Liquidation preferences, short-term vs long-term greedyPosted: June 30, 2014
Last week I wrote about that for early stage venture investors downside protection is more a or less a nonsensical concept. An entrepreneur I know was sharp enough to comment “Great. No more liquidation preferences at Earlybird.” I promised a follow-up blog post on liquidation preferences but while doing research I stumbled upon two blog posts that cover the subject better than I could:
- by Fred Wilson : Here’s Why You Need A Liquidation Preference
- by Brad Feld: Term Sheet: Liquidation Preference
The point is basically that liquidation preferences are less about downside protection and more about preventing lob-sided outcomes, aligning interests to some extent, allowing for faster investment decisions under information asymmetry (avoiding lengthy due diligence), etc. This is why good VCs don’t care about downside protection but do care about liquidation preferences.
However there is still a ‘wrong’ way to use liquidation preferences (and other protective / minority investor rights) in my book and it has a lot to do with downside-protection or the desire to not lose any money as a VC. Here’s an example:
- Say a company you led an A round in does not do well. Basically the outcome is a tiny exit that barely covers your liquidation preference i.e. the money you put in as an investor. Or you can secure a new financing but only at detrimental terms to the entrepreneurs due to anti-dilution mechanisms etc.
- Option 1 is that you step back, think about what would be a reasonable outcome for everyone and try to split the cake in a way that everyone can walk away with their head held high (or at least: “a good compromise leaves everyone unhappy”)
- Option 2 is that as a lead investor you get so obsessed (I have seen it become quite a sport) with protecting your investment that you squeeze every dime out of everyone else, using your liquidation preferences and minority rights / protective provisions.
Now there will be cases where things get ugly and this is not a carte blanche against using liquidation preferences in scenarios with low outcomes. I am talking about cases where it is being abused.
So in such a case – if you pull option 2, what you will have done as an investor is gotten your money back. What you will also have done is ruined your relationship with the entrepreneur, the angels and potentially other investors.
And what did you get in return? An amount of money that is irrelevant to the fund performance and some serious bad karma in the market with all negative consequences for your ability to work with these folks (and their extended network) going forward. It is short-term greedy and bordering on stupid.
Option 1 is also a greedy. But it’s long-term greedy as it means you are deferring getting money now for the chance to earn a lot more money down the road by being a good & reasonable VC to work with. I intend on being long-term greedy.