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Written by Tim Carapiet-Petit, Lisette Oosterveen and Bart Dreef
Preferred rights often play a significant role when attracting investments. Investors negotiate these rights for various reasons, such as protection against dilution, optimizing returns, and safeguarding their investment. However, stacking preferred rights by investors in subsequent rounds such as anti-dilution protection and liquidation preference are not always reasonable and economically sound. In some cases it even causes founders to be left without an outlook of returns within a reasonable future, and thus a negative incentive to grow the business.
Anti-dilution protection
The anti-dilution protection clause comes in different flavors, such as conversion or issue rights calculated on the basis of full ratchet, fixed percentage or narrow based or broad based weighted average. Each of these compensate the investor for its dilution in case of a subsequent down round, to more or less extent. If Investor A has acquired the preferred shares against EUR 10, and within half a year the company needs funding again and issues shares to Investor B against EUR 7.50, one may feel sympathetic towards the Investors A of being compensated a bit – if he had not invested, the company may not have survived in the first place, but now the second investor seems to profit. Also, you could even say that the company was overvalued when Investor A stepped in.
Both arguments may be valid but only hold up for a limited period of time. Investors (should) take into account risks of downtimes when investing in startups, and will – if all works out well – be compensated by significant returns for taking those risks. It should also not be expected that the original valuation on which Investor A stepped in holds up any longer after a certain period of time – rapid growth and uncertain valuation is the very nature of startups.
It is thereof justified to limit the duration of anti-dilution protection rights. Another reason for limiting such preferred right in time is that it can deter potential investors at the moment when their investment is needed more than ever, to safeguard the continuity of the company. Striking a balance is necessary to protect against dilution without impeding the company’s future, in high and low times.
Liquidation preference
Investors argue that they require liquidation preference to protect their investments. This may be valid – to a certain extent – in case the company fails. Yes, investors should also include risks in their valuation, but their funds are used by others (founders) to try and grow a company, and also pay their wages. From this perspective it can make sense that after paying off the debts of the company, the remaining funds are first paid out to the investors. Non-participating preference limited to the invested amounts that prefers payout in case of actual liquidation, insolvency or limited returns upon exit may thus be justified.
However, there is no need to be first if there are sufficient returns upon exit. Founders have done the work to bring the company to that high valuation, and early investors without liquidation preference have run greater risks to get to exit in the first place. It seems unfair for them to bear the entire responsibility for potential losses while later investors are partially protected and take a larger piece of the cake (or even the entire cake) if the company did well. They are all in the same boat, so it is reasonable to share pro-rata each of the parties’ contributions, as expressed in the nominal shareholdings.
Investors should also not underestimate the precedent they set to later investors: if Investor A demanded participating liquidation preference 1x, then Investor B will also require at least the same if not higher, and often at a preferred rank. In the end, liquidation preferences are stacked high, requiring much higher exit values before everyone is satisfied, including the founders who will be last in line. Will those founders still want to work hard for these investors, if their payout becomes out of reach more and more? Participating liquidation preference should therefore not be on the investors term sheet, and early investors should definitely not be the first to introduce these preferred rights.
All in all, a balanced approach is needed to safeguard both investors and founders when including preferred rights on the term sheets.
