How deal terms affect valuation & liquidity

Illustrating the impact certain terms have on portfolio company valuations & exits

Recently, entrepreneur-turned-venture-capitalist-and-blogger Mark Suster had an excellent post titled, "Want to Know How VC's Calculate Valuation Differently from Founders?"

In his post, he referenced the importance of deal terms to company founders and we wanted to expand upon that discussion. In summary, each party involved in a venture capital financing should be concerned with their individual return at liquidity. Deal Terms are a powerful aspect of each financing a company undertakes. Often, however, the terms are overlooked by founders who at times prefer to focus only on the valuation price. You can get a great valuation. But if the deat terms are awful, the valuation doesn't much matter. 

Remember, the devil is in the details.

Now, I do not know Mr. Suster, so any additional observations revealed within this post are simply the result of further analysis utilizing the tools and information available at VC Experts.

Whether it be "The Encyclopedia of Private Equity and Venture Capital," the "Glossary of Private Equity and Venture Capital," the "Valuation and Terms Database" (VAT), or the "Portfolio Company Analysis Tool" (PCAT), we at VC Experts like to pride ourselves on the data that we provide to the venture capital community. Our data is not bias to any particular side of the table, but in reality, makes both sides of the table more aware on how the negotiations of a deal are going to affect them.

One of our most utilized tools is the Valuation and Terms Database, or what we refer to as the VAT. The VAT is a one-of-a-kind database that provides the specific deal terms and valuations for thousands of private company financings.

This is not exactly the type of data that you can find through a search engine on the internet. The data is compiled using publicly filed regulatory documents (both state and federal), such as the Amended and Restated Certificate of Incorporation. We make copies of these documents available with every set of deal terms that we post in the database.

Within the VAT, we report Liquidation Preference as the order in which the liquidation amounts will be distributed. (Ex: Senior, Pari-Passu, Junior, or N/A if there are no other rounds prior to the current. This is assumed that if Preferred is issued, then all Preferred Stock is Senior to the Common Stock unless stated otherwise.)

We report the Liquidation Multiple which dictates how much of their money the investor will get before any other holders get anything.

Below is an example from an actual Restated Certificate of Incorporation in our database where you would/could find the details of the Liquidation Preference and the Liquidation Multiple.

Here we see that the Series D Preferred has a Senior Liquidation Preference with a 1.5x Liquidation Multiple.

1. First, the holders of the shares of Series D Preferred shall be entitled, before any distribution or payment is made upon any Common Stock or Junior Preferred, to be paid an amount per share of Series D Preferred equal to 150% of the Series D Original Issue Price (as adjusted for any stock dividends, combinations, splits, recapitalizations and the like with respect to such shares after the filing date hereof plus all accrued and unpaid dividends on the Series D Preferred for each share of Series D Preferred held by them).

One term, which many consider to be the most "influential" on an exit or liquidation event, is the Participating Preferred Stock. This term has become more popular in recent financings across the U.S.. Participating Preferred Stock allows the preferred stock to participate in any remaining assets on an "as-if converted basis" alongside the common stock. In short, after the Preferred Stock receives their initial preferences and multiple, they can then participate with the Common Stock in any remaining assets. This could be an unlimited amount based on the number of shares, unless there is a Participation Cap present.

Below is an example from an actual Restated Certificate of Incorporation where you would/could identify the Participating Preferred Stock.

Here we see there is no cap stated on the participation.

1. Third, after the payment of the full Series D Liquidation Preference and Series B Liquidation Preference pursuant to Section 3(a) and 3(b) above. the remaining assets of the Company legally available for distribution in such Liquidation Event (or the consideration received by the Company or its stockholders in such Acquisition or Asset Transfer), if any, shall be distributed ratably to the holders of the Common Stock and Series Preferred on an as-if converted to Common Stock basis.

To better illustrate the impact that these terms have on the returns and equity stake in a company, we are going to use our Portfolio Company Analysis Tool to display some very simple examples.

Example Company

• Raising a $1 MM round at a $3 MM pre-money resulting in a $4 MM post-money
• Using a hypothetical $4 MM exit value to demonstrate the returns and true price per share of the holders at the time of the investment
• What are the results of Conventional Convertible Preferred Stock vs. Participating Preferred Stock?
• What are the results of a 1x Liquidation Multiple vs. a 2x Liquidation Multiple?

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Using Conventional Convertible Preferred Stock and 1x Liq. Multiple for the Series A Preferred:

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Note the expected distributions of 75% Founders & 25% Investor #1.

Also note the share price per share are $3 for each the Founders and Investor #1.

Using Participating Preferred Stock with a 0 Participation Cap and a 1x Liq Mult for the Series A Preferred:

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Note the change in distributions to 56.25% Founders & the 43.75% Investor #1.

Also note the price per share at issue versus the price per share at the proposed exit. Using the Analysis Date as the investment date allows us to see the true impact. The shares of Preferred are issued at $3 and already worth $5.25, whereas the Founders shares are worth $2.25 per share.

Using a Conventional Convertible with a 2x Liq Mult for the Series A Preferred:

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Note the change in distributions to 50% Founders and 50% Investor #1

Also note the price per share at issue versus the price per share at the proposed exit. Using the Analysis Date as the investment date allows us to see the true impact. The shares of Preferred are issued at $3 and already worth $6, whereas the Founders shares are worth $2 per share

Using Participating Preferred Stock with a 0 Participation Cap and a 2x Liq Mult for the Series A Preferred:

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Note the change in distributions to 37.50% Founders & to 62.50% Investor #1.

Also note the price per share at issue versus the price per share at the proposed exit. Using the Analysis Date as the investment date allows us to see the true impact. The shares of Preferred are issued at $3 and already worth $7.50, whereas the Founders shares are worth $1.50 per share.

In summary, each party involved in a venture capital financing should be concerned with their individual return at liquidity. Deal Terms, while often overlooked, are a powerful aspect of each financing a company undertakes. Are you getting the best terms for your company or clients?