For entrepreneurs, liquidation preference are tough pills to swallow. But they come with almost every financing term sheet in today’s climate. You toil away building a company of value only to have the environment for an IPO change leaving acquisition as the more likely outcome. All of those preferences kick in, substantially reducing your share of proceeds from an acquisition.
In the event of an IPO, an exit option currently considered all but nonexistent right now, all shares convert to common. This means that all of the added benefits that preferred shareholders might have reaped in the event of an acquisition disappear if a company goes public. Such a tradeoff makes sense if the value of an IPO is so robust that it pays everyone back multiple times for the risk taken and money invested.
However, in the event of an acquisition, as most VCs know and many private company employees do not, preferred shareholders get paid first. And they get paid – according to the terms within most recent term sheets, themselves loaded with liquidation preferences – at multiple times the value of their most recent and even previous capital infusion.
This article discusses the issue and suggests that the time has come for the VC community to think more carefully about liquidation preferences.
It’s interesting to note that one of the things Jack Welch talks about in his book is that he took GE from zero percent employee ownership to 31% employee ownership during his tenure as CEO of the company.