Liquidationspräferenz aus Investoren-Sicht [ENG] | #Investoren 💰

00:00:00: Hello and a warm welcome to another episode of Inside We See, the podcast from The Guitar Compact.

00:00:04: My name is Joakar Tvarik And next to me sits Christian, hello Christian!

00:00:09: It's been a while, actually.

00:00:10: We just found out that we need to think about like what was the name of our format.

00:00:13: So we didn't do that many recordings in the past.

00:00:15: but this will change and today we'll kick off with liquidation preferences?

00:00:36: A term that comes into play when the company gets sold.

00:00:40: So, we call it a liquidity event.

00:00:43: basically this is the sale or exit of the company and so fundamentally The thinking behind It Is That When you invest at a Company in the venture world You pay a valuation that takes into account the future option value Of the company not something thats based off of cash flows but really Something Thats Basically assuming that the company is going to be successful minus a certain discount, too basically credit for the risk.

00:01:13: And so what you want to make sure Is that if things don't go as planned and the company gets sold For value?

00:01:20: That's below or significantly below The valuation that you have attached To the company at the time of your investment that you Don't end up not getting any money Or are getting only a fraction Of your investment while the common shareholders, so basically the founders or other investors that were invested prior to you actually make money and have a positive return.

00:01:41: So the idea is... You want to protect yourself as an investor against scenario where you lose money?

00:01:47: And others who've been inside of company previously make money?

00:01:51: Basically an investor comes around saying I'm taking certain risks by investing in your guys.

00:01:57: In return I would like to have some kind of safety that saves me from losing my money or not getting back as much As i invested and ideally, I want ten times the amount.

00:02:04: I invest it.

00:02:05: And then The reasoning very simply is that you say hey guys?

00:02:09: I'm willing To pay a price here.

00:02:11: That assumes that things are going to go well in the future.

00:02:14: right but in case we've been collectively wrong and Things don't go Well and the company sold for value thats below Even the capital that has been invested by us or you know, whatever investor then You want to make sure that at least you get your money back really before others start making money which I think That is fundamentally a fair Principle because you don't want to have situations where you have a buyer stepping in And being able to say, you know I buy the company for cheap and you Mr.

00:02:45: Founder still make a good amount of money because You would still own a big chunk of the company unless no care about your investors even if they lose half Of it.

00:02:53: speaking about Germany German VC scene our liquidation preference is standard like for quite a while right from The beginning.

00:02:59: or is this something that just came up over time?

00:03:02: So the liquidation preference tool is something that has been around since the eighties in the US.

00:03:07: And so it's been around, since the Wild West days and Germany in the nineties where Germans have been very creative with weird terms.

00:03:15: but I think liquidation preferences are not one of them.

00:03:22: I

00:03:23: think this is important to give young founders, maybe first-time entrepreneurs an idea that it's really a standard term they should calculate with whenever we talk about VC.

00:03:32: And how does it solve technically?

00:03:34: What happens if a VC comes and the founder of the table starts discussing or negotiating?

00:03:40: How has this liquidation preference done basically in contracts?

00:03:43: There are fundamentally two ways but before getting into them what you say exactly right... If i look at a term sheet And you quickly want to get a sense for this deal that we wanna do.

00:03:53: There are about two or three things I look at, and liquidation preference is one Vesting is another and then sort of the rest as economics valuation, all that kind of stuff.

00:04:03: But that's about it.

00:04:04: so It is one of two three key terms for investors That you do want to have a place in some way shape or form.

00:04:11: now having them in place.

00:04:12: What does it mean?

00:04:13: You can fundamentally have two different kinds of preferences.

00:04:16: There is one that called The fully participating liquidation preference which confusingly for the German listeners is called The Nichtanrechenbare Liquidation Preference.

00:04:30: And so, they're fully participating in Likpreff.

00:04:31: what it really means that you basically take the invested capital off of top of proceeds from a sale and everything that remains after having paid back the invested capitol to the investor... Everything that remained after that?

00:04:48: You then split according to the ownership in their company.

00:04:52: So a very simple case, let's say somebody has invested two million of the company.

00:04:55: you sell the business for.

00:04:57: that is ten million.

00:04:58: then your first pay the two-million back to the investor and you then distribute eight million that remain According to the ownership at the cap table.

00:05:08: And lets' say the investors initially bought twenty percent of his business still gets those twenty percent Of the eight millions.

00:05:14: so In total The Investor would receive Two million from his initial investment plus twenty percent of eight, so one point six million.

00:05:23: From the pro rata split.

00:05:24: So that is why it's called fully participating because you take your money off the top and then still fully participate in The distribution of proceeds after the liquidation preference has been served.

00:05:35: there Is another model?

00:05:37: That's called the non-participating or in German the anrechenbaric relation preference which basically is more of a downside protection.

00:05:44: So what it effectively means, that as an investor you either get your capital paid back or participate in the prerogative distribution of proceeds and typically choose what gives you money.

00:05:59: so if let's say you have invested two million and bought twenty percent for one and a half million because it really, you know wasn't successful exit.

00:06:08: You first get paid out two million there's only one-and-a-half million to really get payed out.

00:06:13: so those go straight to you.

00:06:15: in this case It is an O-brainer you choose exercising the liquidation preference.

00:06:19: let us assume however that company gets sold for twenty million And if bought twenty percent then we would get The Two Million which is identical with the capital that you've paid In If went asking for the liquidations preference.

00:06:32: or You get twenty percent of twenty million, so four million if you go for the parato distribution.

00:06:37: In that case basically... ...the effect of the degradation preference is zero.

00:06:43: in any case where.. ..you would get more from the proceeds than a parato-distribution then just having your capital paid back?

00:06:52: So it really means that if the company's successful there are zero.

00:06:56: let's call it penalty to the founders or other shareholders.

00:07:01: If the company really is not successful, you have this downside protection.

00:07:05: where... ...you make sure that in a situation when others are making money.

00:07:11: I learned fully participating liquidation preference was also called double dipping.

00:07:17: This is nice image although investors probably do not like it having idea of dipping your hand into water and doing twice as much water as possible.

00:07:25: Now we just said either take the money out, you invested or participating in your Parato proceeds.

00:07:31: So far we only spoke about one X liquidation preferences if you like.

00:07:35: what is standard here?

00:07:37: I mean quite often it also happens that investors ask for more than once the amount invested.

00:07:42: putting a multiplier on the liquidation preference You start entering the territory of really let's say optimizing The economic terms along different dimensions.

00:07:53: so For example some founders really want a very high valuation of their businesses for whatever reasons, equity story reason optics.

00:08:02: And then sometimes you say hey okay that's fine we'll pay a very higher valuation but You give us two acts participating in liquidation preference.

00:08:11: so basically lock-in A base return For any scenario?

00:08:16: That is reasonable outcome.

00:08:19: on the other side you paid a higher valuation.

00:08:21: So what it means?

00:08:24: You get a multiplier on your invested capital.

00:08:26: So if you have two X non-participating and let's say with the same example, you would've paid in two million then you don't only take two million off of top actually four million up to top.

00:08:36: there is another model where we put an interest rate or preference.

00:08:39: when he said hey every year this preference grows by interests of you name it ten percent.

00:08:46: both of those are sometimes done later stage deals.

00:08:50: were sort of this valuation play becomes more relevant.

00:08:54: I personally would only do those in, you know very special situations.

00:09:00: usually our goal is to keep it very clean and simple And not make the liquidation preference a tool of economic optimization but really restricted towards original purpose which basically is downside protection tools.

00:09:14: We are also trying give young founders an idea which liquidation preference does make sense when, or as you just said sometimes this may be an instrument to negotiate with a different strategy basically.

00:09:27: As you said at some times high evaluation makes sense in return for more aggressive liquidation preferences.

00:09:32: what is your standard?

00:09:34: What would you recommend to young founders?

00:09:36: and not ideal maybe but fitting liquidations preference strategies?

00:09:41: so I always lean towards really keeping it simple.

00:09:46: And that's mostly really for two reasons.

00:09:48: One is, it then basically really accurately reflects the state of the company because optimizing high valuations can have a negative impact on your next fundraising round.

00:09:58: if you haven't achieved quite as much as you had hoped.

00:10:01: You're in situation where looking at flat or possibly down-round which makes fundraising very hard and painful and shuts out investors who are not willing to go through pain of pricing.

00:10:15: I would always counsel people to keep things sort of relatively straightforward and not do too much, let's say financial engineering as part of a venture out.

00:10:23: And what that then means is you basically try as the founder and go for non-participating liquidation preference.

00:10:30: so no double dipping as nicely called it Because that is, and the second reason.

00:10:35: That's sort of a simple downside protection... ...that keeping it very straight And that helps you in future financing rounds.

00:10:41: because The one argument I think thats sort of the strongest on the side of founders Is whatever give to guy who comes into series A or even in seed round.

00:10:53: In terms of liquidation preference It gonna be minimum that next guy who come int he next round will ask for.

00:10:59: So we call this establishing precedent, right?

00:11:02: And if you're setting the precedent that you are giving somebody a fully participating liquidation preference.

00:11:08: It is very unlikely that you can convince the next investor to not get the same type of structure.

00:11:14: so The more you keep it simple then while you keep at plain vanilla The better it is for follow-on financing rounds because you can just tell everybody hey

00:11:30: Quite often you see these legal terms with class A shares, class B shares.

00:11:34: This is how this is solved from a legal perspective and sometimes this can get really messy because what we just said it's basically stack mechanics right?

00:11:42: If investor one has that liquidation preference the second one wants to... One alike maybe even harder.

00:11:50: What's your view on this?

00:11:51: How can I control this aspect?

00:11:53: and maybe we should also say one sentence about the famous last in first out because unexperienced business agents would also say, hey.

00:12:00: Uh, i'm the guy taking the biggest risks here.

00:12:02: Why am I the less want to be paid out via liquidation

00:12:04: preferences?

00:12:05: exactly?

00:12:06: Yeah That is a very good point.

00:12:07: Let us take that First.

00:12:08: I think The way the mechanics really work Is that you Say whoever gets in first Also pays the lowest

00:12:13: price.

00:12:14: Your position In the liquidation preference stack Is based On when You invested And the Price You got at the time.

00:12:20: So the logic is that whoever comes and last paid the highest price.

00:12:25: And because of that, The risk or failure really should be lowest.

00:12:30: so if the company isn't successful on the liquidation preference scenario kicks in... ...the guys who came at last get their money out first Because they overpaid most.

00:12:40: That's what the logic here is People while initially take the highest risks They also you know, in a typical structure paid the lowest price.

00:12:49: And that's why there is this what we call stack as you said where basically it's last day and first out.

00:12:55: whoever paid in lasts sits on top of the liquidation preference stack and others are kind of stacked below that.

00:13:02: so let say you really have a hierarchy of payouts.

00:13:07: So if the proceeds are very low they only pay back lets' say the last round investment.

00:13:13: then thats lucky guy Right?

00:13:15: If they're low but enough to pay back all the paid in capital, All of guys are gonna get their money back.

00:13:21: There's situations where you flatten this stack and put everybody on same footing.

00:13:26: that what is called a pari-pasou so in lockstep preference.

00:13:30: But typically it is this stacking And we in Germany for example solve these usually through waterfall where in the documents you basically say, investors who hold shares from this round get their money first then from previous rounds and so on.

00:13:48: In

00:13:48: U.S.,

00:13:49: why are these share classes with different preferences attached to a series of shares?

00:13:54: That's really something that we want to be mindful if US investors come because they're going to be very surprised.

00:14:02: or maybe it is for another podcast but not preferred shares.

00:14:06: or, you know understanding that we actually don't have preferred chairs but We can create the same economic structure by putting in the right provisions and their shareholder agreement.

00:14:16: so kind of having a lawyer who Can translate to us investors how?

00:14:21: The German structure mirrors what they're used to in the u.s.. Is very very important.

00:14:27: as You said one of the things you look at when checking out an investment is liquidation preferences.

00:14:34: What do you look for basically?

00:14:35: Let's say, You have a company that had AC Drowned as series A maybe also serious B and your other guy coming into the next round.

00:14:43: What do you look for on liquidation preferences?

00:14:46: Just the simple aspect of is it a one X or two X liquidation preference, so there are other stuff as well.

00:14:51: The logic is very simple if we feel that valuation is fair We typically go for non-participating straight liquidations preference.

00:14:58: no bells and whistles.

00:14:59: That also has an advantage which was important point.

00:15:03: when we think they're going to be follow-on rounds, we don't want a lot of money sitting in front us.

00:15:09: In that preference stack and if you know... We won't be able to avoid that because other investors for the same reasons will at least ask for nonparticipating preferences as well.

00:15:20: however then it only becomes relevant in the downside case but doesn't reduce our return in successful cases Because You Don't Have The Double Dipping So.. As an early stage investor over time become more aligned with founder because our share class is sort of more similar to theirs in a way than, you know the ones with late-stage investors.

00:15:39: So it's an hour interest not put into things that hurt what we call common shareholders or founders too much as they are very close at the end of their day.

00:15:48: so will typically just ask for nonparticipating preference if we feel the valuation is fair.

00:15:54: If you get scenario where we think we're paying high price then sometimes participation or if previous investors already have it.

00:16:02: Then of course we ask for a tool, but typically don't one compromise that you often see?

00:16:07: That's what I would recommend to founders If they find themselves in the situation where they haven't invested They like.

00:16:13: But then investor is very focused on getting a participating preference.

00:16:18: One very good compromise Is that you say look guys You can get the participation For any event Where your return is less than an.

00:16:26: insert your multiple here of the investment.

00:16:29: Typically, two X three times that type of return.

00:16:32: and you say if You only quote unquote make two or three times your money?

00:16:38: You can do the double dipping.

00:16:39: we give you sort of this extra kicker because We're all sitting here assuming you will get a ten x or something.

00:16:45: If That doesn't work out And it's A small exit!

00:16:47: We Give you This Extra Kicker This Double Dip.

00:16:50: If things go well and you Make It Ten X Why Should You Get That Kicker?

00:16:55: Yeah...It's Gonna Be Mostly Material.

00:16:57: It doesn't make a big difference for you.

00:16:58: So then let's wave it, so basically say You put what we call a cap on the preference in the sense that once you hit that multiplier Let's make three X The preference participation really goes away.

00:17:11: That I think is very good compromise and incentivize management to seek For large exits which are what you want as an investor And still gives you as Investor who has paid high price some level of downside protection if the exit isn't.

00:17:25: So I think that's usually a fair compromise in situations where you kind of have the two camps pitted against each other.

00:17:32: Yeah, this is nice picture like... You've got downside protection for investors.

00:17:36: and then your motivation aspect as well because founders often get nightmares saying they're doing an exit and only see KMK or even nothing!

00:17:47: This is the aspect their founder may be thinking about.

00:17:52: thinking in this less in-first out logic, you might be interested not having a fully participating leak preff at the beginning.

00:18:00: Is it possible by way to change this over time if first investor had and second one doesn't want?

00:18:06: It's unlikely that they don't want.

00:18:08: what you can do sometimes is negotiate away with the new investor in let's say your second round of financing and saying hey you only get non-participating, then go back to your inside investors.

00:18:22: This guy is willing to invest on non participating terms so that they should waive their participation.

00:18:29: Waving is a good keyword here!

00:18:31: Let us think about a fuck up case... If the company is sold, so it's not a total disaster.

00:18:39: It doesn't went for bankruptcy.

00:18:41: but if its sold at price that rather small Is there possibility of an investor to say hey I'm waiving this preference or giving some kind compromise?

00:18:51: There always are.

00:18:52: you have distinguish between two situations.

00:18:54: One i think where a company has solid business taken on a lot of capital and it would become obvious that management is no longer really incentivized because its gonna be very hard for them to create the return that exceeds all the capital thats been invested.

00:19:11: One example I believe has been discussed quite publicly, recent financing round for postmates where they basically created structure were investors waived their liquidation preference in past investment on the new money that came in, in order to not basically put the bar for management too high.

00:19:34: so those guys would never be able really see any of their money because it's almost impossible for them to create an exit.

00:19:40: That will leave enough on-the table for then after satisfying all this money has historically gone into business.

00:19:48: So you have over life with a company where Okay, we recognize a little bit too much money has been gone in.

00:19:55: You know We went through a couple changes and we kind of have to wipe out part of the preference.

00:19:59: The other scenario is you bring in new management at A later stage of the company or... ...you come into the same recognition that you say Oh!

00:20:07: Too Much Money Has Gone In And we Have To Make Sure That Founders Stay Incentivized.

00:20:11: Then You Can Create What We Typically Call A Carve Out Where Basically Say X percent of the proceeds go to the founders or the CEO, whoever it is kind alongside all the preference.

00:20:23: So think about like a waterfall where every euro that comes in gets split into two parts one goes towards the liquidation preference and another part you know certain percentage ten twenty whatever.

00:20:37: what ever the carpet is goes straight to management.

00:20:40: so thats why its called carve out because your sort of carved out of the proceeds.

00:20:45: So those are, you know there a number other tools that can do but nothing is ever set in stone.

00:20:50: In fact it's very high likelihood.

00:20:52: if your investing in series A at some point and follow on rounds these things get changed.

00:20:58: But its just let say hygiene factor That you try to put into documents early.

00:21:06: And so that's why it is important to have a clean and simple.

00:21:08: You create the right structure from beginning, waste as little time possible on renegotiating those points when you are raising follow-on rounds.

00:21:17: Cool, I think this gives us quite an idea of how liquidation preferences work.

00:21:21: And also like these wordings like carf out or double diffs.

00:21:25: that's really you know That give a VC business bit of the feeling off A nerd or a tech guy.

00:21:31: You know what?

00:21:31: I mean

00:21:32: for dinner party.

00:21:33: Yeah

00:21:35: kind of liked it and i learned that we should do a podcast on How to deal with American investors if i'm a german guide interested in american VC.

00:21:43: so thanks a lot and see next time

00:21:44: your welcome looking forward to.