Why should I care?
Bull market term sheets are supposedly clean – the price is sometimes negotiated, but investors often took the price and ceded control on other terms. Bear market term sheets are seen as “dirty” – full of structure in the form of control clauses and ominous terms. Most venture investors who haven’t seen sour market conditions don’t even know about the nature of other terms included in term sheets – they were viewed as largely unimportant or sources of deal friction when the only thing that mattered was getting into the company.
First, the most important term in a term sheet is the valuation (either pre- or post-money). But, the liquidation preference takes the mantle for second-most important. Even in an extremely founder-friendly funding environment, most term sheets had liquidation preference clauses, and while term sheets may have more structure in aggregate in this bear market, I’m not quite sure the nature of the liquidation preference will change much i.e. become more extreme. Here’s what the liquidation preference does, why it exists, and how entrepreneurs, employees, and investors who built stakes in private tech companies over the last couple years should think about its impact.
The liquidation preference determines who gets what in the case of a liquidation event; usually defined as wind-downs, acquisitions, mergers, or changes of control. IPOs do not count on a technicality, and in those cases, preferred stock converts to common anyway. Professional VCs, who buy preferred equity in companies, usually write in a 1x liquidation preference. This means that those investors get at least 1x their investment back before common stockholders (typically founders and employees) during these events. I believe many term sheets issued in 2020 and 2021 have 1x liquidation preferences – note that further complexity arises when you introduce multiple rounds of financing, pari passu, and participating preferred vs. non-participating. More about all that here.
On its surface, the liquidation preference looks like a “heads I win, tails you lose” situation for the investor. The liquidation preference was designed with an intent towards alignment and downside protection. It doesn’t end up mattering if the price of the equity continues to rise, and the business is ultimately successful with a favorable acquisition or public listing. And here’s how to think about downside protection. Say you’re an investor and you invest $1M at a $10M post-money valuation. You now own 10% of a startup. If there is no liquidation preference, the startup could get sold for $5M 2 months later, and the founder(s) could take home $4.5M, and you have now lost $500K. Naval points to an even more extreme example here – the founder could dissolve the company after you wire the $1M, distribute the proceeds, and just give you $100K (10%) back.
Ok, again – why did I write this? Because the liquidation preferences written into term sheets in 2020 and 2021 will come into effect – there will be (more) down rounds, wind-downs, and less-than-appetizing acquisitions. This is the unfortunate reality due to the degree of over-capitalization and dearth of product-market fit. In downside scenarios where liquidation preferences kick in, startup employees typically are the worst off with regards to equity value (due to holding common stock). I found this resource from Fred Wilson to be the most detailed if one plans on doing a DIY liquidation waterfall, but I suspect your company will not part with all the information listed as key inputs. Founders could be in a similar situation as their employees and hopefully Fred’s guide helps if you are considering paths to liquidity or exit options. Early-stage investors (angels and seed funds) could get crushed in a preference stack if venture or growth stage investors wrote in greater than 1x liquidation preferences or participating terms. However, most boilerplate seed term sheets (like Cooley’s which we use at Haystack) write in 1x liquidation preferences and the standard YC SAFE (which many use) also has a liquidation preference. But it is important to note that early stage investors will have to advocate for themselves with the founders they’ve partnered with at each subsequent financing.
It’s not as fun to write about the mechanics of term sheets versus opportunities for new markets and products (more on that soon). But hopefully writing this can help demystify some important stuff. The exercise even helped me, and understanding how all this works is an integral part of being a venture investor across cycles.