It is not uncommon for founders to walk away from a successful exit empty-handed. How does it happen? The payout of preference shares might simply exceed the exit value. Since the preference shares sit on top of common shares on the distribution table, the management team walks away with nothing. Imagine building a company for 5 – 10 years and receiving nothing in the end. Brutal. This is a scenario neither the founder nor the VC wants. The VC wants to back serial entrepreneurs, and they are not here to destroy the founders.
A liquidation preference overhang is the amount of money that the preferred shareholders are entitled to receive before the common shareholders in a liquidity event.
Why are we talking about this now? Reason one, the record funding activities in the past two years have created many overvalued startups with inflated round sizes (often meaning giving away too much too early). As the world swiftly shifts to the “capital is scarce again” mode, some find themselves looking at down rounds. Reason two, for those who are raising, many intend to raise more to weather the potential storms ahead. Raising more equity in today’s climate means issuing more preference shares. Both of these scenarios lead to a potential liquidation preference overhang issue.
How to manage the liquidation preference overhang to avoid the devastating scenario we mentioned at the beginning of this article?
Look at the terms beyond valuation. 1.0x, non-participating liquidation preference is the standard. Be careful of words that mean otherwise, e.g. 2.0x liquidation preference.
Create a mechanism that aligns the interests of the core management at a liquidity event that is unaffected by the liquidation preference overhang. For example, an incentive plan that awards the management team with a percentage of the exit proceeds when the payout has been determined.
In conclusion, managing the potential liquidation preference overhang is crucial for founders and investors alike. By paying close attention to the terms beyond valuation, founders can reduce the risk of getting wiped out at liquidation events. Additionally, implementing a mechanism that aligns the interests of the management team with the exit proceeds, unaffected by the liquidation preference overhang, can provide a fair and equitable solution.