Good Technology's situation isn't uncommon. It is something that we call “liquidation preference overhang,” and “shadow preferred stock” is the answer. Comment [D10]: Note that this number might be higher for those investors who invested with a discount, even if the doc says 1x Comment [DR11]: Cumulative dividends do Seniority: This is the investor's place in the stack of preferences. It essentially says: this SAFE is an illiquid, private company investment. The overhang leads to an investor having more liquidity preference than they paid for when they convert at series-A (Meaning they get paid out before you, which isn’t good). Dilution I Suppose instead the entrepreneur decides to issue the new VC with RP from FINA 4603 at The Hong Kong University of Science and Technology There are a lot of buzzwords and lingo in the startup and VC ecosystem. Convertibles need to be viewed for what they are: a bridge to a fixed-price If a VC tried to do this to you on an early-stage deal they would get such a bad reputation that no other VCs or entrepreneurs would work with them. The liquidation preference overhang is the amount of money that is needed in a liquidation event to pay all the liquidation preferences before the common stock (founders and employees) receive anything. If there had been a 1x liquidation preference in place, the investor would be guaranteed to get $3 million back. When they burn through your cash and raise somebody else’s cash, you’re no longer sitting on top of them in a liquidation preference overhang. However, multiple liquidation preferences can backfire if they cause an "overhang" of investor preferences that may be too large to provide any meaningful return to management or the other shareholders (particularly in the context of a trade sale at a price that is less than the aggregate liquidation preferences of the preferred shareholders). In the simplest terms, say a company raises $10 million in one round of financing and receives preferred stock with a 1x non-participating liquidation preference.This 1x non-participating liquidation preference is a common type of liquidation preference, though pay attention to each figure and term. This Series A preferred stock will typically have a 1x liquidation preference, so $2M of liquidation preference overhang will be created as a result of the conversion discount/price cap. Find spectacular products at an unbelievable value when you shop DollarTree.com and view our closeout items for only $1 each. One common concern that founders express when considering whether to take venture money is the impact that the venture investor's Liquidation Overhang – This refers to the concept that a noteholder, if they convert at a discount to the price paid by the new fixed-price round investors, they will get liquidation preferences they didn’t pay for. The hidden multiple liquidation preference. In this article, I will first explain what a liquidation preference is (par. This Series A preferred stock will typically have a 1x liquidation preference, so $2M of liquidation preference overhang will be created as a result of the conversion discount/price cap. Liquidation preference is a safety net for investors who are getting preferred stock. Protecting Management from a Liquidation Preference Overhang. Complex liquidation preference: In an effort to keep from doing a down round, or too much of a down round, there will be tension between your old investors and your new investors (if you have them) around your new liquidation preferences. ), resulting in a cluttered capitalization table and other administrative complexities. Preference Overhang If a Series A investor pays $1.00/share, and a note converts into preferred stock at a 20% discount, then unless the terms of the note provide otherwise, the note investor would have $1.00 of liquidation preference for every $0.80 actually invested. Liquidation preferences, participation, ratchets – even the very term preferred shares (they are called ‘preferred’ for a reason) are things every entrepreneur needs to understand. In an effort to keep from doing a down round, or too much of a down round, there will be tension between your old investors and your new investors (if you have them) around your new liquidation preferences. When that initial note converts in stead of $500,000 liquidation preference they would get $2.5 million liquidation preference in stead of a $500,000 or a whopping 5x liquidation preference. A senior liquidation preference is a liquidation preference that is superior in rank and claim to other liquidation preferences. Liquidation preference is a key term negotiated in venture and even seed stage investments. It’s the amount of money the preferred stockholders are contractually entitled to receive off the top on a sale of the company before the common stockholders receive anything. The company raised $21 million at $15.22/share. The preferred stock issued to a Safe investor upon conversion has a liquidation preference equal to the amount the investor paid for the Safe, so the company is not unjustly burdened (and the investor is not unjustly enriched) with liquidation overhang. If your company has a lot of “liquidation preference” built up over the years, and if you think it is not worth that amount in a sale situation, your company is in a liquidation overhang situation and your employee equity is not worth anything at this very moment. However, between 2015 and 2016, there was a 60% increase in deals that gave “senior” preference to later-stage investors — meaning they get paid first. The new one doesn’t. Voting rights have some effect although, in most cases, that’s really negligible in a private company with big block stockholders. Seniority: This is an investor’s place in the preference stack. This solves what’s sometimes referred to as the “liquidation preference overhang” exposure with most convertible notes. Liquidation preference = the right of the holders of preferred stock to get their money back (and perhaps more) before the common stock when a “liquidation event” occurs (generally, an M&A transaction). This is a warning to investors. We sat down with Sonia Sahney Nagar, the founder of Pickie, for Do What You Love — a new series that showcases the entrepreneurs behind emerging companies. Voting rights have some effect although, in most cases, that’s really negligible in a private company with big block stockholders. A responsible investor will aim to obtain a fair liquidation preference to protect its downside, but recognizing the demoralizing effect of excessive liquidation preferences (a “liquidation preference overhang”), will not gouge the company by seeking excessive liquidation preferences except in … Liquidation preference overhang: There was one in the pre-money SAFE. The liquidation preference overhang is kind of like musical chairs when a company gets sold, […] I always said I was going to be a CEO. In straight preferences the investors only get this money in a “downside” scenario as protection that they get their money back if your company isn’t successful. The liquidation preference determines who gets paid first and how much they get paid when a company must be liquidated, such as the sale of the company. ... José Ancer did a great job of summing up the problem of “liquidation overhang” in the post The Problem in Everyone’s Convertible Notes. Hashtag puppy. Here we provide a guide to the most commonly used terms, so that you can reference them as … Valuation overhangs give note or SAFE investors a better deal if you raise the next round at a valuation above your cap. In other words, they got a 4x participating liquidation preference. Liquidation preference is the amount of money that an investor gets paid before the common stock (e.g. In very simple terms: "Liquidation Preference" is an agreement between a company and an investor that when the company is acquired or IPOs, the company will pay the investor some specific amount of money BEFORE any other shareholders get paid. The liquidation preference overhang is kind of like musical chairs when a company gets sold, where the chairs are the money, and the VC always gets a chair. In this blog post, I’ll briefly explain the liquidation preference overhang phenomenon and discuss how to keep founders and key employees incentivized with a carveout arrangement. Liquidation Overhang – This refers to the concept that a noteholder, if they convert at a discount to the price paid by the new fixed-price round investors, they will get liquidation preferences they didn’t pay for. Priorities among the series of prior investment are preserved, but valuation differentials are eliminated and the preference overhang is reduced. Liquidation preference is the amount of money that an investor gets paid before the common stock (e.g. Overhang is when preferred stock shareholders' liquidation preference is greater than the amount of proceeds the company receives for liquidation. Because of liquidation preference, those holding preferred stock (investors) will have to be paid before those holding common stock (employees). • Preferred shareholders will always look to convert their shares to common shares if the conversion works out economically favourable. A company is in liquidation overhang when the value of the company doesn’t reach the dollar amount investors put into it. If there is overhang, none of the proceeds will be disbursed to the common shareholders. A Sample Fact Pattern Meet our early … It In straight preferences the investors only get this money in a “downside” scenario as protection that they get their money back if your company isn’t successful. A liquidation preference overhang lowers the value by lowering the chance that the option will come into the money before it expires. When that initial note converts in stead of $500,000 liquidation preference they would get $2.5 million liquidation preference in stead of a $500,000 or a whopping 5x liquidation preference. This effectively prevents a liquidation overhang. management, founders, angel investors) get any money. Then use the down round to clean up your preference overhang. Liquidation Overhang happens when there is a convertible note that converts into preferred stock without a mechanism to address the discounted shares. Lots of digital ink has been spilled on VC funding, so we'll limit ourselves to the aspects germane to the liquidation overhang. The new SAFE creates a sub-series of stock such as “Series A-1”. Liquidation Preference Sometimes “multiples” are used (1x, 2x, 3x the investment amount) Sometimes accruing dividends are included (essentially like adding an interest rate component to the preference– range of 4% to 9% in Q3). 2), followed by an overview of the main types of liquidation preference (par. Recapitalizations – “preference reset” • “Preference Reset” • Pro rata reduction in liquidation preferences of some or all prior preferred • Sell next series • Reduces liquidation preferences • Preserves priorities • Preserves valuation differentials • Reduces “preference overhang” over common stock | 28 We will explore liquidation preferences through an example. Companies with a liquidation preference overhang may want to consider new ways to motivate and retain their employees. Because of liquidation preference, those holding preferred stock (investors) will have to be paid before those holding common stock (employees). Preference overhang is the amount of money that preference share will first receive after which the remaining of the liquidation proceeds will then be allocated to the common stock holders. For example, if the liquidation preference payable is $50M but the company's value is $60M, investors would be hard pressed to invest-especially anything above $10M-because they would not have confidence that they would at least get their money back upon the company's sale or liquidation. ... the liquidation of investments . Sometimes accruing dividends are included. What is a liquidation preference? In the case of your startup failing, liquidation preference gives the investors a possibility of getting at least some of their money back. Hashtag puppy. The $1.5 million difference is the “liquidation overhang.” Ask me if I think founders/common stockholders care whether they will get an extra $1.5 million in an exit. When startup investors make millions in a sale, but money runs dry before reaching employees, a bad preference stack is often the cause. Sometimes “multiples” are used (1x, 2x, 3x). The Series B holders also invested $10 million for participating preferred, but with a 2X liquidation preference (i.e., $20 million plus accrued dividends) and the Series C holders put in $20 million and have a 3X liquidation preference. Liquidation preferences are the terms determining who gets paid what—and in what order of priority—in different liquidity events. All of that said, there’s still a … For example, if an investor invested $1M on a Note with a 20% discount and the note converted to preferred stock, the investor will receive shares with a liquidation preference of $1.25M. A VC investor will be issued preferred stock, not common stock, which is what founders and employees get (the latter usually by way of options). In the cleanest restarts, the company is recapitalized via the new investment, reducing (or eliminating) the previous liquidation preference overhang and well as the previous equity ownership. Wipeout. If your company has a lot of "liquidation preference" built up over the years, and if you think it is not worth that amount in a sale situation, your company is in a liquidation overhang situation and your employee equity is not worth anything at this very moment. The math can get a little tricky, but this article by Silicon Hills Lawyer does a nice job of explaining it all. VC Term Sheets – Pay to Play Provisions by Scott Edward Walker on May 19th, 2011. SAFE Preferred Stock has the same “rights, privileges, preferences and obligations” as Standard Preferred Stock, but the liquidation preference, conversion price, and dividend rate are calculated based on the price per share of the Safe Preferred Stock. Issue common when you can. The more owed in liquidation preference, the less your equity is likely worth. You can grow out of a liquidation overhang situation. Most unicorns have a “pari passu” structure, in which all investors with a liquidation preference are paid simultaneously. In other words, there is a “liquidation preference overhang.” As a result of a liquidation preference overhang, a company’s common stock, typically held by its founder and employees, is essentially worthless. It is something that we call “liquidation preference overhang,” and “shadow preferred stock” is the answer. The ‘ Convertible note liquidation preference overhang ’ is used to illustrate the overhang effect we will discuss later. All of that said, there’s still a … Let’s skip it for now. can have significant implications for the company and its stockholders and can be complicated to correctly implement. Are the terms determining who gets paid before the common shareholders to common shares if conversion. 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