Term Sheet (1) Liquidation Preference How do VCs share their money on exit?
VCs invest money into startups not for charity, but for the return on earnings, so what determines the return to investors?
It goes without saying that when the company goes public, the common stock and preferred stock will be pushed to even out, and everyone will be able to earn a tenfold to a hundredfold.
But the listed company is after all a minority, in most cases startups will still be acquired. At the time of acquisition, the most important clause to determine the economic interests of investors is the "liquidation preference", which is usually the first substantive clause in the Term Sheet, the so-called "preferred stock (Preferred Stock)" of investors ".The word "Preferred" is firstly reflected in this place.
First of all, we are now talking about the "liquidation" in the "liquidation preference", we may have some prejudice against this "liquidation". Think that this is the company is going to bankruptcy, but in fact, here is the company was merged. We can look at a common liquidation priority in the case of "Deemed Liquidation Event" :
A sale of all or substantially all of the assets of the Company, a merger, reorganization or other transaction in which 50% of the outstanding voting power A sale of all or substantially all of the assets of the Company, a merger, reorganization or other transaction in which 50% of the outstanding voting power of the Company is transferred and an exclusive, irrevocable licensing of all or substantially all of the Company's intellectual property The holders of a majority of the outstanding Preferred Stock will be treated as a "Liquidation Event", thereby triggering the liquidation payment. The holders of a majority of the outstanding Preferred Stock may waive the treatment of such a transaction as a Liquidation Event.
What is really useful in this paragraph are the first two sentences, " A sale of all or substantially all of the assets of the Company, a merger, reorganization or other transaction" means an asset acquisition, and " in which 50% of the outstanding voting power of the Company is transferred......" means an equity acquisition, which means that it covers two types of acquisitions, asset acquisition and equity acquisition. Next, do not misunderstand the "liquidation" of the "liquidation preference" as the bankruptcy of the company.
After understanding this point, let's analyze the specific content of the "liquidation preference", first look at a Term Sheet of the common liquidation preference example sentence.
Liquidation Preference:
In the event of a liquidation, dissolution or winding-up, the proceeds shall be distributed to the stockholders as follows: First pay 2x the original purchase price plus declared but unpaid dividends First pay 2x the original purchase price plus declared but unpaid dividends on each share of Series A Preferred Stock (the "Liquidation Preference"). Any remaining proceeds shall be paid to the holders of Common Stock.
Guo Jing founded North Warrior Technology to get such a Term Sheet, Venture Capital Fund's investment of the Series A investor ,Jiangnan Seven Monsters, is $2 million with twice the participating distribution preference (2X participating). Then assume that after a year the company is not operating very well and is acquired for $5 million, although the ratio between Guo Jing and the Series A investor Jiangnan Seven Monsters is 80% and 20%, but Guo Jing finally gets not 4 million, but only 800,000.
Why is this so? This is all kinds of foul play in the liquidation preference. "The "liquidation preference" has a mandatory right that is "priority", but it also has an optional incidental right, called "participation in the distribution right.
Ⅰ. Mandatory Right - Priority
There are two dimensions of priority, one is the order and the other is the multiplier.
1. Order
I must emphasize the order of this issue. Many entrepreneurs have been engaged in entrepreneurship fora long time but have not understood a point that when the company exits, who exits first? I can tell you how many founders think that the earlier the investors come in, the sooner the exit, and even some people think that the founder first exit and then the investors exit. These are extremely wrong ideas. The answer is that the later the investors come in, the earlier the exit, which means that if a Series C company is acquired, it is C, B, A, seed investors, angel investors, and finally the founder. This is what we often hear about the concept of cash out, which is why there will be "founders forced to sell the company cheaply due to investor pressure". If sold at a good price, then everyone has a return, but if the company does not develop well, then investors will think about their own capital. After a round of investor cash out, there is not too much left for the founder, and sometimes even the angel round of investors can not get anything.
Note the order of priority in this place, strictly speaking, the latter round of investment is earlier than or equal to the previous round, that is to say, it is possible that the startup's investors are more familiar with each other's funds, and A, B, C round of investors agreed to exit in the same position distribution. However, this situation is not uncommon. If you have few years of entrepreneurial experiences, then you should know, often, your B round of investors are introduced by your Series A investors and your Series C investors are introduced by your Series B investors. Of course, it is possible that your previous investors do not have any resources to help the business upward, or that your startup is developing too fast, the previous round of investors can not keep up with you, like Guo Jing's North Warrior Technology. Because Guo Jing is too competent, where there are investors to pay attention to him, without the introduction of the previous investors, Guo Jing can lightly marry into Yushi Huang's family , learn the art from the North Beggar Hong Qi Gong, and be brotherhood with Zhou Bertong. In these five top venture capital, Guo Jing took three. His early master Jiangnan Seven Monsters of this level of investors, have long been out of reach, then, if the latter round of investors and the former round of investors will often still have a succession of.
2. Multiples
In this issue of multiples, we often see the 1X and 2X, so what do these mean? 1X is the investor double back, 2X is twice back, so this also appears in our example at the beginning. The amount of investment of A round of investors, Jiangnan Seven Monsters, is 2 million. When the North Warrior Technology was acquired by 5 million dollars , Jiangnan Seven Monsters can get double return back first, 2 million plus two, that is also 4 million. Later when we talk about the right to participate in the distribution, we will discuss why Jiangnan Seven Monsters can also take away another 200,000.
Note that this priority multiplier is the same as the order. The later the investors come in, the multiplier is higher. That is to say, North Warrior Technology has A round investment of Jiangnan Seven Monsters, B round investment of All True capital, C round investment of Beggar Capital. Then may be A round investor, Jiangnan Seven Monsters, has 1X priority; B round investor, All True capital, has 2X priority; C round investor, Beggar Capital, has 3X priority. There may also be like that Jiangnan Seven Monsters, All True Capital, Beggar Capital all have 1X priority. Of course, there are various other permutations.
Be aware that in most cases, even VCs are more friendly and companies are healthier, the liquidation priority on the list of terms should be only 1X, 2X up to 3X. If you find a 5X priority, it only means that the investor is not optimistic about the company and has very high return requirements for the company. For example, in the process of investing in "Wan Yan AI" founded by Yang Kang, the founder of Ouyang Feng as the GP of West Poison Capital, it proposed 5X participating liquidation preferrence. The reason is that West Poison Capital did not think highly of "Wan Yan AI", but the original investment in "Metaq" had a premature death of the founder Ouyang Ke before the completion of the Vesting Schedule maturity. Therefore, we had to switch to "Wan Yan AI". This situation often occurs in the late stage of the company financing when company volume has been very large but the prospects are not very clear. Because you can think, if the investor is very optimistic about the company, then certainly the investor expect the company to go public to make a lot of money, then there is no need to rely on the return of capital.
Ⅱ. Optional Rights - The Right to Participate in the Distribution
The second right in the liquidation preference is actually the right to participate in the distribution. The right to participate in distribution has another name called double dipping, that is to dip twice. Let me just give you an example.
Just now we did not give an example of 2X participating. The amount of investment of Series A investors, Jiangnan Seven Monsters, is 2 million. When the North Warrior Technology was acquired by 5 million dollars, then because the investor Jiangnan Seven Monsters have 2 times the liquidation priority, Jiangnan Seven Monsters can first draw away 4 million. Then because the equity ratio between Guo Jing and the Series A investors, Jiangnan Seven Monsters is 80% and 20%, Jiangnan Seven Monsters can also divide the remaining 1 million with Guo Jing in accordance with the equity ration. This is the magic of the right to participate in the distribution.
In fact, the right to participate in the distribution is also subdivided into the following kinds
1. Full-participating Liquidation Preference
2. Capped-participating Liquidation Preference
3. Non-participating Liquidation Preference
