Term Sheet from Hell: (Molten) Liquidation Preference

I’ll start my “Term Sheet from Hell” series by taking a closer look at its liquidation preference clause. There’s a lot of existing literature on liquidation preferences so I won’t be repeating the obvious. Instead, I’ll focus on how select clauses in this term sheet come together to make it unique to Southeast Asia, and positively molten.

Lava fountain of a Pahoehoe

[white_box]If you want to get comfy with the basics of liquidation preferences, I suggest starting with two of Brad Feld’s posts [1] [2].[/white_box]

When reviewing a term sheet, I look at its liquidation preference after price (valuation). I won’t be commenting on price for this specific term sheet, but will discuss valuation more broadly in my last post of this series.

For proper context, note that this is the entrepreneur’s first financing round. Let us call him CG. He had raised some capital from friends and family when he started, but those were probably in common stock. This, combined with what I understood about his business and the size of the round being raised, tells me this term sheet is for his seed round.

Here is this particular term sheet’s liquidation preference clause:

Liquidation Preference - In the event of a liquidation, dissolution, winding up or distribution in specie of the assets of the Company, the Investor shall be entitled to receive double their Investment Amount plus any dividends accrued on the A RCPS but not paid in preference to the ordinary shareholders. Thereafter, any remaining proceeds and/or assets of the Company which is legally available for distribution to the shareholders of the Company would be distributed on a pro-rata basis, according to the respective shareholdings on an as converted basis.

A consolidation or merger of the Company or sale of all or substantially all of its assets will be deemed to be a liquidation or winding up for purposes of the Liquidation Preference.

The clause is pretty standard, except for its hellish 2X liquidation preference plus participation.

Let us assume that CG accepts this clause and raises $500K from the investor at $2.50 per share. Investor X receives 200,000 Preference Shares (RCPS) representing 20% of CG‘s company on an as converted basis. CG does a great job with the company, raises no further capital and finds a buyer at $10M for 100% of the company 2 years later. To make things simpler, let us assume that no ESOP was issued, and CG is the only founder. Here’s how the math plays out for Investor X and Entrepreneur CG under the first scenario.

At first glance, it doesn’t look that bad. The investor takes back $2.8M on $0.5M after just 2 years, and the entrepreneur goes home $7.2M wealthier. The stuff of dreams, at least on Southeast Asian scale where exits rarely fall outside of the $10M – 30M band, if ever at all.

Let’s see what happens when we adjust our second scenario for realism. CG makes a couple of mistakes along the way, takes longer than expected to reach cashflow positive and ends up raising $700K in a bridge financing round 12 months after his seed round. Investor X subscribes to his $140K pro-rata while the new bridge Investor Y, seeing the existence of a 2X Liquidation Preference and Participation and sensing blood (ok ok, value), insists on the same 2X Liquidation Preference and Participation for his $560K investment. CG thanks his lucky stars that his business fundamentals are strong, and is able to convince Investor Y to value his company at a decent premium (40%) to his seed round, at $2.80 per share. Three years after his seed round, CG makes good on his promises to his investors and finds the same buyer for his company at the same $10M valuation.

In our second (more realistic) scenario, CG goes home with $4.86M or 32.5% less than in the first scenario. The entrepreneurs amongst you will invariably feel that CG got the short end of the stick thanks to the investors’ 2X Liquidation Preference and Participation; how sore CG ends up feeling about the clause in question will probably depend on how much value-add he thought his investors added to his business growth and eventual exit.

To wrap this post up, let’s see how scenario 2 would have played out if Investors X and Y had only gotten 1X Liquidation Preference with Participation. I won’t even present a scenario with no participation; I’m not aware of seed-stage investors (other than while I was investing out of Neoteny Labs) that gave such terms.

In Scenario 3, Investor X gets $2.4M (on $0.64M cost), Investor Y gets $1.97M (on $0.56M cost) and CG takes back $5.63M, versus $2.8M for Investor X, $2.34M for Investor Y and $4.86M for CG in Scenario 2. The difference in investor returns between both scenarios isn’t significant imo, but I’m pretty sure CG will be much less motivated to take money from Investors X and Y or recommend his entrepreneur friends to them if he ends up feeling sore at the end of the day. Caveat emptor!

I think Liquidation Preferences beyond 1X makes sense at later financing stages when investors are trying to ensure some baseline return; see Fred Wilson’s post for more. I think 2X Liquidation Preference plus Participation is okay if the investor doesn’t have much faith in it becoming a decent exit down the road, but still wants to give it a shot because they don’t have other ways of deploying their capital for better return. I think every entrepreneur should seriously consider capital that’s offered to them, because every drop counts when you’re in a desert. I only hope the investor isn’t expecting to reap returns without really adding value, and the entrepreneur isn’t signing on the term sheet until he or she fully understands what they’re getting themselves and their team into.

*cue devilish episodic music with bling harmonics*

[dark_box]In my next post, I will be discussing the effects of the Redemption and *gasp* Put Option clauses in our “Term Sheet from Hell”.[/dark_box]

eleven Comments

  1. Remco On 30 Dec ’12 at 21:38

    You being a VC yourself it would be interesting to see the term sheet you offer entrepreneurs looking for a Series A funding.

    My experience is that contracts related to any round are vast, complex and full of legal mambo jambo. The best advice I can give to young entrepreneurs is to get a lawyer that has done deals like this before. Expensive but with the right lawyer possibly the best money spent ever.

    • James Chan On 30 Dec ’12 at 21:45

      The deals I’ve done were mostly seed investments, but I’d like to think they’re fair (1X liquidation preference, no participation). I subscribe to the camp of leaving enough on the table so that the entrepreneur is motivated to make the pie bigger for all of us. I obviously can’t share the specifics since I need to maintain confidentiality, but I’m sure you can ask around about my terms ;-).

  2. Remco On 30 Dec ’12 at 21:58

    Don’t get me wrong here, I wasn’t doubting the fairness of your terms cos obviously I don’t know them. My point was more that you might be on thin ice here since these terms are not fictional. Every investor has his own signature which can be recognised fairly quickly and then it’s just a matter of time till someone blows the whistle. My guess is that the entrepreneur who gave these terms to you signed and consequently breached an NDA and might be in trouble when it comes out.

    No harm in advising entrepreneurs on the legal and financial sides of funding deals, I just wouldn’t base it on actual term sheets. As you state yourself, you can’t share any specifics and need to maintain confidentiality and the same goes for other investors. It’s a really small world….

    • James Chan On 30 Dec ’12 at 22:00

      He wouldn’t be signing the term sheet as it is, and hence, nothing was breached.

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