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The Finance of Startups: For Dummies (Part 2)


Finance lessons part 2! Excited to share this, but also hoping I can transcribe what I’ve recently learned in a clear, concise way.

I was reading Buffer app’s somewhat recent blog post about raising $3.5M at a $56.5M pre-money valuation – “We’re Raising $3.5m in Funding: Here is the Valuation, Term Sheet and Why We’re Doing It”. The startup is a “fully distributed team” meaning that they (the employees) operate anywhere and everywhere; though, they’re headquartered in San Francisco. Interesting company in how they operate in being highly values-first and built on “full transparency”. Like, everyone’s emails are open to one another, salaries are out in the open, etc. I wonder if they have unisex bathrooms, too. (That’s my attempt at a joke.)

Anyways, they’re looking to raise $3.5M and in the spirit of full transparency, they share with the digital world everything including why they’re raising, what they’re going to do with the money (including reserving $1M each to the two founders to put away), valuation, etc. Very unheard of to be that open, but very cool to read about and learn from.

It’s through Joel and Leo’s (the two founders) blog post where I realized I needed to expound on my Finance Lessons Part 1 post, especially around the concept of preferred vs. common stock. I’ll focus here since these types of details can really complicate VC deals.

Liquidation.

The first and fundamental concept today is Liquidation, and what I’ll build on beyond. This isn’t really a tough one, but liquidation happens largely in two ways – through acquisition or through bankruptcy.
  • Bad Company LLC goes bankrupt and is sold for parts at $10MM
  • Great Company LLC sells for $60M to Bigger Company Inc.

Liquidation can mean the sell-off of assets, acquisition by another company, etc.

Liquidation Preference.

Recall from Part 1 that preferred stock ensures shareholders the allocation of funds before common stock shareholders. Liquidation preference is a mechanism used to help protect investors on their initial investments while also being a means to “line up” in queue for claims to money.

Investors usually will have set a multiplier on their initial investments written into the contracts, too.

Let’s say Hugh invested $10M in each of Good But Not Great LLC and Great Company LLC initially at 40% equity each (each company had a value of $25M). The companies’ founders and employees owned the other 60%.

Scenario 1: Hugh had a 1X Liquidation Preference.

Good But Not Great LLC
Great Company LLC
Initial Investment by Hugh
$10M for 40% equity
$10M for 40% equity
Liquidation Preference
1X
1X
Company Sold For
$30M
$60M



Hugh Guaranteed
$10M (1 x $10M initial investment)
$10M (1 x $10M initial investment)
Founders and Employees Distribute (what’s left)
$20M
$50M

Scenario 2: Hugh had a 2X Liquidation Preference.

Good But Not Great LLC
Great Company LLC
Initial Investment by Hugh
$10M for 40% equity
$10M for 40% equity
Liquidation Preference
2X
2X
Company Sold For
$30M
$60M



Hugh Guaranteed
$20M (2 x $10M initial investment)
$20M (2 x $10M initial investment)
Founders and Employees Distribute (what’s left)
$10M
$30M

Participating vs. Non-Participating Preferred Stock.

Note in the scenarios above I didn’t say, “Hugh Receives”. I said, “Hugh Guaranteed”. That’s because there’s also this notion of participating vs. non-participating preferred stock. This part gets tricky so perk up!

Investors (namely VCs here) can negotiate for participating vs. non-participating preferred stock. Participating preferred stock allows the investors to participate in converting their preferred stock for common stock to realize gains. These gains can be added ON TOP OF the liquidation preference. Note that the conversion of preferred stock to common stock is dependent on some conversion ratio of preferred stock-to-common. The participating vs. non-participating election in addition to the Liquidation Preference give the investors a function to maximize returns. So let’s do a couple scenarios.

Scenario 3: Hugh negotiated for nonparticipating preferred stock with a 1X liquidation preference.

Good But Not Great LLC
Great Company LLC
Initial Investment by Hugh
$10M for 40% equity
$10M for 40% equity
Liquidation Preference
1X
1X
Company Sold For
$30M
$60M



Hugh Guaranteed
$10M (1 x $10M initial investment)
$10M (1 x $10M initial investment)
Hugh’s Pro Rata Preferred-to-Common Stock Conversion
$12M (40% equity x $30M liquidation)
$24M (40% equity x $60M liquidation)

Founders and Employees Distribute (what’s left)
$8M
$36M
What’s happening? Hugh would obviously choose to convert his stock in both options as he would be +$2M in the Good But Not Great sale (return of 20%) and +$14M (return of 140%) in the Great Company sale.
Scenario 4: Hugh negotiated for participating preferred stock with a 1X liquidation preference.

Good But Not Great LLC
Great Company LLC
Initial Investment by Hugh
$10M for 40% equity
$10M for 40% equity
Liquidation Preference
1X
1X
Company Sold For
$30M
$60M



Hugh Guaranteed
$10M (1 x $10M initial investment)
$10M (1 x $10M initial investment)
Hugh’s Pro Rata Preferred-to-Common Stock Conversion after Guarantee
$8M (40% equity x $20M liquidation ($20M = $30M less the $10M guarantee))
$20M (40% equity x $50M liquidation ($50M = $60M less the $10M guarantee))
Hugh Receives Total
$18M ($10M guarantee + $8M from conversion)
$30M ($10M guarantee + $20M from conversion)

Founders and Employees Distribute (what’s left)
$12M
$30M
What’s happening? Hugh’s making out like a bandit with 80% returns in the Good But Not Great sale with 60% of the total sale amount even though he owns only 40% of the company!
In the Great Company sale, Hugh takes home $30M representing 50% of the sale amount with the same 40% equity share.

As you can see, there are some BIG ramifications depending on how Hugh and the companies structured their investment contracts. Now, let’s take those same scenarios, and see what happens when there’s 2X liquidation preference.

Scenario 5: Hugh negotiated for nonparticipating preferred stock with a 2X liquidation preference.

Good But Not Great LLC
Great Company LLC
Initial Investment by Hugh
$10M for 40% equity
$10M for 40% equity
Liquidation Preference
2X
2X
Company Sold For
$30M
$60M



Hugh Guaranteed
$20M (2 x $10M initial investment)
$20M (2 x $10M initial investment)
Hugh’s Pro Rata Preferred-to-Common Stock Conversion
$12M (40% equity x $30M liquidation)
$24M (40% equity x $60M liquidation)

Founders and Employees Distribute (what’s left)
$10M
$6M
What’s happening? Hugh has a bit of a choice here in converting or take the liquidation preference for the two sales. In the Good But Not Great sale, Hugh would obviously choose the liquidation preference option which is +$8M over the conversion scenario.
In the Great Company sale, Hugh would likely choose to convert his preferred stock so he can realize the gains with a +$4M value over the liquidation preference.

Scenario 6: Hugh negotiated for participating preferred stock with a 2X liquidation preference.

Good But Not Great LLC
Great Company LLC
Initial Investment by Hugh
$10M for 40% equity
$10M for 40% equity
Liquidation Preference
2X
2X
Company Sold For
$30M
$60M



Hugh Guaranteed
$20M (2 x $10M initial investment)
$20M (2 x $10M initial investment)
Hugh’s Pro Rata Preferred-to-Common Stock Conversion after Guarantee
$4M (40% equity x $10M liquidation ($10M = $30M less the $20M guarantee))
$16M (40% equity x $40M liquidation ($40M = $60M less the $20M guarantee))
Hugh Receives Total
$24M ($20M guarantee + $4M from conversion)
$36M ($10M guarantee + $20M from conversion)

Founders and Employees Distribute (what’s left)
$6M
$24M
What’s happening? Seriously, Hugh’s killin’ it. In the Good But Not Great Sale, Hugh has a 140% return with 80% of the sale price with only 40% of the equity.
In the Great Company sale, Hugh gets to look at buying a plane and a helicopter to avoid Atlanta traffic as he receives a disbursement of $36M – a 360% return on his initial investment! This represents 60% of the sale of the company despite only 40% equity.

Notice what’s happening to the money left over to be disbursed to the rest of the shareholders to both companies in each of the scenarios. The liquidation preference and the participating vs. non-participating mechanisms can have DRAMATIC effects to the money left for the founders and employees. What happens if Good But Not Great has a sale of $20M when Hugh has a 2X liquidation preference on his initial $10M investment?


Good But Not Great LLC
Initial Investment by Hugh
$10M for 40% equity
Liquidation Preference
2X
Company Sold For
$20M


Hugh Guaranteed
$20M (2 x $10M initial investment)
Hugh’s Pro Rata Preferred-to-Common Stock Conversion
$8M (40% equity x $20M liquidation)


Founders and Employees Distribute (what’s left)
$0 ($20M sale - $20M to Hugh)
What’s happening? Hugh will likely take the liquidation preference at $20M as it maximizes his return. Though, maybe he’s nice, and will give some of it back.
It’s clear it’s important to consider the preferred stock options of investors in a startup whether you’re looking to raise or you’re joining a company. Depending on the terms, that hope of an exit to pay for a new life may not pan out.

Caps.

Okay, so some of the scenarios above look incredibly dismal. Is there anything that can be done outside of negotiating or anything to put in the investment terms to protect the startup? After all, the liquidation preference and participating vs. non-participating stock help protect and maximize value to the investor. There are a few mechanisms, but one of the more common ways is via a cap that limits the returns of what investors can achieve.

With caps, companies can protect their equity stakes and that of other shareholders including the employees. I’m not going to illustrate this, but if you want to investigate, check out the sources below. When you do, also look up “Zone of Indifference”. The zone of indifference is the region between acquisition values where the returns to the investor won’t change due to structures of the liquidation preferences, participatory vs. non, and caps.

Conclusion.

When I ended Part 1, I listed several finance terms and subjects I would talk about… whoops. I started reading about Buffer, and I had so many questions. After doing my research, this stuff was just too good to not share. Okay, so let’s repost the list from last month add a few subjects, and then I’ll shoot to research them and share in January.
  • Types of financing including equity vs. debt
  • Convertible
  • Earnings per share (EPS)
  • Pre-money vs. post-money
  • Dividend
  • Pro-rata
  • Etc.

Umm, I’ll also perhaps start the S-1 IPO filing reviews beginning next year… maybe. We’ll see how all this goes in addition to the technical posts having launched Dee Duper a couple weeks ago.

What are your thoughts about the concepts introduced and talked about here? What questions/ concepts are you wondering about that I can help do some research for you? What questions do you have about what I’ve shared above, or comments?


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