Founder Friendly Term Sheets: Liquidation & Participating Preferences

Most founders get their experience on term sheets from the deep-end training on their first. And many, perhaps most, get screwed – without even knowing it. Let’s talk return preferences: Liquidation and Participating.

Liquidation Preferences [LP]: a multiple of a VCs investment that will be return to the VC, before anyone else gets anything.

Participating Preferences [PP]: describes how the VC shares in the returns left after they have taken their Liquidation Preferences.

Taking both is generally considered double dipping. Ten years ago, Northern Ireland had some of the most egregious preference terms I’ve seen. Perhaps today its fairer.

Back in the 80’s – that’s as far back as I go on term sheet stuff – the intent of these terms was to give financial preference to the VC when the exit was not big enough to meets the generally accepted IRR that would be needed to satisfy the funding Limited Partners. Somewhere in the late 90’s, it became a means of taking even more from the founders. And while most founders can conceptualize this, and perhaps even consider it as a cost of doing business, there is a better way.

But first, let’s illustrate the depth and nature of the screw, by way of an example, with simple numbers to make the math more accessible,

Take a £500K Series-A investment, at $1.5M pre-money and x3* Liquidation Preferences and full, non-capped Participating. [* I’ve seen an NI term sheet that has x5]

[If you don’t understand that previous sentence, consider yourself the perfect mark for this screw.]

And, again to make the arithmetic easy, Let’s say the exit valuation is £20M.

So, the VC owns 25% of the company post-money … and to keep things simple, there are no further rounds, and hence no dilution.

At exit, WITHOUT LP & PP terms, the VC gets 25% of £20M = £5m … an attractive x10 of their investment.

Now factoring in LP & PP. The VC first gets x3 of their investment = £1.5M, then then 25% of the remaining funds (25% of (£20M – £1.5M) = £4.625M) for a total return of £6.125M. That’s a x12+ return to the VC, and 22.5% better than the £5M.

But that still not the ‘eyes wide open” way to look at this. To get £6.125M return from a £20M exit … without LP & PP, the VC would need 30%+ ownership.  With money-in of £500,000, that equates to a valuation of ~£1.132M or ~25% less than the pre-money valuation of £1.5M you THOUGHT the VC had agreed to. 

What you don’t know really can cost you.

But, a simple change to the LP & PP terms can rectify this.

Liquidation Preferences of x1 the investment amount shall first be returned to the investor, provided that the total amount returned to the investor is less than x7 the investment amount.”

Investor shall have the option of taking their Liquidation Preference, or fully participating according to their share ownership, but not both.

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