Term sheet terms (part 2) – liquidation preference

by Simon Murdoch

One of the challenging stages of making an investment is explaining to first time entrepreneurs why some of the terms in a term sheet are really important to VC investors and therefore why you see them in almost every VC’s term sheets. (Here is our standard term sheet and my previous post about standard term sheets)

If you raised money from angels first time around, you probably found you could state your own terms and the angels, especially the cash-rich time-poor angels, just agreed to your terms. In the UK, as long as they get their SEIS or EIS tax benefits, most angels tend to be happy.

VCs like Episode 1 are not as flexible, though we really are reasonable 🙂

So in this and subsequent posts to come are my comments on why most VC term sheets have these terms in there – terms which the entrepreneurs sometimes feel are tough on them, but VCs feel are perfectly reasonable and standard.

Liquidation preference

We insist on liquidation preference and we almost always want the more benign form of liquidation preference for entrepreneurs, ie non participating.

Non part liq pref chart

We invest in Seed Preferred shares which have this right to sit ahead of the Ordinary Shares at an exit.

Non participating (or hurdle) preference means that in low value exits the Seed Preferred Shares are paid out first. In higher value exits the preferred shares convert to Ordinary Shares at the time of exit – which means the preference becomes irrelevant.

So for a case of £1m investment at £3m premoney and no further rounds before exit, the proceeds for the £1m investment are as in the chart above. (X axis is exit price, Y axis is money out to the Seed Shares)

For exits from 0 to £1m all the money goes to the Seed Shares. Then from £1m to £4m, the Seed Shares get £1m and the Ordinary Shares share the rest. Eg at a £2m exit, the Seed Shares have £1m and all the Ords share £1m pro rata to their shareholding. Above £4m exit, Seed Shares are better off so would convert to Ords at an exit and therefore everyone gets their pro rata share, eg at £10m, the Seed Shares get £2.5m as they have 25% of all the shares.

The reason VCs insist on preference is that frankly most early stage companies aren’t really worth £5m or £3m or even £2m. Just try asking an accountant to value your early stage company which is loss making, has zero or tiny revenues, and is probably not raising enough money to get to breakeven. An accountant’s valuation is almost always zero for such a business.

VCs suspend disbelief and know that enough of these sort of companies will grow like crazy to justify the valuation handsomely and pay for the 25-50% of companies they will lose money on. BUT we really really don’t want the founders to have any incentive to sell the company at less than the price we invest at.

To illustrate that situation consider the case of two founders owning the whole business and a VC invests £1m at £3m pre, so it is £4m post (ignoring option pools etc). So the founders each have 37.5% of the business. If after 7 years of effort, the company is sold for £3m the VC would get their £1m back and the founders receive half of £2m, ie £1m, each. The founders have done ok but the VC has only got its money back after 7 years, no profit at all. Without liquidation preference, the VC would get back 25% of £3m, i.e. £750k and lose money while the two founders would have £1.125m each, which the VC would be very unhappy about.

For completeness let’s consider two other forms of liquidation preference that are less common these days but may well come back if it becomes a buyers market and valuation come under continued pressure.

Participating preferred

Participating liquidation preference means that the Seed Share get their money back plus their percentage share of the remaining proceeds. The red line in this chart shows the difference vs the blue non participating preferred line:

Part pref and non part pref chart

So in the case of £1m in at £3m pre money, £4m post and no further rounds until exit, with participating preferred at say a £3m exit, the Seed Shares get back £1m and their 25% share of the remaining £2m. So the VC gets £1.5m and makes a profit, and the two founders get £750k each. Personally I don’t think that’s unfair, but the piece entrepreneurs object to, especially if there is a lot of preference in a company, is in the great exit – say £50m, the VC still gets its money back as well as its % stake of the rest – nicknamed “double dipping”.

Participating preferred with a cap

And the third version is a compromise of the two. Participating preferred until the Seed Shares have made 3x is a good example. I believe this is reasonable for both sides. VCs don’t like helping a company for n years and then just getting their money back. The chart below shows how this works – green line being the preferred with a cap:

All three preferences chart


But we live in a free market, and so even though I think this is pretty fair for both sides, for two reasons we have decided to opt for the more benign non participating liquidation preference.

The first reason is that most entrepreneurs we meet don’t understand this stuff intimately, so if our term sheet has participating preferred with a cap and another term sheet has non participating preferred, we get accused of ‘double dipping’, and it materially reduces our chances of persuading the entrepreneur that we are an entrepreneur friendly VC house – so we think we’ll be less likely to win the deal.

The second reason is that our liquidation preference sets a precedent for future rounds. We have a fairly small fund at £37.5m and so if our companies end up having Series C, D … rounds, then eventually we can’t follow on in the later rounds. We think that if we have a more generous form of preference then future rounds will shoot for the same form of preference. Eventually our incentives are aligned with the entrepreneurs’ and the last thing we need is huge amounts of participating liquidation preference sitting ahead of our Seed Shares. Even if the company sells for a reasonable amount, we might get nothing after years of helping the company.

So there you have it. Liquidation preference 101 and why VCs insist upon some form of preference.

Another instalment on term sheets coming soon…


Suggested Articles

Standard term sheets and what you need to know about them
by Simon Murdoch

I was a panelist at the UK Business Angel Association conference this week. One of the earlier panelists said he wished there was a standard for early stage term sheets. Well there is. Saul Klein arranged a short series of excellent meetings in 2010-2011 called SeedSummit and I attended. The attendees were about 50 European early stage investors both VCs and experienced angel investors. One of the topics raised was that we needed a standard for term sheets like the NVCA’s equivalent…

  • Matt Celuszak

    Thanks for sharing this Simon. This is a great topic and I have some considerations.

    Fully understand about protecting your downside. I do question whether prefs drive the right VC and Entrepreneur motivations to do so in two areas.

    First is around collaboration when times get tough. If the breakeven point of a company is at the value you’ve mutually set, the VC is not as motivated to really dig in as they fallback on sale of company and assets rather than a managed shift into profitability (which requires larger efforts in most cases). A VC sells an entrepreneur on their ability to deliver more than cash which is about helping mitigate the risk. A pref, calls this ability into question. With a small fund and specifically your achievements, not sure if a prefs term is helping the argument.

    Second, Let’s take the outside example whereby the company hits a higher valuation without raising more capital in which case the VC and entrepreneurs did a fantastic job at mitigating the risks (perfect pairing), yet the entrepreneurs still succumb to preference restrictions.

    Presumably these can be solved with terms around the prefs including an audited share on a pre-agreed valuation method or the like?

    My 2p, and thanks again for sharing.

    • Simon Murdoch

      Thanks for your comments Matt.

      Your thoughts may be theoretically correct, but real life doesn’t work like that.

      On the first point, it is really hard to sell a company unless the management want to sell because the buyer will usually want the management team to agree continue working there for at least a year or two – though often they leave after only a few months. Therefore despite what the preference terms say if a business is being sold and preference kicks in so much that management don’t make any money then the exit deal won’t happen. So what usually happens in a fire sale where a non participating preference is a big part of the exit proceeds, is that the selling management cut a deal with the investors to get a bit more of the upside if they do a good job of the sale process.

      On your second point, then the preference terms have no effect provided the preference is non participating which is what we always offer to entrepreneurs as explained in the post.

      • Matt Celuszak

        Simon – totally missed this comment – apologies and thanks so much for the response.

        Take your second point and appreciate the non-participating.

        Stuck on the first from a motivators perspective, though I am novice at this. Happy to chat offline and understand it a bit more.

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