More on Liquidation Preferences

A long time ago I had asked a VC about what pre-money valuation he was planning to put in a term sheet he had promised to send over.  He jokingly said something like, “I’ll let you pick the pre-money valuation if I get to pick all the other terms.”  He said it as a joke, but it is totally true that pre-money valuation is just one of a handful of key economic terms in a term sheet.

One of the least understood of these key terms is the liquidation preference.  I’ve posted before on how a liquidation preference works (which is actually one of the most popular blog posts I’ve written), but now I wanted to share some data on how it’s used.

Below is a chart of some data from the 2010 CompStudy survey.  The chart show average pre-money valuation by liquidation preference for 667 rounds of first or second fundings for US technology companies that actually had a liquidation preference.

The first thing I noticed was that the vast majority (76%) of financings have a “one x” preference.

Liquidation preferences can be quite complicated introducing caps and participation which the CompStudy survey hasn’t historically captured (more on that later).  But first, let’s look at pre-money valuation by liquidation preference.  The thing that immediately jumps out is that the rounds with higher pre-money valuations have much higher liquidation preferences.  For example, rounds with a preference between 1.1X and 2X had an average pre-money valuation of $8.6 million but rounds with a preference of 3X or more had a 72% higher average pre-money valuation!

The cynic in me says that this high liquidation preferences are VCs taking advantage of entrepreneurs who don’t understand what they’re giving away, but I suppose there are scenarios where these deals would make some sense.

But this last chart gives some insight into how unfavorable to founders (Common actually) these preferences can be.  The chart below shows the price per share to each series of shares at different net exit valuations.  The preferences used in this example were relatively benign, but yet you see that the price per share varies radically and Common doesn’t make *any* money until quite a large number.

So the take away here is that entrepreneurs should negotiate liquidation preferences as hard as they negotiate for pre-money valuation (and other key terms).  And yes, some financings don’t have any liquidation preferences at all (although that’s actually a pretty small number).  It’s something that we’re going to be doing a better job of with in future CompStudy surveys.