The Making of a Winning Term Sheet: Understanding What Founders Want the Special Founder Liquidation Preference

PART ONE

The Making of a Winning Term Sheet: Understanding What Founders Want The Special Founder Liquidation Preference

By Jonathan D. Gworek

mbbp.com

Morse, Barnes-Brown & Pendleton, PC • Waltham, MA • Cambridge, MA mbbp.com The Making of a Winning Term Sheet: Understanding What Founders Want The Special Founder Liquidation Preference

Introduction paper is the first in a series of articles to is one reason that some founders resist describe a few approaches that venture venture money altogether. The overhang Know your target market. It is one of investors might consider using to en- can also create a misalignment of inter- the most fundamental principles of any hance the chances of winning a com- ests between the venture investors and successful marketing strategy. Investors petitive deal. the founding stockholders because who understand what the founders of acquisition scenarios can occur in which a startup really care about will stand a Special Common Liquidation the common stockholders will not better chance of winning the competi- Preference receive any proceeds for their stock, but tive deal. in which the investors get a substantial return or at a minimum get a portion of The Overhang Issue. One common Currently when competitive situations their money back. This misalignment, concern that founders express when arise, most venture deals are won and coupled with a lack of control of the considering whether to take venture lost on the basis of premoney valuation company post financing, further adds to money is the impact that the venture and the perceived reputation and fit of the founders’ concerns. investor’s “liquidation preference” will the competing venture firms. Winning have on the founders’ ability to realize deals on the basis of aggressive pre- While a preferred liquidation prefer- a return on their common stock. The money valuations is a one dimensional ence is considered “market,” there is typical venture deal provides that upon strategy that relies on speculative infor- no reason why the standard liquidation the sale of the company the preferred mation about competing offers and can preference can not be modified to lessen stockholders will receive their money drastically impact return on investment. the impact of the overhang. It is the rare back first, plus often a dividend return, Younger, smaller venture firms that founding group that has the leverage or before any proceeds are allocated to the are still establishing their place in the nerve to test the limits of what terms common stockholders. The result market are often not able to compete the venture investors may be willing to is that in certain scenarios the holders on reputation. In an investment envi- accept. Notwithstanding this fact, there of common stock, including the found- ronment in which too much money is is ample precedent in the venture com- ers, will not receive any of the sales chasing too few deals, venture firms may munity for exceptions to the standard proceeds. As rounds of funding stack be well served to think creatively and act liquidation preference described above. on top of one another — Series A, B, proactively in crafting term sheets that Like all terms, this one too is negotiable. C, etc... — this liquidation preference are attractive to founders. Several deal The liquidation preference provisions “overhang” can become quite stifling to terms can be modified with this objec- can be modified in several ways to be the holders of common stock leaving tive in mind without significantly affect- more attractive to founders. The good little hope of any meaningful return for ing an investor’s return on investment. news for the venture investor is that the founders other than in the most opti- In the end, giving up marginal deal variations need not have a significant mistic of exit scenarios.1 protections will prove a shrewd strategy or adverse impact on their return on if the result is a stronger portfolio of investment. The savvy investor can of- Sophisticated or well advised founders companies. fer to modify the standard liquidation are very sensitive to this overhang and it preference rights for the benefit of the A number of creative approaches to 1 For a more complete discussion of the founders without realizing much if any standard terms and conditions will liquidation preference overhang issue, see direct impact in many scenarios — a “The Liquidation Preference Overhang”, by capture the attention of founders. This Jon Gworek. See: http://www.mbbp.com/news/ true “win win.” the-overhang-problem

Morse, Barnes-Brown & Pendleton, PC • Waltham, MA • Cambridge, MA • mbbp.com Special Common Stock. As a start- equal to the pre-money valuation agreed A senior liquidation preference would ing point in exploring this alternative upon with the investors as this amount eliminate the risk that the founders approach, investors need to understand is presumably some measure of the value would get nothing in a liquidity event, that like preferred stock, common stock that was created by the founders prior to and therefore greatly mitigate the can be split into different classes, with the funding. overhang risk, because the founders’ certain classes enjoying special rights. In common liquidation preference would fact it is not uncommon for an emerg- A third possible approach is to take always come off the top. ing company to have two classes of the total number of shares that will be common stock, one that votes and one owned by the founders, postfunding, Alternatively, the special common that does not. Distinctions between and multiply that number by the price liquidation preference could partici- classes of common stock can also be per share of preferred stock. This third pate alongside the preferred (so called drawn along economic lines. approach eliminates the value associ- “pari passu”). In addition, in any of the ated with the option pool (the shares foregoing cases the special common For example, the founders’ stock could of which are generally considered part stock could be either participating or be set up (or reclassified if it already of the pre-money capitalization for non-participating once its liquidation exists) into special common stock that purposes of pricing the preferred), and preference has been satisfied.3 carries with it a liquidation preference is arguably the truest indication of the that is different than the other common value that the founders created through Illustration of Impact on Preferred stock. The idea of creating a special class their sweat equity and other contribu- and Common Return. The follow- of common stock for the founders is tions prior to the venture investment. ing tables show how the return to the the basis for a range of approaches that investors, founders and other holders of can reduce the impact of the liquidation In the end, the amount that will deter- common stock can be affected by intro- preference overhang described above. mine the special liquidation preference ducing a special class of founder com- is a matter up for negotiation. mon stock with a liquidation preference. Determining the Amount of Prefer- Both tables assume the following facts: ence. If an investor gets comfortable Determining the Priority of Payment. 1. investors have put $5M into the with allowing a special class of common Once the value of the special common company, and therefore have a $5M stock that carries a liquidation prefer- preference is established, the next ques- liquidation preference, for 50% of ence, the next question is what the tion is to determine how this liquidation the common stock on an as-con- dollar value of this preference will equal. preference gets paid out relative to the verted basis, No established rules or parameters exist investor preferred and the other com- regarding the appropriate dollar amount mon stock. Again, no established rules 2. the founders own 25% of the com- of this type of preference.2 From the exist to explain how the special founder mon stock on an as-converted basis, investor’s perspective, the special liqui- stock should participate in a liquidity 3. the other common shareholders dation preference would be an amount event relative to the other capital stock. own 25% of the common stock on that is attractive to the founders but an as-converted basis, that does not significantly impair the While there is little data available from 4. the liquidation preference on the investors’ return. If the founders have which to draw, the most typical ap- special common stock is $2M, and put in significant capital, the amount proach seems to be to establish a special of this capital might be the appropriate common stock that is junior to the 5. the special common stock is non- number for the liquidation preference. preferred stock, but senior to the other participating. common stock, in terms of liquidation Another approach is to set the liquida- preference, and not participating regard- The first table shows the distribution tion preference at an amount that is less of whether the preferred is partici- of proceeds when the preferred stock is pating or non-participating. non-participating, and the second table 2 For preferred stock, the liquidation preference is equal to the original dollar amount 3 In any case it is likely that the special com- invested, plus in many cases a return on that While the above approach is the most mon stock would need to be convertible into gen- original investment. This “dollars in” approach common, many other possibilities could eral common stock. If the special common stock does not provide a useful basis for establish- is participating, it needs to be convertible, or ing the founders’ liquidation preference unless be considered when structuring a special deemed converted, in order to participate. Also, the founders have put in a significant amount common liquidation preference. For if the special common stock is non-participating of capital themselves. It is therefore necessary example, the liquidation preference it would need to be convertible into general when setting up special common stock to “pick” common stock or the founders’ upside would be a liquidation preference amount. could instead be senior to the preferred. capped at its liquidation preference.

Morse, Barnes-Brown & Pendleton, PC • Waltham, MA • Cambridge, MA • mbbp.com shows the distribution of proceeds when the preferred stock is participating.

The rows show the proceeds payable to the investors (“Preferred”), the founders (“Founders”) and the holders of other common stock (“General Common”) at 3 different sales prices-- $8M, $20M and $100M. Under each price, the column to the left shows how proceeds would be distributed assuming there is no special class of founder common stock (“W/Out Founder LP”), and the This first table shows that the special common stock results in a transfer of value only column to the right shows how proceeds at the $8M sales price. In this case, $500,000 is transferred away from the other * would be distributed assuming there is common and to the founders. There is no impact on the preferred stockholders. a special class of founder common stock (“W/Founder LP”).

Summary of Impact of Special Common Stock on Investor and Common Return

Impact on Liquidation Preference of Preferred. If the special common liquidation preference is subordinate to the preferred, the common liquidation preference will have no impact on the preferred liquidation preference as it will always, This second table shows that under the same range of scenarios in which the pre- by definition, be paid after the preferred ferred stock is participating, the special class of common stock results in the transfer stock liquidation preference. The venture of $1.25M to the founders-- $1M from the preferred stockholders, and $0.25M from the other common stockholders-only at the $8M sales price. The special common investors will always get their original stock has no impact on the return to either the preferred stock or the other common investment back first irrespective of this stock in any other scenario. common liquidation preference.

* The table illustrates the outcome based on just one set of facts. While none of the scenarios impact the preferred return, there are situations in which the preferred return would be negatively impacted by the special common stock liquidation preference. This will be true in any case in which the special common stockholders percentage of the sale proceeds on an as-converted basis is less than their liquidation preference and the percentage of the sales proceeds that the preferred would receive on an as-converted basis after deduct- ing the common liquidation preference is less than the preferred liquidation preference. This results from the fact that if the amount that the special common would get on an as-converted basis after the liquidation preference is paid to the preferred stockholders is less than the special common liquidation preference, the holders of the special common stock will opt to take their liquidation preference. The preferred stockholders would then, on an as-converted basis, receive their pro rata share of what is left after the special common stockholders take their liquidation preference. As a result, the preferred stockholders might in certain situations choose not to convert and instead take their liquidation preference whereas without the special common stock liquidation preference to consider they would have been better off taking their as-converted share. For example, if the table labeled “Non-Participating” were re-run using a $5M common liquidation preference with all other variables remaining the same, at an $11M sale, the preferred would convert and take $5.5M in the absence of a special common liquidation preference. However, if the preferred were in fact to convert, the special common would opt instead for their $5M liquidation preference which is greater than the $2.75 the special common would get if they opted to convert into 25% of the common. This would leave only $6M for the preferred and the other common stockholders to share on an as-converted basis, of which the preferred would take 2/3 or $4M. Since this is less than their $5M liquidation preference, the preferred would not convert but instead take their $5M liquidation preference leaving them $0.5M less than they would have received if there had not been any special common stock. To eliminate this transfer of value away from the preferred stockholders, the special common stock could be subject to conversion in those scenarios in which the preferred stock would, in the absence of the special common stock preference, be deemed converted to common stock.

Morse, Barnes-Brown & Pendleton, PC • Waltham, MA • Cambridge, MA • mbbp.com Impact on Return of the Preferred. even at the time of the formation of the Conclusion The special liquidation preference can company. have an impact on the overall return to While creating a special class of com- the preferred stockholders above and Another question is whether the found- mon stock for the founders with a spe- beyond their liquidation preference. The ers should vest in the special common cial liquidation preference is not typical, extent of the impact on the preferred stock. Imposing vesting would reduce it is an option that offers investors a return will depend on whether the the risk that one or more founders great deal of flexibility and creativity. A preferred stock and the special common would decide to leave the company special founder common stock can be stock is participating or non-partici- prematurely. Related to this is whether, structured in such a way that it has min- pating. If the special common stock is should a founder leave the company imal impact on the preferred stockhold- subordinate to the preferred stock and without having fully vested in the spe- ers and the other common stockholders non-participating as in the above ex- cial common stock, the special liquida- under most scenarios. The benefit to the ample, the impact on both the preferred tion preference should be reduced or be founders, and the cost to the preferred stock and the other common stock will effectively re-allocated to the remaining stockholders and other common stock- occur mainly at low end sales prices and founders. This would be a way of holders, would occur mainly at sales at the higher sales prices their will be no transferring value from one founder to prices on the low end of the spectrum. impact. another-an additional benefit that can Founders who are concerned about this be conferred on the founders to sweeten type of downside protection, and feel Other Considerations the deal. that they should share more equitably in such scenarios, might find a special class Tinkering with special common stock One final but important issue that of common stock to be a compel- in the ways previously described raises special common stock raises is the ling feature. Investors willing to allow several other practical questions. One is impact that this special common stock founders a special common stock may whether the idea of a special preferred may have on the ability of the company find that this concession allows them stock is fair to the other class of com- to raise subsequent rounds of financ- to attract better deals, especially in a mon stockholders. As demonstrated ing. The company, the founders and competitive environment. In the end, above, the impact need not be signifi- the investors should understand that what really makes a venture portfolio is cant on the other common stockholders the special common stock would be a the number of quality investments, not who hold general common stock. separate class of stock, and that under the downside protection. If a fund were Delaware law no adverse change may be to widely use a special class of common In addition, if a company is going to made to that class of stock without the stock over a portfolio of 20 companies, implement a special class of common consent of the holders of this class- i.e. 5 of which are sold in scenarios that cost stock, there are some important tim- the founders. Given that founders some- the investors $2M each, the total cost ing considerations. If there are other times leave the companies they start, to the fund would be $10M. But if the common stockholders at the time of the affording them this leverage might be a fund is able to attract just 1 more deal funding event, then under corporate risky proposition. For example, future that returns a multiple of their invest- law all such holders would need to have investors could require that the special ment, the loss of $10M would seem their common stock converted to special common stock liquidation preference, inconsequential. common stock as well. The conver- as well as other preferred preferences, be sion could not be “selective”. The same given up as a condition to funding.4 For more information, please email might also apply to shares subject to an Jonathan D. Gworek at jgworek@mbbp. option plan if there are any. 4 While there certainly are scenarios in which com. the founders may be able to throw up barriers if they hold a special common stock, they should In addition, converting general com- not be able to limit or block the ability of the mon stock to common stock with a company to raise subsequent venture rounds that are senior in liquidation preference to the liquidation preference could be a taxable special common stock. In anticipation of those event to the recipients of the special future scenarios in which investors condition funding on the elimination of the special com- common stock. Both of these facts mon stock liquidation preference and all other suggest that if the founders think they liquidation preferences (i.e. a cram down or re- might want this structure in place at the capitalization), the security could be structured in such a way that it converts to common stock if time of a venture round, it may make the venture preferred converts to common stock, sense to put it in place early on, possibly or upon other triggers.

Morse, Barnes-Brown & Pendleton, PC • Waltham, MA • Cambridge, MA • mbbp.com