Downstream Consequences: Exits

12 minutes, 5 links


Updated September 15, 2023
Raising Venture Capital

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danger Many founders, at the time of a liquidity event, are shocked to learn that they can sell their company for millions of dollars without a penny making it into their personal bank account.

To fully understand the implications of your early-stage financing choices on valuation and dilution, it helps to play this all the way through to a liquidity event. To do so, you need to understand a few more key concepts: preference, conversion of preferred stock to common stock, and participation. We’ll lay out the most common scenario here (1X non-participating preference), and you can get the rest of the gory details in the section on term sheets.


Definition A liquidation preference (or preference) is a contractual clause that sets the order and, in some cases, the amount of payout for a company’s creditors and holders of preferred stock in case of a liquidity event. Preferred stock usually has a liquidation preference and, when this is the case, holders of preferred stock get their investment back before holders of common stock are paid.

Preference means that preferred shareholders get paid before anyone else. You’ll often see preference expressed as “a 1X liquidation preference,” where the 1X refers to the multiple—that is, a return of the original investment amount. A 1X multiple is the most common. 2X (or even higher) multiples were common during the crash of the 1990s dot-com era. Today, only 19% of deals have a 2X or greater liquidation preference.** (For biotechnology and life sciences companies, the multiple can be 2–3X, likely due to the much larger amounts of up-front capital required to start these kinds of companies.)

The important thing to understand about preference is that, in the case of a liquidity event where the investment return via preference is less favorable than what common stockholders would receive (which would be the case in a big exit like an IPO), preferred shareholders would choose to convert their preferred shares to common.

Definition Liquidation preference overhang (or liquidation overhang) is an outcome of exchanging a convertible note or convertible equity for preferred stock in which the resulting liquidation preference is greater than the original investment. Liquidation overhang can occur where the original investment included either a conversion discount or a valuation cap, allowing the investor to acquire preferred stock at a reduced price per share.

For example, if an investor invested $1M on a safe with a 20% discount and they convert to full-value preferred stock, they’ll get shares with a liquidation preference of $1.25M. The discount and cap, on convertible debt and equity, were created to give early investors more ownership because they were taking a risk on an untested company. The liquidation overhang, however, gives the investor even more.

dangerSignificant liquidation overhang can have drastic consequences: Holders of common stock will receive no payout in a liquidation or liquidity event if the company’s value at that time is less than or equal to the amount of the aggregate liquidation preference, holders of preferred stock exercise their liquidation preference, and there is no particular protection for common stock. Even very large exits can produce no payout to the common stock if, as a result of a history of large financings with substantial liquidation preferences, there is a liquidation overhang.

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There are two ways to give early investors more shares—in accordance with the risk they took—without the liquidation preference overhang.

  1. Create the discount via common stock: Investors get preferred stock up to the aggregate amount of their liquidation preference and then all their discount shares are issued via common stock. This is ideal for founders. Less experienced investors may bristle at using common stock to create the discount because they can’t mark the full value of their position in your company as high when reporting to their LPs, as common stock is valued separately (via 409A) from the preferred price. Experienced firms should be comfortable with this, because they know this will not be material to the long-term performance of the investment. If an investor does challenge you on creating the discount via common stock, this is a red flag that the investor may not have your best interests in mind.

  2. Offer an additional class of stock with a lower per-share liquidation preference so that the investor’s aggregate liquidation preference stays the same, but they still get additional shares.

Definition Shadow preferred stock is a separate series of preferred stock that is designed for use with convertible instruments and calculates per share liquidation preference, conversion price, and dividend rate based on the original investment amount in the relevant convertible instrument. Except for these distinctive features, shadow preferred stock has the same rights, privileges, preferences, and obligations as the series of preferred stock issued to new investors. Shadow preferred stock is designed to solve the problem of liquidation overhang associated with convertible instruments. Investors whose convertible instruments are exchanged for shadow preferred stock still get the benefit of purchasing shares at a discounted price, but their liquidation preference cannot exceed their original investment.

controversy Shadow preferred stock is controversial because, while it converts to the same class of preferred stock, it is a separate series of preferred stock, which grants its holders rights to block certain actions under Delaware constitutional law (remember, most startups are Delaware C corporations).

dangerSome lawyers have raised concerns that shadow preferred stock can complicate future deals such as merger and acquisition offers, in the case that holders of shadow preferred stock feel that their ownership position is being adversely affected.

By way of illustration, let’s assume the following:

  1. 1M shares of common stock outstanding on a fully-diluted basis.
  2. $100K convertible instrument outstanding with a $10M valuation cap.
  3. The $10M valuation cap means the convertible instrument converts at $10.00 ($10M/1M shares).
  4. $20M pre-money Series Seed round valuation, resulting in a per share price for new cash investors of $20.00 ($20M/1M shares).
  5. The Series Seed preferred stock has a 1X participating liquidation preference (each share of Series Seed preferred stock will have a liquidation preference of $20.00).
  6. The $100K in convertible instruments will convert into 10K shares ($100K/$10.00 per share).

If the convertible instruments convert into 10K shares of the same Series Seed preferred stock as the new money Series Seed investors, then the convertible instrument holders would have a total liquidation preference of $200K (10K shares multiplied by $20.00 per share). So an original $100K investment would result in a $200K liquidation preference, which is equal to a 2X liquidation preference rather than the 1X liquidation preference the new cash investors will receive. If the convertible instruments instead convert into 10K shares of a shadow series (like Series seed-1 preferred stock) with a per share liquidation preference of $10.00, then the original $100K investment results in a $100K liquidation preference, which is equal to the 1X liquidation preference the new cash investors will receive.

Conversion to Common Stock

Definition Conversion rights are a feature of preferred stock that governs how and when it is exchanged for common stock. Optional conversion, which is the most frequently seen form of conversion right in venture capital term sheets,* allows investors to choose when and whether to exchange their preferred stock for common stock. In a liquidity event, preferred stockholders with optional conversion rights will typically exercise them if the proceeds from converting to common stock are greater than the value of their preferred stock’s liquidation preference, any accrued dividends, and participation rights. By contrast, an automatic conversion (or mandatory conversion) provision specifies conditions under which preferred stock must be exchanged for common stock. Typical conditions are: when a majority of preferred stockholders consent, or in the event of an IPO that meets specified criteria for overall company valuation and price per share.*


Definition In a liquidity event, participation rights (or participation) govern how proceeds are distributed to preferred shareholders*—that is, how they participate in the distribution. An investor with full participation rights (or participating preferred) is paid according to the liquidation preference agreement, plus a pro rata portion of what remains as if it converted to common stock—in effect, being paid twice. An investor with capped participation rights is also paid according to the liquidation preference and a portion of what remains, but their payout cannot exceed a predetermined figure, generally calculated as a multiple of their initial investment.

Participation is complicated because it is not exactly what it sounds like. All preferred stock “participates” in the upside of a liquidity event because preferred is always optionally convertible into common stock by the investor. In particular, capped participating shareholders might choose to convert to common shares if that is a more favorable outcome for them. Participation, in the legal sense you encounter it here, means that the investor gets their preference in addition to participating in additional returns alongside common stockholders (either in full, or up to some capped amount).

But the vast majority of the time, you’ll encounter non-participating 1X preferred, which gives investors two options in a liquidation event. First, the investor can opt to exercise just their liquidation preference. Second, the investor can opt to convert their preferred shares into common and participate pro rata in the liquidation proceeds as a common stockholder would.

In the event of a tremendous exit, all of the preferred stockholders would agree to forego their liquidation preference and be treated as common stockholders in order to take more of the exit. This can have a significant impact on dilution for a founder.

Consider this example from Capshare:

Imagine shareholder A has 100 shares of preferred stock worth 10% of the company and a 1X liquidation preference. For the sake of easy math, let’s say the shares are worth $1 a piece. During liquidity, the shareholder would reach 100 dollars and stop participating. They got 1X their shares, but they didn’t receive 10% of the company. Now, let’s say that shareholder A had negotiated a 1X liquidation preference and 2X conversion rate to common stock. Instead of walking away with $100, the shareholder would convert to common stock, and double his/her shares to 200 and thus 18.18% of the company.*

TL;DR: This stuff is crazy complicated. A few folks have created some templates to help you with this—the most common one (at least in Silicon Valley), is the safe, which we discuss in detail next.

Template Documents for Convertibles

controversy Various sets of templates for early-stage financing documents are available online. Templates save you time so you can close the round fast, but—despite popular belief to the contrary—even template documents may contain unfavorable terms. You will inevitably hear the phrase “standard documents” or “standard docs.” This is a reference to template documents, but it’s misleading. There is no such thing as a “standard set of documents.” Every law firm has their own set and everything is redlined in a negotiation. In any case, be sure to understand the terms you agree to, and consult a lawyer before you sign anything.

You can execute a convertible instrument agreement by working with a lawyer and drafting your own documents. Alternatively, you can use standardized convertible instrument paperwork from accelerators and other startup programs and institutions.

controversy These tools try to simplify the convertible instrument process, and are known for controversial approaches to eliminating downsides for investors.

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