"Three Things You Must Have" | Hacker News Reader

"Three Things You Must Have"

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40 pointsChirag14 comments

There is a missing piece from Fred's post, as I often find the case to be. I know Fred's smart, so I'm not sure why he omits key pieces of the discussion.

In this case, he is leaving out his views on participation rights. What this means is that if you have a 1x liquidation preference (you get your money back) do you ALSO then convert to common stock and participate pro rata in the distribution of remaining proceeds? If yes, that is unfair to the entrepreneur and you are double dipping. If no, then a 1x liquidation preference is entirely reasonable.

Here's an example: Let's say someone invests 1mm with a 1mm pre and a 2mm post. So they own 50% of the company. Now let's say that the company has an offer to be purchased for $3mm. With participation rights and a 1x liquidation preference the exit looks like: 1mm money returned to investor, 2mm remaining. Then the investor converts to common and the remaining 2mm is split 50/50 since the investor owns 50% of the company. That gives the investor 2mm and the entrepreneur 1mm. Is that fair? I don't think so.

Once you know that converting to common will net you a positive return above and beyond your original investment, you should convert. If that were the case here, the return would be 3mm split 50/50, so 1.5mm to the investor and 1.5mm to the entrepreneur. To me, this is fair. Everyone had an exit. Nothing amazing, but it accurately reflects the cap table of the company.

Finally, while I am comfortable with a 1x liquidation preference in any company I start, there are a lot of strong arguments about why a 1x pref is not appropriate. The most common reason is that "we're all in the same boat. You bring the money and I bring the idea and execution and if we win, we all win, and if we lose, we all lose, all equally."

I don't buy that argument, but that's the one people try to make.

http://www.avc.com/a_vc/2010/05/an-evolved-view-of-the-parti...

Bingo. Fred should link to this in his post today.

And furthermore, Fred's points of when it makes sense to have participation rights are dead-on and exceptionally well articulated.

I agree with the commenters, liquidation preferences only really make sense as protection when they are 1X. Higher than that and it starts smelling an awful lot like greed.

And personally, I would prefer a liquidation preference over the investor tying my hands too much. They invested in me, they should put their mouth where their money is.

yup

above 1x is a huge red flag on the investor. entrepreneur beware.

and i also agree that the elegance of the liq pref is that it is an economic deal and does not impose governance on the entrepreneur

I agree with the basic principle of a liquidation preference, but his argument sounds like a bit of a strawman.

If he invests 20% for $1 million - he's validating the idea at $5 million dollars. Presumably, the investor has to due enough due diligence to say, "you know, this idea is really worth $5 million". If that's the case, if they sell for $2.5 million later on, the founders take a loss too - just because they don't have that much cash invested doesn't mean that they lost out as well.

Ideas aren't worth anything, and early startup valuation is just voodoo. The numbers balance the venture capitalist's need for a certain stake, the company's need for capital, and the founders' desire to avoid excessive dilution. They don't actually reflect what anyone would be willing to pay for the company at that stage.

Ideas are certainly worth something - they're just not worth anything unless they're actually implemented. If a VC truly believes that early startup valuation is voodoo, then he shouldn't invest. His willingness and want to invest early is shown in the amount of risk he carries, but VC's need to remember that risk carries both ways.

If the investor is valuing it at 5mm, so are you. You are telling the investor that the company is worth at least 5mm.

If it sells for 2.5mm, you screwed up. Why should you participate in the proceeds of a sale?

These "must haves" will be challenged by the rise of super angels, who typically don't demand board seats, nor the same types of liquidation preferences.

I think the board seat requirement, in particular, will be rendered obsolete soon. But then again, the whole VC industry might be obsolete soon.

that is clearly a risk, but ..

i'll bet ten years from now these are still must haves and the current crop of "super angels" will be crusty old VCs just like me demanding them

i invest $1mm in your company for 20% -- the company is six months old and this is the first investment of outside capital -- a week later you sell the company for $2.5mm -- you get $2mm for six months work -- i get a $500k loss does that sound fair? -- no it does not -- that is why there is a liquidation preference -- to protect investors from that happening to them

A founder selling a $5+ million company for $2mm probably has a reason for trying to get out (like catching the start of the spiral before there's nothing left). Would you prefer the company be scuttled and a $1mm loss instead?

You need to realize early stage valuations are basically a guidepost for negotiations, not a real monetary amount people have committed to pay for a company. By comparing your valuation to other valuations of companies at similar stages, both parties can be sure they are getting a fair shake. This has little to do with the idea of the company being sold, in full, for that amount.

If you're a founder, and you are getting some traction, it might very well be that you can raise money at a $5mm valuation with little more than a prototype and a few initial adopters. However, if you all of a sudden have a chance to turn your fledgling startup into $2mm in the bank, after only a few months, many would take it and use that money for the next startup.

This is a great list of the essentials. Without a liquidation preference, you can lose while the founders win; without the ability to participate pro-rata in future rounds, you can't control your exposure to dilution; and without a board seat, your effectiveness as both an investor and advisor are compromised.

Where do you go from there? What else winds up in a lot of your term sheets?

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