Milton's "Three Things You Must Have"

Milton Pappas and his partner Bliss McCrum taught me the venture capital business. I was 25 years old and straight out of business school at the time. Ten years later, I left their firm and started Flatiron Partners. I owe a debt of gratitude to Milt and Bliss and part of the reason I blog every day is to pay it back by paying it forward.

Milt had three things he would never invest without. I have kept them and they are mine now. They are:

1) A liquidation preference

2) A right to participate pro-rata in future rounds

3) A board seat (or an observer seat and information rights)

That doesn't mean we don't expect and ask for a lot more in our standard term sheet. But what it does mean is that these three terms are non-negotiable for me. I won't invest without them.

A commenter on yesterday's post asked me why I would not invest without a liquidation preference and here is how I responded:

i invest $1mm in your company for 20%

the company is six months old and this is the first investment of outside capital

a week later you sell the company for $2.5mm

you get $2mm for six months work

i get a $500k loss

does that sound fair?

no it does not

that is why there is a liquidation preference

to protect investors from that happening to them

Some investors are willing to take this risk or structure governance and controls to protect them. I prefer the elegance of the liquidation preference. If you can't get me out at a better valuation than you want me to invest at, then just give me my money back. It's simple, it works, and it has stood the test of time, from Milton and Bliss to me and hopefully to all of you.


Comments (Archived):

  1. kagilandam

    1X LP is fair … but there are guys who demand more like 2X and 3X… which is unfair to the entrepreneurs .

    1. DonRyan

      Agree. 1x LP simply makes the investor whole in the event of a sale. The usurious 2-3X LPs are ridiculous.

    2. fredwilson

      totally agree

      1. davidu

        Does the 1x liquidation preference you require include participation rights?I think that’s double dipping, and is unreasonable. That said, a 1x preference makes complete sense as long as it doesn’t also include participation rights.

        1. Alex Murphy

          That’s not double dipping. That is giving a return for the contribution. If the investment came in at a $4MM pre, and the company put $1MM in cash on the books, and then 7 days later sold for half of the post investment valuation, then by all means the investor should get a return.On a side note, the example is a little ridiculous but certainly could happen. In the event it does, the entrepreneur should be flogged.

          1. davidu

            You don’t understand my question and your example is ambiguous.Participation Rights are very clearly explained:If the investor puts in $1mm in a $1mm pre then the company is worth $2mm and the investor owns 50%. If the next day the company sold for $3mm and you have a 1x liquidation preference then you have two possible outcomes w/r/t participation rights:With Participation Rights: $1mm returned to investor, then they convert to common and share the remaining $2mm 50/50 leaving the investor with $2mm and the common holders with $1mm.Without Participation Rights: The investor evaluates getting the 1x pref of $1mm vs converting to common. Since a conversion to common would net them $1.5mm ($3mm split 50/50) they opt to convert and forgo their liquidation preference as a preferred holder.To me, a 1x liquidation preference is a protection measure, but if you also get participation rights then it’s a double-dipping technique, which is bad. So I am happy to give investors a 1x liquidation preference, but only if they forgo participation rights as a consequence.This aligns all interests best, imho.

          2. Alex Murphy

            Why would they split the remaining 50/50? Wouldn’t the investor take 20% of the remaining 1.5?

          3. davidu

            I have no idea where you get 20%.But anyways, Fred has answered about his views on participation rights before (I didn’t remember):…And his views are spot-on, entrepreneur friendly and are exceptionally well articulated.

          4. Alex Murphy

            The 20% is the % ownership the investor bought in the example above. I don’t think it is a 50/50 split. Regarding the participation, it depends on limits, expectations etc. As Fred noted, there are cases where they do seek it out depending upon the situation. It is one of many levers to use in the discussion.

          5. JLM

            If something like that happens, then the Board is a bunch of scoundrels and Management is worse.

          6. Alex Murphy

            If this scenario actually played out this way, then I 100% agree. However, I have to think that this was simply an example.

      2. Mkogan

        seems to me that 1X LP is fair if it has a time limit. If it has no time limit asking an entrepreneur to provide a floor for the value of the investment is not fair. Once you own the equity of the company at whatever price you paid for it, then its your problem if the valuation turns out to be too high. Why not have a 5 year time limit on the liquidation preference?

  2. Guillermo Ramos

    Fred,Thank you very much for your answer, I do learn a lot with your MBA posts. My yesterday´s question was more about the fairness of the liquidation preference in certain scenarios. I included the following comment to your answer.this is an example were we both agree, but let me show the one I´m thinking about:I found a company were I invest in cash $ 0.2 and the team work for 18 months with very low salaries or none.You invest $ 1mm in my company for 20 %After 2 years we sell the company for $ 1mmYou get all your money back.I don´t get any money (+ none of the 18 months low/none salary period)does that sound fair?my point is that liquidation preference is probably quite unbalanced in cases like the above mentioned, which by the way is quite common

    1. fredwilson

      yup, saw that. i replied to it.i don’t understand why the entrepreneur would sell in that situation.he or she would be better off shutting the company down.which means your scenario doesn’t happen. the investor and theentrepreneur negotiate a new deal if they both want to see the companysold for $1mm.

      1. Guillermo Ramos

        the entrepreneur would sell because of drag alone clauses, admitting the failure or starting up a newco.What would be a “common” split of the $ 1m in the “new deal” you mention?(while I´m writting I´m dreaming about having a nice Videconfcall on MBA Mondays where we could all meet for 30 min. and ask you questions… Thanks a lot for your time.)

        1. fredwilson

          i replied on the other threadbut the drag is a real issue. nobody should be dragged into a salewhere they make nothing.the other two are not real issues in my mind and i explained why onthe other thread

          1. Guillermo Ramos

            Ok thanks. I guess my question about “common” split of the $ 1m in the “new deal” you mention” is way too intimate.

      2. Harry DeMott

        This may sound heretical – but there is one thing about this comment that always irks me:”I don´t get any money (+ none of the 18 months low/none salary period)”This concept that is bandied about that people who work at start-ups are somehow entitled to the full salary and benefits of someone working at Cisco or Google or whatever makes no sense to me whatsoever. It is certainly a free world and people can work wherever they want. If you go to work at a start-up you do so with your eyes open, and the trade-offs you make, in terms of salary and benefits and offset by a more robust work environment, more personal freedom, the ability to rise up faster in an organization, and most of all – in the opportunity – IF SUCCESSFUL – to make more $ because of the culture of equity ownership. I’m sure I’m missing something in that list – but the point is the same.The idea that you should found a company have someone put in $1M and then complain about an investor – who gave you an opportunity to grow the business – because they are getting their $ back and you are not getting compensated for the opportunity cost of the venture is ludicrous to me. The investor could simply look at everything else and decide that they have an implicit opportunity cost as well.So for every deal that is not successful for Fred, he can look and say, why didn’t we put that money into Zynga – so not only do I want my 1X liquidation preference, I want a 35X liquidation preference – because that’s how much I made on Zynga so far. (I have no idea what it is, but I am guessing I am not terribly far off)Everyone gets something in these deals. If you are a founder – you get a shot at the title. You get experience. You get a playbook for the future. You get contacts. You get an education and someone else is paying for it.Similarly, the investors get something as well. They get an opportunity to make a return. They get contacts. They get more accumulated wisdom for future investments.Looking at things solely from one side is a big mistake – and I see comments like this all the time one way or another.Just my point of view.

        1. David Semeria

          So Enron investors should not only get their capital back, they should get back what it would have been worth if it had gone into Google.Two words: caveat and emptor.

          1. Harry DeMott

            A bit of a twist on what I am trying to say which is:I don’t like the idea that anyone is entitled to anything. If you choose tomake an equity investment then as you put it – CAVEAT EMPTOR. If you chooseto work at a start-up – then you are not necessarily to entitled to lostwages for your hard work.Start-ups are like working at a hedge fund to some degree. If you are notsuccessful – you get paid far less than you would if you worked at a biginvestment bank. The pay scales are obviously vastly different – but fail ata hedge fund and you will not get paid and you will be fired – and your fundwill be shut down. Your investors get their capital back – and you getnothing.Not unlike the start-up world.

          2. David Semeria

            I agree that some founders too want to “have their cake and eat it” ie both market wages and big upside potential.My dislike of liquidation preferences is focused more on self-funded startups who create a lot of IP which they risk losing through no fault of their own (eg Google, FB etc offers their product for free).

          3. ShanaC

            Hedge funds pay small base salaries, startups can pay none.- that seems to be the larger issue. When you are young, it means that you have the ability to not work out of your parents basement, or pay for health insurance by yourself.So you either believe that some particular startup is going to be huge, or you have the potential as an employee to make very little (liquidation of your stock is going to be at much lower rates, potentially not enough to cover you)

        2. Guillermo Ramos

          HarryLet me try to explain my point.There is a market value for a talented team of 5 people working for 18 months that is easy to translate into $s.Your point is that the investor gets these $s for free? So entrepreneurs $s are not equal to VCs $s?In a LPreference scenario both the investors and the entrepreneurs may loose 100% of their investment. So both are assuming a big risk. Is it unfair for the entrepreneurs to ask for a $1= $1?Looking at the same issue from a relative point of view. Entrepreneus are putting at risk 100% of their time and sometimes 120% of their wealth. VCs bets per company are usually less than 15%.I think it is fair to give value to entrepreneurs assets in case of a LP scenario. Proceeds should be split on a fair basis. What you propose is not fair IMHO.And, by the way, I know a lot of entrepreneurs that think working for a big Co is not an alternative. They are entrepreneurs by nature, to the same extent there are (a lot more) people that can only work for a big Co.

  3. herve

    A key question for me is at which level should liq pref stop? I agree with your protective view of the thing, but when does it begin to be unfair to the team. There is something else not much mentioned: you know that liq pref does not work in case of IPO; but what about M&As? Are acquirers uncomfortable with the structure as they know they will work with the team in the future, but most likely not with the investors…

    1. fredwilson

      it doesn’t matter in an IPO because everyone converts to common in an IPOin a sale, it only comes into play when the company is being sold fora price that is less than what it takes to get the investors theirmoney back

    2. Dan Sweet

      you asked “when does it begin to be unfair to the team”? in my mind it doesn’t. the founders are signing a contract when they take money. they don’t have to sign. this is why people shouldn’t always just raise the most money possible. don’t take 10 million for 20% of the company if you can’t ever see yourself selling for more than 20-30 million. if you do this, you are just kidding yourself and your employees. the whole green energy space is littered with companies who took too much money (and VCs who invested too much). this is why the founders and other top executives are always leaving, joining competitors or launching new startups. it is obvious to them there is no upside left for them. this myopia up front can cause a lot of pain down the road.

  4. David Semeria

    Here we go again….I could pull out my counter-example of the founders losing everything (including years of uncompensated sweat equity) whilst the VC gets out whole….but we’ve been through this many times on AVC.Perhaps more any other topic, liquidation prefs really polarize the startup community.

    1. kagilandam

      If we make LP time bound (say valid only for 12 months) then it will be more appealing to the founders and it will solve most of the problem you mention. But alas the man with the money makes the rule 🙂

      1. fredwilson

        that is not trueit is the talent, vision, and creativity of entrepreneurs that is in short supplythe man with the money is a commodityi can assure you of that

        1. baba12

          Possibly accurate, but most of the VC’s I know and those I read about are probably the most risk averse people I have met. They will not invest in talent/vision and creativity alone, they want a proven track record to go along with or a extremely close connection to them through their network of friends.Taking risks would be diminished one would think given so many web services require very little capital yet that is not necessarily the case.Money people maybe a commodity but it is also a oligopoly.

        2. paramendra

          That’s your VC perespective. But I can’t fault you for that! You are – it says out loud at the top of the page – AVC. 🙂

      2. David Semeria

        I think many people are suspicious of liquidation prefs because they allow the investor to “have their cake and eat it”All the upside of an equity investment but with the seniority (and therefore downside protection) of a loan.Whatever happened to: “You pays your money, you takes your chance” – a cornerstone of capitalism.

        1. Harry DeMott

          My guess is that if someone came to a VC with a highly risk new business plan and demanded that the cap structure was an equity only cap structure that the VC would demand a far greater chunk of the business from the founder than if he had a liquidation preference. I view the preference as a valuation gap tool – which is why, even in the 2X and 3X versions – I understand them. They may not look fair – and I can see your point – but very few people (I think none) are handing over $1M on a $4M pre money valuation just for an idea with no revenues and cash flows.

          1. David Semeria

            Fair point. But what about all the competition we’re hearing about to fund the best deals?Surely the market sets the valuation, and hence the constant presence of liquidation prefs could perhaps be viewed in an anti-competitive light? That said, I’m hearing whispers of VC’s being more flexible on prefs as a way of gaining access to deals.For what it’s worth, I think the whole issue could be resolved by giving the investor a veto on any exit which values his/her stake below par.

          2. Harry DeMott

            It is certainly a supply demand driven marketplace – for capital, both humanand financial – and those dynamics are going to drive and dictate the termsof agreements.If VC’s believe so strongly in a concept or founder perhaps they go a morecommon route – or a capped convertible – or even an uncapped convert (withthe converts aren’t we just having the same conversation)To me it is all about risk and reward. The more reward you see, the morerisk you are willing to bear.Liquidation preferences are merely a tool to deal with risk and reward in aprivate company setting. More equity like than debt – and everyone goes intothem thinking that they will convert to equity when the company issuccessful.Giving anyone a veto is a dangerous thing. Too often you get into situationswhere one party holds up the others because they have a veto – so I would bevery careful on this one. If the company needs to be sold because it hasgone sideways – there should be an amicable split that allows everyone toget out.

          3. David Semeria

            Your valuation gap argument makes a lot of sense, but it would be more persuasive if it were common practice for VCs to offer founders a choice: lower valuation without liq-prefs or a higher one with. But as you know, this doesn’t happen.As regards vetoes – a liq-pref is a form of veto. It forces the two sides to re-negotiate terms to get the deal done.

          4. Harry DeMott

            Just theoretically, what would you rather haveA. $1M at a $4M pre money – VC owns 20% but with a 1X liquidation preferenceorB. $1M a $250K pre money – VC owns 80% but it is all common stock.If you think you are going to be even modestly successful – the answer is A.Anyone bold enough to start up his or her own venture believes in themselvesstrongly enough to bet on themselves – and that is exactly what choice A. is- a bet that theycan create more than $1M of value.I disagree with your second point – a liquidation preference is not a vetoper se. The investor can’t force you not to sell the company – they simplyexercise their rights. It is perhaps a pocket veto – or a deterrent to a lowball sale – but it is still up to the founder (at the earliest stage) andthe board to make the decision.

          5. David Semeria

            I choose C

          6. Matt A. Myers

            Great discussion David and Harry. Thanks. 🙂

          7. davidu

            A veto right? No way.At least in an acquisition where a preference takes all the proceeds the employees can get an earn-out package.In your scenario, maybe the company just goes out of business instead? That’s a scenario I wouldn’t want to force.

          8. David Semeria

            It’s the same with a liquidation preference. Why would common stock vote through a deal where they get practically nothing?

          9. Matt A. Myers

            I personally wouldn’t feel very confident investing in a business who wasn’t confident that they’ll at least be able to build a company at least a bit more valuable than the investment they get.

    2. fredwilson

      except that i have never seen your scenario in 25 years in the venture businessit just doesn’t happen that way even though the contract says ithappens that way

      1. David Semeria

        Perhaps not the limit case were the common gets exactly zero.But startup history is strewn with entrepreneurs who have been on the wrong side of liquidation prefs (a quick visit to The Funded will confirm this).Why do entrepreneurs agree to a sale under such terms? At the end of the day, a small windfall is better than nothing, and – as you always point out – if your keep you reputation intact you can live to fight another day….

        1. fredwilson

          investors are under the same constraintsyou fuck over an entrepreneur at great risk to yourself and your firm

          1. Mark Essel

            I think it’s high time you guys sat down for that drink over this one.

          2. fredwilson

            we gotta figure out how to do that in some really fun way that getsthe whole community involvedbut i agree with youit’s time

          3. Pete Meehan

            I have some thoughts on this, and the platform to do it soon, but best I package the idea first.Anyway… imagine the value, entertainment and otherwise, where a live video feed coming out of say a coffee shop where the investor and entrepreneur work through the terms.Even in ‘draft mode’ it would be illuminating.

          4. David Semeria

            I remember that! I think we agreed on our liquid preferences…….

          5. Matt A. Myers

            Thanks for the LOL.Regarding getting the whole community involved in an event, I’d say at minimum a live video feed to a live..Oh I know. Perfect. Shot for shot for each valid point made (voted on live by the AVC community). I don’t officially endorse this as I don’t drink, but this could be fun for the viewers. 😛

        2. RichardF

          I’ve seen the common get zero plenty of times, including employees who bought stock as part of a “friends and family” scheme.A bridging loan is used that wipes everyone else off the slate. It’s the doomsday scenario where management/loan provider are just trying to find a buyer for the company to salvage something.It’s a tough one but at that point everything is up for negotiation.

          1. David Semeria

            Good point Richard – but that scenario is more in the “rape and pillage” category and not really specific to liquidation preferences.

          2. RichardF

            lol (rape and pillage) …..true

          3. ErikSchwartz

            My experience with bridge loans is you better know damn well where, when, and a good idea as to what price the next chunk of money (after the bridge) is coming from. If you do a down round out of a bridge then the investors own basically the whole company.

          4. RichardF

            That’s great advice Erik.

          5. fredwilson

            As Bliss used to say:”It better be a bridge to somewhere “

          6. paul

            that’s an awesome quote

          7. Denimrsmith

            Or it better be a bridge and not a pier. Make sure you can see the other side clearly.

        3. markslater

          david – i’ll hazard a guess that a great deal of those are a mismatch of partners from the outset. An entrepreneur should not accept 2 or 3X LP unless he is desperate (in which case the investor is stupid to invest) and the investor should not impose these terms as the person accepting them likely has no other options – either side of this ends badly IMO.

      2. Hank Williams

        Well, I am sure it doesn’t happen a lot, and I don’t want to make most investors out as bad actors, but I also have personal history with the investor named in the below quote, and according to the San Francisco Chronicle article listed below, these things (and much worse) *do* happen. I have pulled a small quote from the article, which is 6 pages detailing some of the worst practices of silicon valley investors. Today the world may be different as founders may have more power. I suspect your reputation as a good guy probably also keeps some of these practices from happening in front of you.———–With the help of company counsel and Wilson Sonsini partner Adam Dolinko, they negotiated an agreement that called for loans to be paid first, then the noncompete agreements, then the series B through E preferred stock and, finally, the series A preferred and the common stock.The deal went down on Feb. 11, 1999, with Applied Magnetics paying about $65 million in stock for Das Devices.But after trickling through the descending levels of debt and equity, there was just enough money for the board of directors, Sierra Ventures and the other investors.Das got nothing. His more than 1.7 million shares of series A preferred stock and 5 million shares of common stock were worthless.Front page of article:…page 6 of article where above quote is pulled:

        1. fredwilson

          you lie down with dogs you come down with fleasand there are a lot of dogs in the venture business

          1. paramendra

            There is that human nature element that permeates all human groups. There are assholes in the movie industry, in the venture capital business, there are asshole tech entrepreneurs. You have to stay on the lookout.

        2. Rahul Jaswa

          Wow, Hank. Thanks for posting this. Turns out that cute little Indian kid on the front page is my now, adult-aged, best friend, who works at Playdom, a social gaming company that my VC firm, Bessemer, funded.Unbelievable coincidence..

          1. Hank Williams

            Your friend is Shyam Das? If it is I’d love to chat with him some time. We could share war stories.

          2. Rahul Jaswa

            Shyam Das (and also Narpat Bhandari, also in the article) are two of my family’s closest friends in the world. Apparently all our friends have gotten punked by VC firms.. no wonder nobody has been enthusiastic about me and my brother both working for “corporate” VCs at all the family parties ;).Happy to put you in touch if you. Shoot me an email at [email protected] and i’ll pass it along!

    3. markslater

      I have to say – if you have ever taken money from an institution or private investor, its a huge amount of responsibility. If you dont wake up every day or stay up every night feeling that pressure then you should give it back immediately.the moment you accept someones else’s money is the moment you have the ultimate responsibility of FIRST protecting it, and then growing it alongside yours. As someone who’s been on both sides of this, its important for entrepreneurs to set their expectations of entitlement when they raise capital. Work hard for an investors money and they will be there in the hard times – its worked that way for me so far. Likewise – i have had exactly the same experience when i have made the few angel investments i’ve done.

      1. David Semeria

        I don’t disagree with any of that, but I don’t see what it has to do with liquidation preferences.

  5. LIAD

    subject to having the necessary voting rights. no liquidation preference gives the unscrupulous entrepreneur a simple get-rich-quick scheme:VC puts in $1m for 20%Entrepreneur sells the company the next day just for the ($1m) cash in the bank.Entrepreneur makes $800k overnight. VC takes a big hit and looks like a shmuck.

    1. David Semeria

      Assuming the VC has no veto…..

      1. LIAD

        yeah, that’s what I meant by voting rights.

    2. Matt A. Myers

      Soooo, wanna invest in me with no liquidation preference? 😉 I hear it’s your fave!

  6. RichardF

    Do you publish your standard term sheet on the USV website Fred? I’d be interested in seeing it.

    1. fredwilson

      there are issues with doing thatwe could do that with a deal for a company that has not had any investment in itbut once other investors are in the deal with terms set, thenstandards go out the windowand that is 75%+ of what we deal withso there are issues with putting something on our websiteit may set the wrong expecations

      1. ShanaC

        If it doesn’t hurt your relationships with other firms and investors, can you write about how to manage a syndication, especially when it comes to terms

  7. Guest

    Hi, what does “mm” mean, as in “$2.5mm” ? Do you mean “$2.5M” that is, 2.5 million dollars?

    1. fredwilson

      i use mm to denote millionsalways have

      1. Dan Sweet

        at work m = thousand and mm = million. i was so confused when i started. my budget is HOW BIG!?!

        1. fredwilson

          Cool discussion about m and mmHacking education one m at a time!

          1. Rob K

            Roman numerals ain’t that hard.

          2. ShanaC

            mm is roman numerals for a million- they didn’t teach me that in school. I would read that as two thousand…

    2. Adam

      M is the roman numeral for ‘1000’, and is used as ‘MM’ in the financial sector (and a few others) to denote 1000 thousands, or a million (10^6).It’s common practice – so much so, that using ‘M’ alone usually indicates thousands, rather than millions (you can see this on a variety of financial documents, such as SEC filings).

    3. Bruno Morency

      Confuses me as well. I always used k to denote thousands and and M to denote millions (billions would be G)

  8. Mark Essel

    What I negotiate for and what I would accept are uncorrelated.I’ll always negotiate for as much as any party will give, and I expect them to do the same.If the final offer doesn’t meet a threshold, there’s no shame in walking away, deals fall through all the time. I like 1X.

    1. Matt A. Myers

      Make sure you know your value and the value of your potential investors though. 🙂

      1. Mark Essel

        Sure thing Matthew.Part of that process is learning what value the other party places on your participation in the deal, and knowing precisely what they bring to the table (beyond dollars, company building advice, reputation, potential buyer relationships).My comment is not to negotiate considering the minimum you’ll accept, because that commoditizes your efforts. There will always be someone cheaper than you, but will they do a better job leading a team/building a business or provide greater value? Without a track record you have to build something from nothing first as proof that you’re serious.

  9. Senith @ MBA tutor

    I think the discussion of 1X, 2X or 3X is not the key. The key is to make sure that both sides understand fully well what they are getting into. If a VC wants 2X and the founder thinks it is unfair he should just look elsewhere! If on the other hand the founder has no one else he can raise money for his idea, they he is getting the best possible deal and cant complain about this. Someone is willing to put money into your business at specific terms. If you think that this will not work out given your plans, then drop the idea at this stage! Dont try and work for 18 months and hope the VC will turn into a good guy feel sorry for you and change his term sheet.

  10. LIAD

    would be curious what “Milton’s 3 things you must have – the entrepreneurs edition” would look like

    1. Harry DeMott

      1. you must give up a 1X liquidation preference2. You must give up a board seat.3. Everyone participates pro rata.Smart-ass.I know.

      1. kagilandam

        How about only 1.1) Give me the money with no strings attached.

        1. Harry DeMott

          That’s a good first ask for the founder – but I doubt it gets very far!

        2. Alex Murphy

          They’ll Show you the money, but in order for them to give it to you they will want to tie you up.

    2. fredwilson

      Control the boardControl the boardControl the board

      1. David Semeria

        Even after your ‘C’ round?

        1. fredwilson

          No. That was tongue in cheek

      2. RichardF

        In which case that’d be the “Mark Zuckerberg – three things you must have”

      3. Adrian Bye

        maybe this is worthy of expanding on in a blog post

        1. Matt A. Myers

          I’d certainly like an expansion on this. 🙂

    3. Matt A. Myers

      I’m liking this and Fred’s reply because his answer seems important with its redundancy. 😉

  11. Druce

    Good example – the buyer is paying $2.5m for a company that now has $1m in cash, ie they’re paying $1.5m for the business. The founder is walking away with $2m, the $1.5m paid by the buyer plus $500k of your cash.

    1. fredwilson


    2. Max Kennerly

      It’s so bad it makes me doubt if the entrepreneur would get away with it without legal liability. Buying 20% of the company doesn’t give you anywhere near a controlling interest, but the board of the company still has fiduciary duties to you can’t make decisions that benefit them personally but hurt the other shareholders. Consider eBay vs Newmark, where the craigslist Board was gonged by the Delaware Chancery Court for, among other things, an unfair right of first refusal that diluted eBay’s investment.That’s not to say investors should not take a liquidity preference – trust me when I say that it’s better if everyone gets along than if they spend years in litigation – just that the investors may have legal recourse in the event the entrepreneur pulls the rug out from under them to benefit himself.

      1. Evan

        But, even if successful, the potential return on litigation wouldn’t come close to being worth it for the investment of the VC’s time.

  12. William Mougayar

    How do you determine the right ratio of LP?

  13. Dale Allyn

    As a businessman of ~ 25 years (import/export), and involved in three other businesses in totally disparate fields (including a tech startup), and one who is obsessed with “doing the right thing”, I could not enter in to a sales agreement of a company without making my investors whole. This just makes sense to me, as in 1X pref = doh!, it’s the first consideration in the sale.Blood, sweat and tears (founder equity) is meaningful, but that’s just part of the mix of avoiding a 9 to 5 job. It’s a choice. If I didn’t place the investors’ 1X return as the minimum acceptable outcome (and frankly that’s way too low of a minimum, for them and me) then I’d pass on accepting the investment.To me, if it’s not written into the terms sheet it would still be the minimum outcome. Some may say that’s naive and wishful thinking, but not so. VC equity or not, I still see it as a “loan”. However, that does not mean that I would accept usurious terms in the sheet.

  14. markslater

    fred – i have to ask whether that scenario has ever happened?1 X LP is the only fair way to protect your downside. anything above that i would walk away as an entrepreneur on principle.

  15. Sasha Baksht

    A liquidation preference is well explained! Liked it.

  16. Matt A. Myers

    I just read up on information rights (found at… via Google).Regarding information rights, what are you thoughts on thresholds?

  17. Don Holloway

    Great post, and nice to honor your early mentors. I recently spoke on a panel on mentoring at Lehigh University. As I was preparing, I realized how hard it is to communicate the impact of early mentors.One of my mentors Ed Johnson told me that his philosophy was to try and keep business private, but then hold it to all of the requirements of a public business.That has become a guiding principal in everything that I do. I thought your post was a nice way to pay it both backwards and forwards.

  18. baba12

    “That doesn’t mean we don’t expect and ask for a lot more in our standard term sheet. But what it does mean is that these three terms are non-negotiable for me. I won’t invest without them”.Seems fair. What I am curious about is what do you and USV want out of a deal besides the three non negotiable’s you mention. What do you expect more of.Do you Mr.Wilson, strive to strike a fair deal or do you say if the other side is gullible or is unaware of all the tricks etc you would take advantage of that. When I read your blog I feel possibly that you are a fair person and would not mislead anyone nor leave it tot he fine print for the other side to figure out.So when you structure a deal is there a fair deal that you say is a template you follow consciously or it is “buyer beware” as it is a dog it dog world.

  19. Michael Lewkowitz

    These three requirements are the absolute basics for an investor. If you are an entrepreneur that’s fighting those terms it means you trying to get our of keeping your investors whole, engaged, and informed… and that means you have bigger problems to look at.Building things that make the world better is a life long addiction. Be real, be honest and come to agreements that consider both sides. That’s where the best relationships show up and prove out.

  20. RJ Johnston

    Sounds like common sense to me.

  21. ShanaC

    How does your choice of what you sit on affect whether it will be board or observer rights/information rights? What do you have preference about

  22. perfy

    Fred,For some reason this post made me wonder, have you written previous posts on venture vs. Angel funding and why you prefer venture?Thanks

  23. Logan

    liquidation preference makes sense if the term sheet as a whole was my case worked 6 years on a project, 4 of them without paying myself a salary.2years paid less than the market salaries, and the investors (angels own more than 50% of the company) ask me to give me to give a personal guarantee for a bridge loan later.if a VC will ask tomorrow for a liquidation preference, why shouldn’t i ask for liquidation preference for all the years i worked without getting a salary and all the personal guarantees i gave in the past?As a result as a founder i am leaving the company in the middle of a negotiation round with potential new investors.

    1. PhilipSugar

      Working for below market salaries and personal guarantees are two things that get no appreciation….I feel for you. I’m going to write about that.

  24. Nick

    As a founder, I think a 1x liquidation preference makes sense and I’m perfectly happy with it. That said, I don’t understand why a VC would really care one way or another.As I understand it, VC is a hits business. There’s not much difference between a company that fails and one that returns 1-2x for the investors. They’re both “failures” in the typical VC model. Why would you care about an edge case that yields 0.5x rather than 1x?It seems like a bandaid for the real problem: investing in an entrepreneur who wants something you don’t want (i.e., a small exit). Isn’t the greater cost the opportunity cost of using a board seat on a company that isn’t going anywhere?What am I missing?

    1. Ethan Stone

      You’re missing the many ways the founders could try to take the money and run, rather than use it to swing for the fences. A 1X liquidation preference is a simple and effective way to take that out of the picture.

  25. Tristan Louis

    Fred,I understand the first two (1x liquidation prefs and pro-rata rights of participation in future rounds) but why the insistence on the 3rd (a board seat)? Wouldn’t the standard model (in early rounds) be one board sit for the founders, one for the investor class (generally the lead on the deal) and one non-executive seat (more often controlled by the founders but established in partnership with the early investors)?Or do you think it makes sense for entrepreneurs to increase the board size instead, giving more board sits to investors but also creating more board sits for their own side to ensure control of the board?

  26. paramendra

    Are there exceptions to the rule though? What if you came across the next Google/Facebook/Twitter/Etc? Would you forgo one or the other of the three?

  27. Farhan Lalji

    Fred, what difference would the LPs have actually had on the returns on your fund? If you had taken out the LPs in the total returns do you think that would have had a drastic effect on the total returns you gave back to your investors at Flatiron or at USV? For the record I’m okay with a 1x LP but I just wonder if in a fund that invests in lets say 10 companies where 2 home runs really make the fund, are the LPs in the other investments really impacting the overall returns in a major way?

  28. KC

    I agree a 1x liquidation preference is reasonable. The example Fred gives shows why.However, this also illustrates why the “nominal” valuation the entrepreneur is getting is a fiction.In Fred’s example the investor will sell the deal to the entrepreneur by saying the “with my investment of $1m for 20% ownership the post-money valuation is $5m and the 80% of the company you still control is now valued at $4m”.That is a very misleading way to present the matter. The investors 20% of the company is not worth 1/4 of the entrepreneurs 80%. Because the investor has an LP (and other terms) his share of the company is worth well more than 1/4 of the entrepreneurs share.I think it is fine for investors to ask for LP, pro-rata participation, etc. But lets not be misleading in how we talk about the relative valuation of the investors stock vs. the entrepreneurs stock.

    1. Ethan Stone

      I don’t think this is the right way to look at it. A 1X liquidation preference is simply a way of recognizing that the value of cash is different than the value of things other than cash. If the VC puts it $1 million, we all know how much it’s worth. It’s also completely liquid, so there are no costs or obstacles to realizing the value. The main reason for a 1X liquidation preference is to prevent the founders (who have generally put in little if any cash) from taking the cash and running, rather than using it to try to realize on the implied value of the company. $1 million may imply a $5 million valuation of the company, but that’s a guess and it also assumes the effective use of the invested capital. What the VC doesn’t want (reasonably) is for the whole thing to be reduced to cash with the VC taking out less cash than it put in.Anything above 1X is a different matter. It’s not really a question of fairness. As a commenter above pointed out, you can take it or not. But it does start to cut significantly into the value of the common equity for reasons other than simple protection of the VC’s invested cash. Those preferences aren’t about defense. They’re a way for the VC to state a minimum return it wants on its capital before it’s willing to share. I think the appropriate response to a proposed 2X or 3X liquidation preference (assuming you can’t or don’t want to walk away) is to counter with a cumulative dividend payable on a liquidity event and in preference to any other dividends. That deals with the same concern (minimum hurdle return on invested capital) but makes for a more reasonable discussion, since the actual hurdle rate and the time to exit are on the table.

      1. PhilipSugar

        Exactly right. Well said

  29. Rational Investor

    Fred Said: “i invest $1mm in your company for 20%a week later you sell the company for $2.5mmi get a $500k lossdoes that sound fair?”Yes, that’s exactly fair. If you paid $1mm into a company valued at $5mm, then the value of that company drops to $2.5mm, then you should get back exactly $500k. That’s exactly how investments work. If the value of the investment goes up, you make a positive return. If it goes down, you lose money.The entrepreneur lost money too. The value of his work when you invested was $4mm and he lost $2mm of that, which is exactly the same percentage loss you suffered.

    1. David Semeria

      Can I suggest you change your username?

      1. Mark Essel


    2. Dan

      You’re considering that the entrepreneur is rational. Maybe the company is worth $5mm, but the entrepreneur is an asshole who just wants to buy some new toys so he puts 6 months work in, one of his Ivy League buddies gets him a cash out deal with a media company and now the VC who entrusted this young, bright Ivy educated “entrepreneur” is screwed. Not that I feel sympathy for VCs, but if you are lucky enough to get VC, you should be willing to build a great company and so 1x LP is reasonable. Mind you, the company may also totally fail which is the real risk here.

      1. mike gilfillan

        As a founder, 1x LP seems reasonable — for a period of time. Where it goes sideways is 5 years down the road when the company may be worth less than the original investment to a buyer but is still a viable business with long(er) term growth potential. This was my situation during the bust.We were a $5m / 15% profit internet business prior to VC. After two rounds we were on a terrific ramp up but ran out of runway due to the market crash. Because of the fall out, we were unable to continue our growth and/or raise more money. We cut costs to the bone and survived for another 5 years before being forced to sell because of redemption rights, but the VCs took the lion’s share of the money because of the LP. Needless to say it was extremely hard for founders and management stay motivated during those long dark days.I wish I had had the foresight to know that things can and do go south. My investors blew up a few deals because they were greedy (ie: NOT selling for $100+ mm for an 8x return 12 months after the initial round). My lead investor was also the poster child of encouraging’s to spend too much too fast.To be fair, they agreed to rewriting the LP preferences after the crash, but not by much. I think they could’ve done more to stand behind the company by either putting more money in or agreeing to a time limit on Liquidation Preferences (or other cap such as turning down a deal at a specified valuation). Perhaps even a reverse vesting of LP rights.All or nothing on both sides is good for neither party.

        1. PhilipSugar

          Mike I have written about this on my blog. How did the redemption rights work??? They can be all over the map, but usually the VC has a right to a put and then some nasty terms if you can’t pay back. If you want to share privately I’m philipsugar at gmail

          1. mike gilfillan

            The redemption rights are probably a little dated (from 1998), but I’ll dig them up send them to you. From what I recall they weren’t far off from what you described (board control and right to sell at whatever terms to get their money back first).I retained a top tier law firm to help me negotiate the Series A, but so many things to learn when you’re doing it the first time. I should’ve sought the advise of a founder who had been through it all before instead of an attorney.You have some great articles on your blog — I read through them a few weeks ago and lived through most of what you wrote — especially the part about “you guys are so unprofessional!”

          2. PhilipSugar

            You know yours is a good cautionary tale. One thing I would say is that if you have an offer where you can sell the company and have preferreds get more than double their money back in cash the liquidation preferences should go away at that point you know the value you placed on the company was as real as the cash that they put up.Hate to see terms get more complicated…..

  30. Alan Warms

    Fred -Love this. But question which I’ve asked other VCs – why would I do an angel deal without getting similar terms? Especially pro-rata ? These of course tie into your previous post on the myth of two types of returns — where you need to bet heavily on the winners. And you can only do this if you actually have the right to do this. Yet rarely do Angels get this ability.

  31. Alex Murphy

    The best part of the post in my opinion is Pay It Forward.The NY start up scene is thriving, that is obvious from someone outside. I think that it is due in large part to the network of people there that routinely Pay It Forward. LA has the same thing happening. As do San Fran and Boston. You can see that happening in Raleigh, Austin, and Seattle too. These are start up ecosystems where companies and investors win together. The deal structure between both parties are mutually aligned. Other areas around the country that would like to mimic a working model need to ensure that all of the parties align their interests together.A 1x LP is neutral. It is fair. It would be a good idea for it to have some type of time limitation, but that kind of defeats the point of getting outside capital anyway.Other points that make sense are Invest $XXX in a company for 20%. The figure that rarely seems to change here is the 20%. Why? Because that makes the most sense to keep everyone’s interests aligned. We are all going for a big exit. If the Investor ends up taking 51%, then the entrepreneur becomes an employee. Interests will not be aligned.If the LP is above 1x or below 1x, then interests are not aligned. The key to all of this is to make sure that everyone is focused on the same goal. All of the deal terms etc are put in place to try to ensure that this is the case.Thanks Fred for Paying it Forward, hopefully we will all be able to do the same thing too!

  32. Motorcycle Parts

    The board of the company still has fiduciary duties that can not make decisions that benefit them personally, but hurt other shareholders. Consider eBay vs. Newmark

  33. JLM

    Being an incurable entrepreneur, my sentiments almost always come down on the side of the entrepreneur but I must say that folks taking OPM these days have some weird notions.First, let me say that in over a third of a century of being in the money game I still rely on the basic understanding that I am a steward of your — the investors’ — money and that I will safeguard your investment at all costs.I will convince you to invest in ME and my deal in that order.I am never offended by a return OF capital or a return ON capital as a basic tenet of any investment scheme.Where we get a bit throttled in our collective underwear is when we use common stock as that vehicle and suggest that an investor is subjected to the same risks as the sponsor of the deal.I always think of standing at the pay window and giving everybody back their “bait” and a bit of “rent” on their bait and then splitting the profits.Now if I have personally invested a bit of bait myself, well I want that bait back before we split the profits but the notion that an investor is going to get back less than his original investment even in a stinky deal seems patently unfair to me and is not how this type of investment business started.In some ways investors have done this to themselves because they have used preferences and other schemes to mandate a profit but a fundamentally fair deal is — get your bait back first, get a bit of rent on the bait and split the profits in accordance with the agreed upon formula.Never get greedy and move on to the next deal.

  34. JLM

    There is something remarkably charming, Old World and refreshing about acknowledging the apprenticeship one has served in business to learn valuable lessons and to drive a business to success.Fred’s willingness to share his expertise, business acumen and stories is a perfect example of what can make business — a career in business — a wonderful experience.I am old enough now that sometimes I find myself sharing a story w/ someone 30 years my junior — well usually someone whose job is to make me just a bit more money, I hope — and I cannot tell you how much joy it gives me to be able to share something that I learned from someone in the same time period.This cycle of learning, mentorship and fellowship is one of the most satisfying aspects of a long businiess career and I hope that we all take time to value it.

    1. mike gilfillan

      I wish more people thought like you. I was shocked to learn as 29 year old entrepreneur in the late ’90s that many VCs just wanted to wrestle control from the founders and flip the company for a fast buck.With the sharing of info on terrific blogs like this, maybe deal terms will become more balanced so that those unscrupulous investors won’t be able to pull the wool over visionary entrepreneurs eyes and that we will see more long term success stories for both founder and VCs.

      1. Alex Murphy

        Those VCs have had a hard time making a positive return because they don’t get in on the best deals. The industry is evolving and the investors that have their interests aligned with the founders and mgmt are the ones that are winning and those are the start up ecosystems that are flourishing.

    2. Dave W Baldwin

      Yes, you do know the greatest reward in life and truly why we’re here. Though your spouse may not appreciate this, to see the glimmar in the eye of someone you just enabled is the greatest gift.Sad to read all of the war stories. Staying with plain speak, any investor should expect a seat at the table of decision. If they cannot bring anything to the table regarding the product, then that is not a wise investment for either side.A hard lesson on the founder side is going with your gut when the realization comes the so called tentative investor doesn’t get it, so it is better to stick with the polite no and move on.I personally feel that every investor should be worried about placing money on a team of founders that are simply looking for quick return in order to sit the coming years away on the beach. All sides need to go with gut instinct.

  35. TRX trainer

    Seems like 3 pretty good principles to live by when investing

  36. Michael Lewkowitz

    My best gauge is always the nature of the conversation. When there’s a lotof offence/defence it’s going the wrong way. When there explanation andexploration we’re getting somewhere. It’s hardest to achieve in first timerelationships but it’s always proven to be my best guide… well that andfewer terms + simple understanding = better relationship.

  37. Mark Essel

    Hah, your pop nailed it 😀