Monday, April 22, 2013

Unintended Consequence of Debt Notes: Inflated Liquidation Preferences

Frequently seed stage founders ask me my opinion of whether or not they should use a capped debt note structure or an equity structure to finance their company. I strongly believe equity is the right answer, and I have a reserve of 4-5 different reasons why I think equity structure is better for both founders and investors. One argument I use is most effective every time and is almost always overlooked by founders. I’m writing this post to really highlight this one single argument. It’s not simple, so I’ll try to go slowly, step-by-step.

Debt notes lead to inflated Liquidation Preferences, which exceed the total capital invested in a startup. For founders, this creates a higher hurdle to clear in a down-side scenario, which can be very meaningful. Let me explain with a specific scenario:

Company A raises $1mm in a $4mm capped convertible debt round. Lets assume zero interest rate for simplicity.

Company B raises $1mm in equity at $4mm pre-money valuation in 1x convertible preferred stock.

At this point, each company has effectively sold 20% of their respective businesses. (Technically, company A hasn’t sold any equity yet, and if the next round is a down-round, the Founders will suffer more than 20% dilution in their seed round, but this is an unlikely scenario, so both companies effectively sold 20%.)

Then, both companies A and B each raise $10mm in equity at $40mm pre-money valuation in 1x convertible preferred stock.

Both companies have thus sold 20% of their business in the first round, and then another 20% in the second round. So, after two rounds in both companies, the Founders and employees own 64% and the investors own 36% of the company.

(The fact that it is a 64/36 split instead of a 60/40 split might not be intuitive to some people, but it is beyond the scope of this post, so ill ignore it for now. If you want a post explaining the concept of dilution across multiple rounds, request it in the comments).

At this point it sounds like both Company A and Company B have identical ownership splits, and so both scenarios are equally preferable, right? Wrong.

Company A has $18mm in Liquidation Preference.

Company B has $11mm in Liquidation Preference.

Liquidation Preference means that in an exit, the investors “Preference” must be repaid in full before the cap table splits up the rest of the consideration. Unless the consideration is large enough such that the investors opt to convert their Preferred stock into Common stock, in which case they split up the proceeds just like Founders and employees without taking their Preference.

There was a lot of jargon in there, but hopefully the hypothetical scenario we have been building will help illuminate the problem.

Lets say the road gets a bit rocky and Company A and B each decide to accept a $20mm acquisition offer, here’s what will happen.

In Company A, all the investors will elect to take their Liquidation Preference. $18mm of consideration will go to them first. And then the Founders and employees will split the remaining $2mm. So the proceeds will be split as follows in Company A:

Founders: $2mm
First Investors (the $1 on $4 pre round): $8mm
Second Investors (the $10 on $40 pre round): $10mm

In Company B, the first investors (the ones that invested at $4mm pre) will elect to convert their Preferred stock to Common stock and waive their Liquidation Preference. The second set of investors will choose to keep their Liquidation Preference of $10mm. So the proceeds will be split as follows in Company B:

Founders: $8mm
First Investors (the $1 on $4 pre round): $2mm
Second Investors (the $10 on $40 pre round): $10mm

So, two totally identical companies raise identical amounts of money and exit at identical prices. If the Founders choose debt in the beginning, they see $2mm in value. If the Founders choose equity in the beginning, they see $8mm in value.

This often-overlooked unintended consequence of debt financings is worth digesting before deciding to raise money in a capped debt note structure.

Notes

  1. dcrollins reblogged this from thegongshow and added:
    Sometimes things are not as cheap as they appear.
  2. caterpillarcowboy reblogged this from thegongshow
  3. erikschwartz reblogged this from thegongshow and added:
    Awesome post from Andrew Parker
  4. daslee reblogged this from thegongshow
  5. thegongshow posted this