The 3X Liquidation Preference Is Back!

A while ago I wrote about how a liquidation preference works and I’ve noticed that this has quickly become one of the most popular posts on Altgate and a top-10 result in the Google search for that term.  Well, I guess it’s a sign of the time.

This week I’ve spoken with two startup CEO friends who have raised inside rounds and got clobbered with a 3x participating liquidation preference.  I called up a couple of attorney friends and a couple of VCs to see if this was in fact becoming “normal” and everyone said “ya, pretty much.”  From what I can tell the increase in the cost of capital for startups is partly to do with projections being revised down, but also (maybe even more so) because of a big mismatch in supply and demand for capital.  Even companies that have countercyclical businesses are finding cash more expensive.

Let’s recap how expensive a 3x liquidation preference really is.  Say you raise $8MM at $17MM pre-money ($25MM post) with a 3x participating preferred.  Further assume that that money lasts you 2 years until you sell the company for $50MM to Microogle which would certainly be a “happy” ending all things considered.  In that scenario your last round investors will get $24MM of that sale off the top (3x their $8MM investment).  Then your other preferred investors will get their preference (let’s assume they have $12MM at 1x invested in two rounds at a $17MM post-money valuation which would make the “current” round flat).  When you throw in the $5MM of dividends that have accrued on the preferred, then Common shareholders will get approximately ZERO from this sale for $50MM.  If the sale price goes up to $75MM, Common gets to split about $5MM in proceeds.  Yippee.

In reality, what happens is the board will negotiate a carve out for then-current management if an opportunity to sell comes along or a refresh if an exit is still far off.  But non-management employees and founders will be thrown table scraps and crushed down.  You could probably find some pawn shops that offer cash more cheaply.

What’s the alternative?  The only potential alternative is crazy cuts to your expenses that allow you to survive.  What’s crazy?  Could be you need to consider cutting back to just a couple people and then reboot to have any hope of retaining founder economics.