In defence of liquidation preferences

I just read a New York Times article that led with the sentence “Deep inside a Silicon Valley unicorn lurks a time bomb”. It turns out that ‘time bomb’ is the much maligned and, I suspect, little understood, liquidation preference.
To be clear, liquidation preferences are sometimes used badly and founders should generally turn away from investors who ask for multiple liquidation preferences. Additionally, they introduce a small amount of complexity and an element of misalignment between the investor and the common stock holder (usually the founder).
For these reasons our investments at Forward Partners are always in ordinary shares.
However, most of the later rounds or companies raise feature simple 1x liquidation preferences and we’re fine with that. To explain why I’m going to look at the role liquidation preferences play in getting deals done.
In any negotiation it’s helpful to look for ways in which the counterparties see things differently to reach other. These differences create the space for win-win solutions and without them negotiations are a zero sum game.
Liquidation preferences are a useful tool because they exploit a difference in the way investors and management see the future. Generally speaking management teams have more confidence in their success than investors do. Not by much, but by enough that it makes sense for them to accept a liquidation preference in exchange for a higher valuation. That trade gives them less dilution and therefore more cash in upside scenarios but less cash (and potentially nothing) in extreme downside scenarios.
This trade off is now so entrenched that it’s become a market standard that most investors and founders make unconsciously, but they are all aware of the implications. Moreover, in the rare situation where investors offer a choice management almost always go for the higher valuation.
Furthermore, provided the instrument is kept simple (i.e. a 1x non-participating preference share) and the company is successful enough to raise a couple of million or more the complexity and misalignment are more than manageable. Then as companies get towards unicorn status management and investors get increasingly sophisticated and their ability to exploit more complex instruments increases.
None of this is to say that some companies haven’t been overvalued and that liquidation preferences haven’t contributed, but it doesn’t sound like a ‘time bomb’ to me.

  • Bertie

    Hi Nic,

    Great post. As someone who does a lot of analysis on private company m&a/investment transactions, I have a couple of questions:

    (1) If you are analysing investment rounds (say to get a feel of what investors are paying for a particular type of company in the market, or for finding comparable companies for valuation reporting purposes) and a comparable company has issued preference shares (with let’s say a 1* liquidation preference) in exchange for capital, would you discount the resulting valuation and if so what would be your process for discounting/by how much would you discount the valuation?

    (2) A lot of people talk about the economics of venture capital depending on a small number of investments of each fund being ‘fund returners’, whilst the majority of investments make little to no impact on the returns of the fund as a whole. If this is the case, it seems strange that VCs will accept a smaller stake in a company in exchange for a liquidation preference, given that such a preference will make little to no difference (depending on the type of preference) to the proceeds of a ‘fund returning’ exit, but owning a larger stake could make a huge difference to it and thus the returns of the fund as a whole. I would have thought that being able to recoup a small amount of each average/failed investment due to liquidation preferences is unlikely to impact the returns in the same way as owning a few percentage points more of a big winner company will. Is there a flaw somewhere in my reasoning here?

    Thanks!
    Bertie