There's a real danger when it comes to accepting investments in your startup if you're not careful. Many entrepreneurs are over the moon when they receive a high valuation and an influx of money. It's hard not to be - after all, it probably feels like all of their hard work has paid off. But it hasn't, not yet. The mistake many startup owners make is not paying attention to the contract's liquidation preferences. There are investors out there who will include liquidation preferences in the contract that are extremely beneficial to them - and extremely detrimental to the startup's founders.
Understanding Liquidation Preferences
There are two types of stock that venture capital investors can ask for - preferred stock and common stock. Almost every investor will insist on preferred stock, with very few exemptions. Preferred stock is worth more than common stock for a simple reason - preferred stock holders are given preferential treatment if the business is liquidated (such as through the dissolution of the business, sale of the business or through bankruptcy).
Preferred stocks allow investors to protect their investment in the event that the proceeds of the liquidation ends up being less than the original investment since the proceeds will be given to the holders of the preferred stock first before they are dispersed to other shareholders. For example, say an investor puts up $30 million for a startup that's been evaluated at $100 million in return for 30 percent of the company. If they received common stock in the company, it means that if the company sells for $60 million, they would take a loss since 30 percent is only $18 million. With preferred stock options, the investor will receive their original investment of $30 million first and then 30 percent of what remains, which means that they would receive a total of $51 million. The company's common stockholders would split the remaining money.
That's an example of a 1x liquidation preference and it's a common practice. You can't argue that it's unfair either as your company's investors have to protect their initial investment. It would be too easy for investors to lose money if they didn't include a basic 1x liquidation preference in the contract.
What to Watch Our For
The danger is that some investors will include a 2x liquidation preference - or even larger - in the contract. In most cases, this type of investment isn't worth it as it can leave you with absolutely nothing in the event that your business ends up being liquidated.
Let's use the previous example again. The investor has put up $30 million in return for 30 percent of your company, which is valuated at $100 million. However, this time they have a 2x liquidation preference. The company sells at $60 million. The investor will receive twice their initial investment before any other shareholders of common stock are paid out - so that $60 million is already gone. Say the company actually sells for its valuation - $100 million. Once the $60 million goes to the investor, they still get 30 percent of what's left, which means another $12 million - for a total of $72 million, leaving only $28 million for the remaining shareholders out of a $100 million sale.
Before you accept an investment, always make sure that you read over the contract carefully - especially when it comes to the liquidation preferences. One of the most common mistakes startup founders make is to pay more attention to the valuation than the liquidation preferences. You need to crunch some numbers to see if the liquidation preference in the contract is worth taking the investment.