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Everything You Wanted to Know About VC Liquidation Preference But Were Afraid to Ask

Read the second part of a series that walks you step-by-step through a venture capital deal.
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In the last installment in this series of articles on venture capital deals, I discussed what every entrepreneur needs to know in order to properly assess valuations. So, after thinking through the various nuances that affect the valuation you have been offered, you are still elated. Is there anything else that you should think about before you pump your fist in triumph? Yes. There is another important thing: the liquidation preference.

Venture capital investors almost always insist on investing through a "preferred" equity instrument, typically referred to as preferred stock. Preferred stock is better than common stock, because holders of preferred stock receive preferential treatment in the event of a liquidation of the business. For these purposes, a liquidation event can be either a bankruptcy, a dissolution or a sale of the business.

Typically, a liquidation preferenceis designed to protect an investor's monetary investment in a situation where, for whatever reason, the proceeds of a liquidation to be distributed to all investors are less than the amount of the investors' original investment. This is done by distributing proceeds first to the holders of preferred stock and then to all other shareholders.

For example, if a company has raised $10 million of venture money in exchange for a 30-percent stake and is subsequently sold for $25 million, the venture investors will collect $10 million in proceeds in the form of a liquidation preference, even though their pro rata ownership would entitle them only to $7.5 million. This protection is known as a 1X liquidation preference, because it covers the dollars invested on a one-to-one basis, and it's completely standard.

Related: What Every Entrepreneur Should Know About Valuations

What is absolutely not standard is a "super" liquidation preference that gives a multiple return to the investors above and beyond the dollars invested. It would be completely off-market (and offensive) if a venture term sheet entitled the preferred stockholders to, say, a 2.5x liquidation preference. In the above example, this provision would mean that the full $25 million in sale proceeds would go to the venture investors. Assuming that you aren't raising venture money on Mars, the liquidation preference in your venture term sheet should provide for a simple 1X, or return of dollars invested.

The next thing you need to consider is whether or not your investors are proposing a "participating" preferred stock. A participating preferred stock enables an investor to first get a return of its dollar-for-dollar investment as a preference payment, before anyone else gets a single dollar, and then to continue to participate in the distribution of the remaining proceeds as a common stockholder based on its ownership percentage.

So, in the example above, if the $10 million investment was made in exchange for participating preferred stock, the investors will first receive their $10 milion off the top, which will leave $15 million for further distribution. In addition to the $10 million, the investors will collect another $4.5 million based on their 30 percent ownership interest, which means they will collect a total of $14.5 million -- nearly 60 percent of the proceeds. Simply put, a deal that offers participating preferred stock creates a lower implied valuation for your business than a plain vanilla term sheet with no participation feature, because the investors will end up with a disporportionately higher piece of the value created.

A common way to limit this dilution of value is to set a cap on the participation amounts. The holder of capped participating preferred stock will receive all the benefits mentioned above, but the total return is capped. Once the investor has reached that ceiling, he can no longer share in the remaining payment distributions with the common stockholders. As a result, in circumstances where the investor's ownership interest would yield a higher return than its preference and participation cap allows, the investor is forced to forego its preference and simply participate as a common stockholder based on ownership stake.

While the ability to obtain a cap on participation depends on how much leverage you have, and while its benefits are fairly limited in lower value exits, it's fair to say that in today's market, thoughtful investors appreciate the fact that participating preferred without a cap comes at the expense of folks who are actually creating value in the business.

Related: Confidence Among Silicon Valley VCs at Highest Since 2007, Report Shows