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August 8th, 2007:

Liquidation Preferences: A Response to Leo Dirac

In a recent blog entry, Leo Parker Dirac poses the question of the fairness of liquidation preferences in VC financings of startups. He’s going to be delivering a lightning talk based on it tonight at Ignite Seattle.

(To those of you who don’t know, liquidation preferences, or prefs, are usually a multiple of invested dollars that a VC gets out first, before anyone else is paid. This is because if you take $10 M from a VC for half your company, then shut down the company one second after depositing the VC’s check, he would only have a claim on half of it, thereby snookering him out of $5 M. To avoid this outcome, and due to our general greed, we VCs like to ask for at least a 1.0x preference, meaning that you have no incentive to shut down the company until you’ve grown it to something more than our investment dollars.)

His conclusion seems to be that liq prefs can be fair if transparently communicated to all parties. Of course, this implies that sometimes, details of prefs are not communicated clearly.

How can this be? I’ve seen many tens of term sheets, and never once have I seen one that uses invisible ink. Neither have I ever seen a term sheet that has a clause invalidating it if you show it to your lawyer. In short, there is never a case where an entrepreneur isn’t reasonably informed about prefs.

Let me construct an example. Say that you’re a first-time entrepreneur, and that you don’t have anyone on your exec team, nor on your board of directors, nor among your existing investors, who’s ever seen a term sheet before. (I was in that spot starting my first company back in 2000, by the way.) And, let’s say, you get hold of a term sheet that casually throws out there something like “holders of Series A shall be entitled to an amount per-share equal to two times the per-share price…” and you don’t know what it means.

Well, one thing I can absolutely promise you is that no VC is trying to sneak one by you for a shot at 2x his money. A VC investment just takes way too much heartache and worry and effort — not to mention opportunity-cost of not investing in the billion-dollar blockbuster every VC’s looking for — for a VC to fuck around with taking a chance at cheating you out of a couple million (remember, he has to give all but 20% of that profit to his investors, and split that 20% through some formula of his partnership, so even if he cheats you out of $5 M he’s not going to deposit more than a few hundred $k in the bank, and that’s at risk of losing his several hundred $k per year sinecure for a GP of a decent-sized fund).

Another thing I can promise you is that no VC ever wants you to sign anything without reading it and having your lawyer read it twice. Think about this one for just a second: I’m about to wire you enough money to buy twenty or thirty Porsches, based on the notion that you’re a brilliant businessman who’s going to make us both rich. Do I want to give thirty Porsches worth of cold, hard cash to the kind of guy who signs deals without reading the contract??? Seriously: I want you to be the slickest of salesmen, the toughest of negotiators, and the most diligent of dealmakers (not to mention a prodigious engineer, a revered leader, and a master marketer). VCs do not want to give money to sloppy suckers who can’t be bothered to read and understand a term sheet — including seeking savvy legal counsel when appropriate!

Now, having said all this, there are at least two cases where Leo’s thinking really does apply to the question of liq prefs. (It shows of Leo that his thinking on the matter of prefs is mostly abstract, that he does not mention either of these two cases.)

The first case is where you are dealing with a fake VC. A real VC is someone who spends full time managing a fund of committed capital from one or more arm’s length investors, which capital amounts to at least, say, $10 M per general partner and is entirely meant to be invested in growth companies for the purpose of financial returns primarily via capital appreciation. A fake VC is anyone else who calls himself a VC without pointing out the major differences with the above. And a fake VC has God-knows-what sort of motivation and may well want to swindle you out of a preference multiple.

Your uncle who owns a chain of bagel shops is not a VC. A hedge fund is not a VC. A dude who claims to represent a group of “anonymous Asian industrial families” is not a VC. Anyone who is keeping his day job is not a VC. Real estate guys are not VCs. Note that this doesn’t mean they are bad people (unless they pretend to be VCs, in which case they are fake VCs). It just means that the ground rules that you can understand all VCs to play by don’t apply.

If you’re not dealing with a real VC, read everything three times and have your lawyer read it six.

The second case is in follow-on rounds where the company is in a distressed situation. Everything Leo talks about (and everything I assume in the first part of this post) is about the moment before you take your first VC investment: do I take this capital, with its strings attached, for a shot at building my dream? The alternative there is to simply walk away, and go back to working at Microsoft. But once you’re hot and heavy with a company, once you’ve raised money, promised the moon and the stars to your friends and family, bamboozled the VCs into funding you, alienated all your social contacts and exacerbated your RSI, hired fantastic people and worked them to exhaustion and made them love you enough to drink the Kool-aid, extended commitments based on your word and your honor to customers and suppliers — only to find that revenues aren’t ramping up fast enough and you need cash — OK, now you are officially up against a wall. And precisely now is when you will be addled from overwork, and adrenalin-high, and blinded with the urgency of your need — and when the sharks will smell blood.

That is when you will get the predatory term sheet.

If Leo wants to do entrepreneurs (and VCs) a favor, he should take a hard look at what happens then: when you’ve got a company that still holds promise, but is in a distressed situation and needs capital for its very survival. Exploring those moral complexities is a lot more interesting than the sort of clean-room, game-theoretical chatter about whether one accepts term X on a first round of capital.