Conventional wisdom is that venture capital returns follow a power law: a very small number of investments generate a majority of a firm’s returns. This belief is cult-like for seed investors who partner with startups at the earliest stages in the company lifecycle. Given these beliefs, you would think seed investors would optimize their investments to capture value generated by the “unicorns” in their portfolio. But investor actions differ from this philosophy. As Marc Andreesen points out, a liquidation preference, a term that’s general purpose is to protect an investors downside not boost upside, is found in almost all seed deals. Additionally, from my experience, attempting to negotiate this term is a complete non-starter with VCs. Given the visceral reaction, I think it’s worth asking: Are VCs are being rational?
The natural way to answer this question is to analyze whether VCs would make more money by giving up their liquidation preference for something else. Entrepreneurs evaluate term sheets by synthesizing structure and the pre-money “headline” valuation to arrive at an “effective valuation.” Put differently, investors make tradeoffs when deciding whether to increase one term or another to create an effective valuation for the entrepreneur. For example, in isolation, increasing the liquidation preference will improve the investor’s effective valuation while removing pre-emptive rights might do the opposite.
The three terms that most heavily influence a seed investor’s performance are the pre-money valuation, liquidation preference, and pre-emptive rights (which will be the subject of a future post). Pre-money valuation dictates the percent of the company that the investor receives for a given investment e.g. $1m on a $4m pre-money valuation provides the investor 20% of the company. Liquidation preference is the proceeds that the preferred shareholders (investors) receive before the common shareholders (the Founders and employees) begin to earn a return in an exit. Pre-emptive rights are the right for investors to invest in the next financing at or above their level of ownership. I will focus my efforts on evaluating the tradeoffs between liquidation preference and pre-money valuation in this post, and save pre-emptive rights for a later post.
When does a liquidation preference matter?
Before getting into the analysis, I think it is useful to understand when having a liquidation preference benefits a seed investor. Assuming that a company only raises a seed round, a liquidation preference increases the investors return only in exits below the post money valuation of the company (the pre-money valuation of the company plus the capital invested). If the exit is larger than the post money valuation (or more technically the exit produces a return for the investor in an amount larger than the original investment on a per share basis), then the investor converts to common stock and earns their ownership percentage multiplied by the total exit size.
Seed Round Only
Additionally, if a company raises a seed round and additional rounds of funding, then a liquidation preference for seed investors matters only in exits between two exit values: the lower value is the total liquidation preference of more senior share classes and the higher value is where common shareholders earn the same amount as seed shareholders on a per share basis.
Seed Round with Additional Financings
Tradeoff: Valuation vs. Liquidation Preference
Looking at the above charts, triggered the rationale behind this post. I thought seed investors need to have a company sell for a very specific amount for a liquidation preference at all. Would a lower valuation outweigh the impact of not having a liquidation preference? I began to answer that question by calculating the marginal return from having a lower valuation and no liquidation preference versus a typical deal with a liquidation preference. In the analysis below, I assumed a $1 million seed round and a $4 million pre-money valuation i.e. in this situation an investor would own 20% of the business for a $1 million investment. If the investor were to negotiate a 10% discount on the pre-money valuation in lieu of a liquidation preference, then he/she would be investing $1 million at a $3.6 million valuation for 21.7% ownership. Therefore, in this example, the investor would have 1.7% more of the company than if he/she offered a term sheet with a liquidation preference.
What is going on in the above table? The above analysis presents a variety of exit scenarios for a single company, returns for the investor, and potential pre-money valuation discounts for giving up the liquidation preference. The grey column shows the baseline return with a liquidation preference, the blue columns show the absolute returns with a discount to the pre-money valuation and no liquidation preference, and the orange columns show the marginal return generated by the investor for trading off a liquidation preference for a lower pre-money valuation. For simplicity, it unrealistically assumes no additional rounds of financing (we can layer that in a future post).
A couple of quick observations: 1) this is not a silver bullet strategy i.e. there are outcomes in which investors will lose money on a given deal; 2) seed investors make more money when the exit value is above the post-money value (pre-money + investment) whenever there is a discount; and 3) The validity of this strategy and the discount investors are willing to accept in lieu of a liquidation preference is completely dependent on how an investor feels exits will be distributed across their entire portfolio.
Let’s dig into that final point. Investors should be making this decision from a portfolio perspective instead of looking at each individual deal. The simplest way to do this is to aggregate exits into two buckets: 1) exits above the post money value of the seed round (again assuming no dilution for simplicity), and 2) exits below the post money value of the seed round. For exits above the post money valuation, investors are making money vs. the industry standard terms because they have a higher ownership level. Since we are assuming homogenous terms across all investments, we can roll up returns across an entire portfolio into this bucket. For the second bucket where investors or losing money, I assume that exits will occur at the half of the post money valuation or $2.5M ($4m pre-money plus $1m investment), leading to the investor losing nearly $500K on each deal on a $1m investment when compared to a strategy where they have a liquidation preference.
Rolling up these investments into a portfolio shows that a seed fund would need a lot of companies to exit within the liquidation preference window for the term to make sense. The below chart shows the percentage of a seed fund that would need to activate the liquidation preference term for a fund to be worse off after negotiating for a given discount.
Examining the analysis above, it is obvious that the strategy of trading off liquidation preference for valuation improves with fund performance. Second, if a fund is able to secure a 10%+ discount on the valuation, then it becomes almost a no-brainer strategy, particularly if the investor believes that its fund will achieve its target 3x money-on-money return. Finally, even in situations where the seed investor secures just a 5% discount across all investments, over 20% of the portfolio would have to be sold within a very small and specific exit window for a median performing seed fund to have lower returns.
“So, you’re telling me the entrepreneur should give up economics to investors? Billy, I heard you sold out and are now working at a hedge fund. Marc Andreesen warned me of these east coast hedge fund investor-types. Are you pulling a fast one on me?”
Yes and no. Again we are analyzing a tradeoff, not a zero-sum exercise. So, what does the entrepreneur get in return? Well, the entrepreneur gets downside protection of his/her company going sideways: making some money when the company hits that Series A crunch and is “acqui-hired.” The seed investor doesn’t have preferred stock so the Founder will make money. You still own 78% of the company and the company is acquired for $1 million? Congrats, you just made $780K instead of $0.
I think this is a beneficial trade off, because I believe entrepreneurs have more reason to protect downside than investors. First, from a theoretical perspective, investors have a portfolio and are able to eliminate more risk through diversification (see portfolio theory), and also are less economically tied to the company i.e. General Partners are receiving management fees and Limited Partners (the investors in venture capital funds) have 5-15% of their total assets in the asset class, not 100% like the Founder, and are generally wealthy to start. Second, from a personal perspective, when I looked at return scenarios and tried to put myself in an entrepreneurs shoes, I always felt like I should protect my downside and avoid building a huge preferred capital stack. I understand the position of protecting your return and ownership is important; however, I would trade millions of dollars in a unicorn scenario where I am already making tens of millions of dollars to keep hundreds of thousands of dollars in a sideways or downside scenario.
Rationale for Liquidation Preferences
So what are some reasons this doesn’t happen in practice? There are a few practical reasons why this isn’t the industry standard seed rounds. The first reason is that seed investments are highly syndicated both with other investors or angel investors. Straying from the norm may elicit pushback from other investors and prevent a fund from entering certain deals. This reality may not be completely inefficient either. Angel Investors may not have the same level of diversification as seed fund limited partners do in terms of the quantity of early stage deals and aggregate wealth across asset classes. In other words, if an angel investor is only investing in one or two investments, then it is rational for him/her to value additional downside protection instead of upside potential. The second is when a company is being acquired at a low valuation, investors may be able to use the preferred capital stack as an anchor value in negotiations.
Those are the rational and good reasons to have liquidation preferences; however, I can put my cynical hat as well. First, investors don’t really want entrepreneurs to think that they can make money in outcomes that don’t generate VCs a huge return. I remember watching an investor ask a Founder of a company that he/she backed to tell the audience his/her “number” – i.e. the amount of money he/she would need to stop working. The entrepreneur said $2 million. The investor’s response was to jokingly say “I really hope that it’s higher than that.” That moment stuck with me, and serves as a reminder that when you take venture capital you signed up to play home run derby, not baseball. Second, liquidation preferences insulate VC firms from losses, so they can delay markdowns until after they raise another fund. VC returns follow a J-curve, therefore losses come much earlier than returns. Liquidation preferences can serve as valid reasons to not mark-down investments as companies begin to miss milestones or don’t receive an exciting Series A valuation bump (lots of discussion on markdowns regarding later stage investments). Finally, entrepreneurs may have a better understanding of valuation than liquidation preference causing him/her to overvalue high valuations when selecting a term sheet.
Ultimately, I think the reason is neither practical nor cynical, but psychological. VC’s suffer from loss aversion just like everyone else, and I think, is driving sub-optimal returns. The reality is that people hate losing money on individual investments, and the pain, embarrassment, and individual career-risk from losing the majority of capital on a single deal outweighs the aggregate portfolio gains from having lower valuations across the board. The VC partnership structure, where Partners lead individual investments and there is no central portfolio manager, ensures that investments will carry liquidation preferences into the future; however, I think a savvy seed stage investor can differentiate themselves by buying common equity.
Accelerators are already taking advantage of this trade off. Y Combinator, Tech Stars, and other accelerators receive common stock in the company in exchange for capital, mentorship, and other services. These accelerators often undervalue the company, but entrepreneurs value the mentorship, branding, and network that these accelerators provide. I posit that the absence of a liquidation preference in these deals further contributes to low valuations enjoyed by accelerators. Receiving the highest ownership percentage and sacrificing the liquidation preference is the correct strategy given the potential returns for these companies. Overtime, I believe this strategy will begin to move up market as VCs expand seed strategies and chase unicorn investments.