Typically a liquidation preference gives the venture capital (VC) investor a “first right” to a portion of the proceeds available to shareholders in the event of a liquidation or sale of the company. This right is manifested in the terms of their preferred stock and set forth in the formation documents of the entity. Ah, preferred stock … As you probably know, in most startups there are at least two classes of stock, common and preferred. Founders and employees typically own common stock while VC investors typically own preferred stock. While this can get very complicated, it is often helpful to think of common stock as “sweat equity” and preferred stock as “cash equity”.
In essence, the liquidation preference is one of the ways that a VC investor ensures a return on its investment. Simply stated, this guarantees the VC investor a specific dollar distribution, beyond its ownership percentage, in the event of the sale or liquidation of the company. It is important to remember that common stock is in a secondary position to preferred stock.
So what is liquidation overhang? Liquidation overhang is when the liquidation preferences associated with the venture (i.e. from the sale of preferred stock) exceeds any fair approximation of what the company is worth under a reasonable liquidity event scenario. As a result, the common stock (or employee exercisable option for common stock) is essentially worthless. Startups and companies in such a situation now also face the challenge of how to motivate their employees.
Let’s say your startup took on $50 million in venture capital investment and the VCs own 75% of company in preferred stock. The founders own 10% and the employees own 15%, both in common stock. A sale offer comes in for $55 million. You might think that the VCs will get 75% of $55 million ($41.25 million) leaving the founder with $5.5 million and the employees $8.25 million. Not so.
Straight preferred stock gives the VCs the option of recouping their $50 million investment, leaving only $5 million to be split up among the founders and employees in proportion to their ownership ($2 million and $3 million, respectively). And if the VCs’ had participating preferred stock they would also take 75% of the $5 million left over. Now the VCs get $53.75 million and the founders and employees are splitting $1.25 million in proportion to their ownership ($0.5 million and $0.75 million, respectively).
The examples above only serve as limited examples of liquidation overhang. There are other terms of liquidation that can be incorporated into preferred stocks. The attorneys at Moisan Legal, P.C. can review any venture capital agreement and explain its long term implications for you, your employees, and company.