Sunday, January 14, 2007

Venture Capital: Is a Liquidation Preference Acceptable?

These days, every term sheet you receive from a venture capital investor will include a liquidation preference. 99% of them will insist this is a non-negotiable part of the deal, for fairly valid reasons. When, if ever, should you resist?

The answer lies in the overall financing strategy for your company. I always tell my clients to work backwards from IPO/sale of the company (remember, if you are trying to finance yourself within the venture capital model, your business strategy has to steer to a liquidity event within 5-7 years). How much capital will you need to build product, customer channels and revenue?

Software companies typically need much less capital than fabless emiconductor plays (where the rule of thumb is $10 million to tape out one chip). You may need as many as 5-10 rounds before the company is sold, or $50 million ++ to reach that point. That's $50 million that will receive its return on capital in preference to anything you might receive as a common shareholder. And, if that invested money also had a participation right, it will also share in any proceeds distributed to common shareholders.

Very few Canadian startups have engineered acquisitions for more than $100 million, ever. Which means you need to consider now what a liquidation preference means for your stake in the company as a founder in the long term.

Are you likely to negotiate away a liquidation preference? No, unless you have a very solid track record for successful startups. VCs must have a floor that will guarantee some minmum return on investment. The better approach is to start considering now how to structure compensation (and your future contributions ot the business) to mitigate against the impact of multiple liquidation preferences. Here, US startups - many of whom received punishing liquidation preferences as part of financing rounds done during the internet meltdown - provide great examples of how to adjust management compensation where there are multiple liquidation preferences.

More later.

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