. Therefore, key employees at companies with a big liquidation overhang may end up better off than implied by the waterfall. I’m not sure this nuance should factor much into potential employees decision to join a company. If you think the business will do well, this won’t matter. If it doesn’t do well, there are any number of bad outcomes.
Fred,I wonder if startups answer the “simple questions” you’ve suggested. Is that your experience? What do your portfolio companies do? (Or are potential employees not asking the simple questions?)Thanks,Saul
there is no standard practice in our portfolio companieseach company has a slightly different approachi am a fan of transparency in these things
I really appreciate this post Fred. Very useful and clear! My favorite of the MBA Mondays!