Liquidity Preference 101 : All you want to know about Liquidity preference in venture Capital world

Liquidity Preference is one of the few terms in a VC term sheet (other than drag along/vesting and management rights) that really evoke strong reactions from either side. While Majority (or rather 100% ) of VCs swear by it and won’t sign a term sheet without it, entrepreneurs see it as another “Shylock” term inserted by very, very bad VCs to suck blood from poor innocent entrepreneurs. We see numerous posts/blogs by entrepreneurs (funded/wannabes) denouncing “Liquidity preference” and terming it as a draconian term.

So what is “Liquidity Preference”? Liquidity preference is a macroeconomic term, that was first described by renowned economist John M Keynes in his book “The General Theory of Rate of Interest” where it was emphasized that Investors are entitled to a premium to invest risk capital for a long-term which is a function of demand and supply.

However, in Venture Capital / Private equity, liquidity preference refers to the division of proceeds once a company (investment) is liquidated and is one of the standard terms in the shareholder agreement between Investor and company founders.

First, let’s see what is liquidity in this context? Liquidity event does not necessarily mean when the company goes bankrupt, wound-down or insolvent. In this case, Liquidity also means when the company is sold or gets acquired, or there is a change in management control. However one must note that liquidity does not include when the company goes for IPO ( initial public offer) or get listed in a public stock exchange.

Liquidation preference provides downside protection to VC/PE investors from losing money by ensuring that in liquidity event they get a certain return on their money before any other equity claimant. If the company is sold at a profit, liquidation preference can also help them to be first in line to claim part of the profits. As VC/PE investors invest through preference shares (Cumulative convertible preference (CCPS) or optionally cumulative convertible preference shares (OCCPS) etc, they have preferred rights over general stockholders and are paid before holders of common stock.  It is important to note that company founders and employees etc. get common stock and do not have preference shares.

Liquidity preference is defined as: “Liquidation Preference: In the event of any liquidation or winding up of the Company, the holders of the Series A Preferred shall be entitled to receive in preference to the holders of the Common Stock a per share amount equal to [x] the Original Purchase Price plus any declared but unpaid dividends (the Liquidation Preference)”.

Let us see as how liquidity preference works:
Let us assume that a company “ABC private limited is being bought over by XYZ limited for Rs. 800 million in March 2011. ABC Private Limited shareholders include promoters holding 65% stake and the rest 35% is held by Private Equity fund by investing Rs. 100 million in April 2007. So at the time of investment, the company was valued at Rs.285 million

In the above example, the preference shareholders will be first paid out. So out of Rs.800 million, first Rs.100 million will be paid to Private equity fund.

If the company has declared a 10% dividend every year for the last 4 years, but unpaid, totaling to Rs. 20 million, then that amount has to be paid.

The remaining Rs. 680 million will be distributed in 13:7 ratio between promoters and private equity fund. The promoters will receive Rs. 442 million and private equity fund will receive Rs.238 million.

So in total, the private equity fund will get Rs. 358 million for a 35% stake and the promoters will receive Rs. 442 million for 65% stake.

Now, it’s clear that PE fund got almost 44.75% returns despite having 35% stake and promoters made “only 55.25%” on 65% stake and this creates heartburn among entrepreneurs. However, like all scenario, there are more shades of grey (of course not 50 shades) than we can see. Likewise, in this case, VC made 3.58x on multiple and 258 million while entrepreneur made 442 million. It is important to remember that investor provides all capital and hence all risk on capital loss is taken by investor and one must not forget that these kinds of liquidity events are very rare. So rare, that Economic Times will run a screaming headline, CNBC and every business channel worth its name will conduct innumerable interviews and rest of world mentally calculates the money VCs and founders made and plan their next venture!!!

So what happens when these rare events don’t take place, in a day to day scenario. Liquidation preference helps investors to protect their capital when the company is either average or unable to scale up, which is the case in at least 8 out of 10 times Now let us see how investors use liquidity preference to protect their capital and try to get fair value out of it.

2 Ivy league graduates who just returned to India are building kwitter.com a clone aiming to target Kannada speaking population from North Karnataka. Their USP is to focus on regional language and to create real differentiating factor they are focussing only on north Kannada dialect so as to create real deep penetration in the first trial market ( a fact harped by every VC in all last 15 conferences they attended over a lot of red wine and chicken tikka masala).

One misty eyed VC who has just returned to India, so as not to miss the growing economy and all heat (in weather and economy) decided to invest USD 5 million for 40% stake in the company thus valuing the company at USD 12.5 million. Since both investor and entrepreneur speak the same highly accented American English, there is a huge degree of trust among them and so VC ignores his legal counsel’s advice and invests without any liquidity preference. The following scenarios emerge after a year

Scenario A: The dreamy-eyed entrepreneurs are not sure of kwitter, anymore as they realized that all north Kannada guys use English as their first language and are not keen to continue due to lack of sufficient market. They wish to close down the company. The company still has $ 8 million cash left. The promoters with a 60% stake in the company, are entitled to get $ 4.8 million as part of their share.

Scenario B: While promoters believe that kwitter doesn’t have much future, they have a solid team and have built a good translation tool for which a leading search giant is willing to acquire for $ 12 million, provided promoters continue for another two years and 50% payment will come after 2 years.

In the second scenario, promoters will make a total of $ 7.2 million,$ 3•6 Million immediately and the balance after two years.
So, in the second scenario, the company can’t be called a total failure and can be seen as a moderate success as there is some suitor for the product.

But wait a minute – what about investor – he invested $ 10 million and in the first case is getting $ 3.2 million (a loss of $ 6.8 mn) and in second scenario$4.8 million ( a loss of 5.2 million). While in a losing venture, founders will make $ 4.8 million despite closing the company and $7.2 million in case the deal goes through.

It is obvious here that such deals are very unfair to investor and in fact, by structure encourage the entrepreneur to quit early or set a very low sight. Hence liquidation preference is designed to protect capital and depending on the type of liquidity preference, Investor would have received all of $ 8 million in the first case and either all $ 12 million or $ 10.8 million depending on type of liquidity preference (we will learn about types of liquidity preference in our next edition of the article).  Hence one can see that despite all bad press, Liquidity preference remains quite favorite terms of VCs and they don’t like to do a term sheet without it!! Hence Liquidity Preference creates a perfect alignment of interest between VC and entrepreneur where both aim to create a high-value company rather than creating incentives for selling too early.

Now, what happened to Kwitter guys? Well being smart entrepreneurs, they chose to take $$ 4.8 million upfront by shutting the company and moved to Valley while our foreign returned VC friend, last heard, was working as an accent-trainer in local BPO in Bangalore after failing to raise next fund.