Snidely Whiplash And The Liquidation Preference
The liquidation preference gets a bad rap. The term is often necessary to close deals
One of the most maligned and misunderstood terms on the venture term sheet is the liquidation preference. This basically says the venture investor gets his or her money back many-fold before the entrepreneur sees a dime. For example, if I invest $5 in your company and then get $10 back before you get anything, that would be called a "2X liquidation preference".
From the perspective of the VC, the term is virtually required to solve the Snidely Whiplash problem. Less obviously, it is also required to solve the Dudley Do-Right problem. Both are forms of what economists call "asymmetric information" -– a concept behind many of the quirks in the venture industry.
Okay, perhaps we need a little background on the two problems before diving into how the liquidation preference solves them. Dudley Do-Right is a cartoon character from the Rocky & Bullwinkle show, a cult hit on American TV in the sixties. He's a Canadian Mountie who's always trying to save the world (and his girlfriend Nell) from the evil Snidely Whiplash. He's honest and driven and always riding off to save the day. Snidely is really smart and always out for himself –- with a handlebar moustache and an evil laugh.
The Snidely Whiplash Problem: Out To Steal Your Money
So let's start with the Snidely Whiplash problem. Unlike investing in public companies, where there is copious data and many regulatory bodies controlling the flow of information, private companies are primarily funded based on trust. I don't think I'm airing any VC secrets when I say that you, the entrepreneur, will always know more about your company than we will, since you spend 24 hours a day working on it.
The Snidely Whiplash problem is that a really smart, evil entrepreneur could rob an investor blind. The most blatant forms are illegal: Advanced Equities, a Chicago-based venture fund backed a California video compression company called Pixelon to the tune of $30 million. The CEO turned out to be on the run from fraud charges in Virginia. He was arrested, but not before spending much of the raised money on parties and his friends.
That kind of outright fraud is best protected through good diligence –- a quick check on the CEO would have turned up that he was using a false name and was actually under indictment for fraud. However, assuming you move the outright frauds off the radar, there are still many opportunities for Snidely to rob VCs blind. Let's give an example…
Snidely Whiplash is working with a few guys that have a good, solid technology that cures cancer. He negotiates a $10 million investment from a VC firm, which values the company at $10 million. After the financing, Snidely now owns 50% of a company that has $10 million in cash.
Snidely is secretly thinking "I don't think this technology will really work, but I can get the VCs to believe it has potential." He basically shuts down the company and takes his 50% -– in this case, half of $10 million. Now he's made $5 million, and the only work he had to do was put together a really good presentation for the VCs. There are, of course, 20 different ways he can do this exact equivalent without being so blatant. For example, he could also turn around and sell the company for cash value to another company doing a similar thing –- again, pocketing $5 million.
While the VC has some control on the board, early startups require that the CEO have great latitude. I've got to be sure that the CEO is not a Snidely. The liquidation preference helps achieve this goal. I say to Snidely, "sure, I'll give you $10 million –- but when the company sells, you have to give me back my $10 million before you see a dime." Suddenly, Snidely is not interested in my investment anymore, and will move on to another firm –- the exact result I want.
Dudley Do-right, however, will stick with me. Dudley is honest and well-intentioned. He knows he can turn this into a $200 million investment. If the company sells for $200 million, instead of taking back my $10 million, I share the results with him 50%/50%. In other words, the liquidation preference has absolutely no effect on Dudley.
So that explains the 1X liquidation preference. What about liquidation preferences above that number?
The Dudley Do-Right Problem: Bullish Entrepreneurs
There is another, harder, problem. Dudley Do-Right is upstanding and honest and is a true believer in his idea. He'll do anything to get his company, Nell Pharmaceuticals, funded. We VCs who see hundreds of ideas a year are more cynical. We'll think that it is a pretty good bet, but there are lots of those and not all of them work out. Normally, we'd think his company valuation should be $5 million before we put in our $10 million.
Dudley, however, believes passionately that he’s right about Nell -– it will set the world on fire and he will IPO his company for $1 billion when he's done. And you know what? He'd better be passionate about his product and a true believer, otherwise he won't do what's needed to make a wildly successful company. Unfortunately, that means he doesn't value his company at $5 million, he values it much higher. He won't come down below $10 million. The investors can't come to terms with Dudley, his deal fails, and a good company doesn't get to survive.
So the liquidation preference comes to the rescue. The VC says to Dudley, "I'll give you your higher valuation, and if you are right you will win the bet. On the other hand, if you are wrong you get nothing." In this case, we'll give Dudley his $10 million for 50% of the company –- but with a term saying that we get back $30 million before he sees a dime (a 3X liquidation preference).
This will force Dudley, who up until now has had every reason to be nothing but bullish about his prospects, to go back and rethink his situation. He knows more than we do about his product and the market, and now has every incentive to deliver a more realistic assessment of his prospects. If he comes back and accepts the deal, we know he thinks he can sell the company for at least $30 million and our investment is safe (well, if his judgment is sound –- but that's another column entirely). If he comes back and says "sorry, no can do" then we know he doesn't really believe in his chances of making it big –- with the implication that our money is not as well invested.
An even subtler Dudley problem exists –- what happens when Dudley gets an offer for $12 million for his company? If he has a 1X liquidation preference, he is awfully tempted to make the deal work –- after all, even after paying back the VCs he gets a million in the bank. For the VC, however, companies are required to return many times their original investment in order to make up for the companies that don't succeed. An investment that would return $11 million on $10 million invested is a bad deal for a VC (see columns by Naval Ravikant and Tim Oren on why there are plenty of good, profitable businesses that aren't good VC investments). Once again, a high liquidation preference helps in this case by forcing the entrepreneur to go for a higher return (though potentially risking the company) rather than the safer bet. This enforces a discipline and understanding on both the VC and the entrepreneur that this is to be a high risk/high reward proposition.
Liquidation Preferences To The Rescue
So do not fear the liquidation preference –- it facilitates deals by overcoming some of the incentives and information problems that could prevent them. However, make sure you understand the liquidation preference you are signing and why: it should be no surprise later when you receive very little because your company is not the wild success you expected. While this is often the source of much ill will in the venture industry, it should not be if the entrepreneur and VC both understand the deal they are entering before it is signed. It helps to eliminate Snidely Whiplash and motivate Dudley Do-Right at the same time.
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Sorry, this is total baloney. Worse, this is the kind of nasty backdoor share repricing nonsense which is driving (has driven?) smart entreprenuers out of the venture market. Consider: If Kevin's right, what "preference" should shareholders in public companies receive, given the now high likelihood that public company management will be discovered to be "Snideley Whiplashes"? Better, what "Snidely Whiplash" protection do LPs get from venture fund GPs? Also, does nobody care how hard it is to hire smart managers when funding terms make team members equity compensation worthless unless there is a truly wildly outrageous grand slam? Apparantly Kevin doesn't mind investing in dummies -- actually he seems to prefer it.
Kevin, thanks for the great write-up!
Steven, I disagree.
(1) It's not backdoor: when the entrepreneur signs the contract, he knows about the liquidation preference -- it's right on paper.
(2) Public companies are not really comparable: there is much less information asymmetry there given the public monitoring of all shareholders combined in contrast to a private, yet-unfunded company where only the founder knows about its true value.
(3) Entrepreneurs do get protection from opportunistically acting VCs. VCs being repeating players on the market, they have to care about their reputation. If potential portfolio companies find out that their potential VC has acted against the entrepreneurs, he chooses other VCs. Thus, that VC only gets the lemons that nobody wants anyway. Reputation is quite a motivational factor. By the way, entrepreneurs do need to care much less about reputation than VCs because they're usually only in the funding market a few times maximum. That's why VCs need other measures to protect themselves -- liquidation preference being one.
But one thing, Kevin, I agree should be mentioned as well: Let's suppose we have Dudley Do-Right and the VC work together. $20m invested, 2X liquidation preference. Now fast forward four years. The market the startup entered is doing alright, but not as spectacularly as hoped for (not uncommon these days, I guess). The company might be worth, let's say $40 millions with not much potential to grow more on their own. The liquidation preference now essentially makes for the entrepreneur not wanting to do a trade sale. He wouldn't gain a thing... This might even lead to him being less motivated to drive the company forward. He might quit. Then the VC might not even get his money back. --> In these cases, I guess, the entrepreneur needs to get some part of the liquidation preference as well. Or a cash bonus.
Well, sorry I rambled on for so long. :-)
You are trying to rationalize an asymetric relationship between VC and entrepreneur. The more that the relationship is based on just the needs of the VC, the more you can expect an antagonistic relationship to result.
There are significant problems with the venture model: VC's have such enormous overhead, not just bad deals, that they must generate huge returns. For example: 2.5% per year for 10 years means that the capital put to work is only 75% of the committed capital. VC's could know a lot about a business if they got involved - but the typical partner has 5-10 board seats - and little concentrated time to devote to a venture. Imagine if a VC committed half of his time to a partiicular venture, and really got to know the customers and technology? The same VC, spending 2 days a month on a business, wants to make the strategic decisions for a company. That simulaneous desire for control and lack of committed time is a recipe for trouble.
The venture market is going to work better as you get a stronger alignment of goals, compensation and commitment between entrepreneurs and VCs.
I agree with a comment made at www.antiventurecapital.com that liquidation preferences are an attempt at over compensation by VC firms which due to their own stupidity and greed lost a s**tload of money during the dotcom era.
Kevin is also being a bit misleading by using such low liquidation preferences in his examples. In the real world, many VC firms are demanding 5 to 10 times their principal back, plus accumulated dividends, before the founders, managers, and staff see one shiny red penny for their years of effort.
Here's a thought on the VC profession. Up until the 90s, most VCs were older guys with a wealth of industry operating experience. They had accumulated wealth and respect by building companies and then became VCs in their late forties and fifties. These guys knew what entrepreneurship and company building required.
Today's generation of VCs tend to not have any operating experience outside the two years spent working before going back for their MBA at 25. Indeed many VCs are simply the sons of rich dads who used their connections to obtain jobs at VC firms.
Could this lack of real business experience be part of the problem we see in terms of the antagonism between entrepreneurs and VCs today?
Some very interesting comments. Some can be clarified quickly.
Stefan, in the situation of "moderate success" you describe, there is a later financial tool that addresses the incentives. Given the market environment of recent years, the "management carve-out" has become quite popular. This is where the VC and management together say "despite our incentives to make this thing big, at this point it's clear that that isn't going to happen. If we manage to sell this thing, management will get 10% of the sale price before the various shareholders split their gain." That sets the incentives right again. Good point on the incentives issue, Stefan.
Gill Bates, the standard liquidation preference for West Coast deals hovers around 2X these days. The last deal I did was a 1X liquidation preference, and no deal our firm has done is over 3X. I have heard of 5X (particularly from the East Coast, where VCs are more dominated by investment bankers less familiar with their subject matter -- higher liq prefs indicate more information asymmetry, so this is not a suprise), but never seen one myself. Don't mistake the VC looking for the deal with a 10X return (a fairly standard benchmark) with a VC who forces that through a 10X liquidation preference.
Now to the more complicated...
Gill & Steven -- venture capital (as you correctly observe, Steven) is a market. There certainly do exist "Snidely" VCs who will put terms in a deal that the entrepreneur doesn't understand. However, I have yet to see that from a reputable VC in the valley. Bunching everybody together is like saying that because loan sharks exist, all banks are crooked.
Reputable VCs make sure the entrepreneur understands the import of the terms. We won't allow an entrepreneur to sign unless they have had their deal reviewed by competent counsel, for example.
With that as the case, entrepreneurs understanding the deal, are free not to take it. Any VC offering terms too punishing will find themselves unable to make deals and will quickly go out of business. Given the oversupply of venture capital funds that exists today, this is even more true today than it was in the early "clubby years".
The idea that Gill presents that we are trying to impose even harsher terms to make up for lost money both implies that VCs are nicer and stupider than they really are. It implies that they are nicer because the implication is that the terms weren't already as stringent as they could be -- pretty much an impossibility, since any VC who didn't look out for the interests of their investor's money would have a lower return than those who did, and would lose out. VCs are always looking to negotiate the best deal possible -- but a VC with a reputation is looking to do it honestly.
It implies stupidity because in setting more stringent terms in what is by all accounts a more crowded funding market means that one would just get crowded out by people offering more marketable terms.
Terms are tough today because exits are few and far between and at a much lower value (venture-backed IPOs of the last 18 months can be counted on a single hand). It is not because VCs have decided to become meaner to make up for losses.
Vernon, you have given me a great idea for another entire subject, so you'll forgive me if I leave your issues about the structure of VC for another day...
Maybe you should retink the meaning of the word "Venture Captalist". Maybe a change to "Simon Legree Captalists" or maybe "Shylock Captalist" would be in order.
Problem with your math is only homeruns pay off for the founder, CEO and staff. After the 90's, those homeruns are going to be fewer and fewer which raises a question.
If you only wait for the knockout deal, what do you do with your fund until it comes along? Pay 6%?
Venture Capital is not for people who wish to build companies. It is for people who "know" how to play ball and create some sort of transaction in 3-5 years. This is the hidden secret of it all. The romantic vision of a founder to change their industry, change the world, make a difference is something a VC will laugh at behind his back.
The Liquidation Preference is really a test to see if the Founder will play ball. I suggest that terms should include the money the founder puts in at a 5-10x return at any liquidatoin event. This will protect him from the "evil" VC who forces out the Founder and then crushes his stock with a subsequent funding round. If you look at it, the odds are stacked against the Founder. Only a VC who is interested in building a company and not a transaction would agree to these terms.
VC should be a last resort for true company builders. There are many sources of funds available.
The structure I am most familiar with is the double dip, where the preferred gets its preference and then shares with the common on an as converted basis. How does it fit in to your analysis?
IRRC if you do not have something like double dip you create some horrible tax problem, like imputed income from zero coupon bonds.
Lee get a grip. the 90's are over.
For the record, according to Fenwick's venture survey (http://www.fenwick.com/Q2_2003_VC_Survey.htm), in the last quarter, 78% of venture financings had a preference of 2X or less. 11% of the venture financings had a preference between 2X and 3X. And the last 11% were financings with a greater than 3X preference.
Quoting from http://www.antiventurecapital.com/venturecapital.html , : "With the first dollar of venture capital accepted the entrepreneur’s control slips away to 28-year-old MBA wonder-boys with only the shallowest of operating experience."
We recently did presentations to 5 vc firms during which we met with a total of 12 partners. Only three of these guys had any operating experience. The rest were young (under 33) MBAs who seemed to be there because daddy had paid for them to go to the right b-schools.
It really grates to have someone 15 years your junior with any real world experience building a business telling you how and why you are wrong.
Steven Kane, you can buy shares with a liquidation preference for public companies. They are called "Convertible Preferreds" and they trade on public markets. If you want to buy them to protect yourself from Ken Lay in the public market, go ahead.
http://invest-faq.com/articles/stock-preferred.html
Is there any academic research which shows that venture capital-backed companies fair better over the medium and long term than unfunded bootstrapped companies?
My intuition says that they don't.
>My intuition says that they don't.
Good call.
Too bad this thread died. It was pretty good while it was alive.
I have a question re how to respond when a VC asks, "So who else are you talking to?".
I want to say, "None of your business!", but feel a more is required. How should I deal with this?
I have a question re how to respond when a VC asks, "So who else are you talking to?".
I want to say, "None of your business!", but feel more is required. How should I deal with this?
What a fascinating blog. It has been very helpful to read everyone's substantive comments about the VC perspective (I being a long time tech workerbee).
There's just one thing... Dan wrote: "The romantic vision of a founder to change their industry, change the world, make a difference is something a VC will laugh at behind his back."
Wow, an "Atlas Shrugged" moment...
Other than that, this is fascinating stuff.
Frank wrote: "I have a question re how to respond when a VC asks, "So who else are you talking to?".
I want to say, "None of your business!", but feel more is required. How should I deal with this?"
Answer: "No one but you, sparky."
Then shut up and smile.
Now that's funny!
You people need to read an entrepreneur's blog http://extremepreneur.weblogger.com/