Back in February I wrote a post on venture math, explaining how venture fund returns work. While that’s good stuff for you to know, it’s probably far more relevant to know how the math works if and when you sell your own company. So, in this post we will take a simple example and show how the different capital structures that are common in VC financings impact how much money you take home when you exit.
- Two founders with equal ownership
- Employee Stock Option Pool (ESOP) of 15% before funding
- VCs invested $10M in pref shares and owns 30% of the company
- Company sells for $ 20M
That results in the following cap table:
Scenario 1: Convert to common
When VCs own pref shares they usually have a choice. They can take their “preference” or right to take their cost (or cost + some extra) back first, before common shareholders get anything. Or, they convert to common and just take their relative portion of the proceeds. Naturally, they convert if it will give them more money. So, on all great outcomes, VCs convert to common.
So, in this scenario, the VCs own 30% of the company and get 30% of the proceeds. Given that they invested $10M upfront, they would not likely go for this. But it’s the right base case to start from.
Scenario 2: Liquidation Preference
This is the default set up for most VC exits. VCs buy pref shares so that they get the first crack at the proceeds in order to recover their cost first. As you can imagine, they would only exercise this preference for modest exits. This is downside protection. It’s not how VCs generate returns.
Even though the VCs own 30% of the company, they get 50% of the proceeds as a result of the preference.
Scenario 3: Participating Liquidation Preference
This is also known as a ‘double dip’. Essentially, the VCs get to take their preference AND then take their % of whatever is left.
As you can see, this is even more onerous. VCs who own 30% of the company they get 65% of the proceeds.
There are also scenarios where VCs ask for a multiple liquidation preference. This is where they can take some multiple of their cost out before you see a dime. This is pretty rare in the current climate. So, I did not model it. You should just not even think about it if it’s offered to you.
These are pretty simplistic scenarios but hopefully they convey the consequences of the different structures. Here are the main things for you to know:
- 1X Liquidation preferences are the default.
- Whatever rights you give up in your first round become the default ask for all future rounds. So, if you give someone a participating pref on your 1st round, your next round investors will ask for the same. Fight to have the cleanest structure you can
- What these scenarios show is that it’s very easy for VCs and founders to fall out of alignment. As a VC, if I know I’m getting 2x my cost (multiple preference) before you get anything, I’m not aligned with you. When investors and founders are out of alignment bad things can happen
- On modest exits (like this) – which are all too common, the buyer will frequently set aside the cap table and terms and dictate an arrangement that is more in favour of the founders and employees that they are buying. That always leads to some tricky discussions. But the buyer has the leverage.