Watch Out For Preferences

Gary Kremen lived the nightmare of most startup entrepreneurs. As the founder of the online dating service, Match.com, he raised a small round of capital from investors to support his company's rollout. A few years later, Match.com was sold to Cendant for approximately $8 million. Kremen says that all he got out of the transaction was a mere $50,000.

Why don't founding entrepreneurs always get the big pay off on the big pay day? Often it is a matter of liquidation preferences. Here's how they work.

When startup entrepreneurs incorporate their businesses, they have the opportunity to create or "authorize" multiple classes of stock. Each class of stock can have different rights and privileges to their shareholders. The most common form of equity security is called "common stock." It's the type of security most often allocated to founding entrepreneurs, first business partners and friends and family members who invest in startup companies.

Most experienced investors in startup small businesses rarely agree to buy common stock in exchange for their hard cash. From their point of view, it's too risky. They know from experience what it feels like to invest $25,000, $50,000 or $100,000 in a startup only to find the company in bankruptcy a year or two later. Once they feel the pain of a total investment loss, they are much more determined to protect their interests on future transactions. As such, they ask for special treatment and get it.

Preferred stock is top of the list for special treatment for investors. In my coaching sessions with entrepreneurs, I've found that the best way to explain the differences between preferred shares and common shares is to compare two classes of airline passengers. Preferred shareholders sit in the first class seats of a venture deal. They want privilege, advantage and extra security. They get to board the plane whenever they want but leave the plane before "common" shareholders upon landing. This means that preferred shareholders always get their money back before business founders and employees who usually own common stock.

Preferred shareholders cushion their venture ride in other ways too. During the journey, preferred shareholders get fed in the form of extra cash or stock dividends. In addition, if a company's management team doesn't meet their projections as promised, then preferred shareholders might get some extra shares of stock or increased dividends to compensate them for the extra risk.

Liquidation Preferences

Perhaps the least understood element of preferred stock in venture finance transactions is the "liquidation preference." This is the amount of guaranteed return preferred stockholders receive on their invested capital before common shareholders receive any compensation for their ownership position. Usually this preference is stated in terms of a multiple of the original investment amount.

In simplistic terms, if an investor presents a proposal or "term sheet" to invest $5 million in a company with a "3X liquidation preference," then at the time of company sale the investors would receive the first $15 million (three times the original $5 million investment) plus the value of any accrued dividends before other shareholders receive compensation.

If a company issues several classes of preferred stock through multiple rounds of funding, then all investors would receive their contracted "senior preferential amount" before paying out any compensation to holders of a company's common stock. Thereafter, any remaining proceeds are divided among the holders of the common stock and the preferred stock on a pro rata basis. Guess who is at the end of the payout line? Usually the company's founder! In this example, a company would have to be sold for well over $15 million for the founders to make any money. Gotcha!

Most respectable venture fund investors, however, don't typically present investment proposals with liquidation preferences greater than 1 to 2 times invested capital. Asking for higher liquidation multiples can destroy a company's work ethic. If business founders and their top managers don't think they can make big money, why bother working hard?

Susan Schreter is a 20-year veteran of the venture finance community, MBA-level educator and policy advocate for small business owners. Her work is dedicated to improving startup operating performance with reduced personal risk to entrepreneurs. She is the founder of www.takecommand.org, which offers the largest centralized database of regional and national small business funding sources in the U.S., including angel clubs, micro-finance lenders, venture capital funds and more. Follow Susan on Twitter @TakeCommand

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