There are a lot of confusing terms tossed around during funding discussions, although most people likely ignore a good number of them. Unfortunately, there is usually a disproportionate focus on one particular piece of the equation, which of course is the valuation. There is no denying the importance of valuation, but it should not be obsessed over to the exclusion of some of the other terms, many of which can and will have significant consequences on a company in the long run. A particularly important example of this is the inclusion of liquidation preferences. Investors are obviously keen on the addition of liquidation preferences, although they may end up being rather detrimental to the business. Here are some reasons that liquidation preferences may prove problematic:
They Undermine Valuation
Given that company leaders are always quite concerned with a company’s valuation during any fundraising round, it is surprising that they do not pay more attention to things like liquidation preferences. These preferences allow investors to receive their share of the distribution of assets upon liquidation of the business before any other shareholders, i.e., they are afforded preferential treatment. The problem is that a liquidation does not necessarily refer to just bankruptcy or dissolution of the company. In some cases, a change in ownership such as an acquisition or a merger may constitute a liquidation, in which case these preferences may come into play. And, given that these terms give a certain segment of investors preferential treatment, this can undermine the perceived value of the business, as the ownership interests are essentially skewed.
They Erode Morale
The preferential treatment that will be afforded to investors who have been granted liquidation preferences may not sit well with some members of the founding team or employees with stock options who are finding their interests diluted. Granted, common stockholders are entitled to the remaining distribution after any creditors and preferential holders receive their share, but there very well may be instances in which there is not anything left over to distribute. In addition, when seeking to bring on additional talent, they may be less than enthusiastic about joining since liquidation preferences will essentially mean that future hires are going to be receiving a smaller piece of the pie.
They Might Be Expected Later
Investors are going to want to include liquidation preferences for fairly obvious reasons. But, including these preferences for initial investors may end up setting an unfortunate precedent. In the event of any subsequent rounds of funding, prospective investors may also seek to have liquidation preferences included for them as well. Depending on the strength of a business and how desperately it needs a cash infusion, this may be a hard request to deny. Of course, this only further dilutes the founders’ interests and possibly the company’s valuation.
They Could Deter Future Investors
On the other hand, rather than have prospective investors who also want to include liquidation preferences, some may see that they are already on the books for previous investors and cease any further investment negotiations. This is especially true for investors who would only be seeking to invest in some common stock, and thus buying into the company knowing that a lot of other people will get their share before they do upon any liquidation.