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Any investor that takes the risk of investing in a new idea would like some special provisions drafted in his/her favor for future distribution of proceeds. Fair enough! Right? But, the dynamics of this settlement of who gets what can be tricky. So, let us walk you through some of the most important terms in a VC term-sheet that might just save you from getting trapped in an agreement where you as a founder stand to lose later on even after running a successful business.

VC turned entrepreneur, Mark Suster offers a simple suggestion of text you should include in your term sheet: “If this note converts at a price higher than the cap…your stock [will] be converted such that you will receive no more than a 1x non-participating liquidation preference plus any agreed interest.”

You can also read more about convertible debt and how to handle it in your term sheet in the words of VC-cum-entrepreneur, Mark Suster in his blog here.

This video gives a good basic explanation along with examples of liquidation preference.

Liquidation Preference

Liquidation preference is the preference in distribution of proceeds the preferred stockholder gets in case of liquidation. In simple words, it is the investor calling dibs on the distribution of proceeds. This ensures that the preferred stockholder gets paid first in case of liquidation and only after that are the rest of the proceeds distributed amongst common stockholders. This is also called ‘non-participating preferred.’

But, that’s not all.

There is much more math involved here. This liquidation preference can be set at varying multiples. This is where the founders’ negotiation powers are put to the real test. An investor would surely want it to be set at a higher multiple while you as a founder would want to part with the least amount of money.

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This is how it works

If the investors’ preference is set at 1x, he/she gets just their initial investment back and nothing else. Whereas, if it’s set at multiples like 2x or 3x, they’d get twice or thrice their initial investment respectively. This would leave little money for the common stockholders, which consists of the founders, to share amongst them. A founder would surely not want that. So, make sure you negotiate this multiple properly and take proper legal advice from your startup lawyer before agreeing on any figure.

But, the preferred treatment and the investors’ participation in distribution of proceeds doesn’t end here. It so happens that once they cash out their initial investment or a multiple of it through preferred stock, they continue to take part in distribution of common stock through participating preferred.

Participating preferred

This basically means that once they’ve received their share through the earlier preference, they participate as common shareholders along with the founders to get a predetermined percentage of the leftover proceeds.

To put it in mathematical terms; once the investor gets their preferred stock of 1x, 2x, 0r 3x, he or she then goes on to collect their percentage of profit as common stockholder. That is, they get that percentage of the remaining profit too. Thus, they get paid twice. You as a founder must be very wary of this and make sure these terms are clearly defined in your term sheet and take the help of an adept lawyer for the same.

Since, this seems to be playing out mostly in the favor of the investor, you can put a limit to the amount of money the investor can get by putting a ‘cap’ on their participating preferred.

Participating preferred with a cap

In this case, you simply put a limit to the amount the investor can get in case of liquidation. This happens in such a way that once the investor gets their liquidation preference, their participating preferred is set at a limit of a certain multiple of their preference.

For example, if a cap is set at 3x, after getting the liquidation preference, they cannot participate in the distribution of proceeds once they get 3x of their investment as participating preferred even if they're allowed stock percentage allows for more. This is beneficial for you as a founder. So make sure you put a cap on the investors participation.

Ideally, an investor would want a high liquidation preference with a participating preferred with no cap.

Further, at times when the venture turns out to be a greater success than imagined and liquidates at a much higher value than the initial investment, the investor might prefer to convert to common stock as that might be more promising and with limits. You must make sure these terms are properly negotiated.

You can also watch this simple video explaining the different types of liquidation preferences for further guidance.

Thus, ideally, an investor would want a high liquidation preference with a participating preferred with no cap. Whereas, you as founder must aim for 1x liquidation preference accompanied by a low participating preferred with a cap for the investor.

This is a tricky negotiation which can make or break your term sheet as you might stand to lose most of what you worked for at the hands of your investors. Make sure you understand the multiplicity of liquidation preferences properly and have them clearly stated in your term sheet. Take the help of a skilled corporate lawyer to draft your term sheet.

You can find adept startup lawyers here to draft a fool-proof term sheet for your venture here at Lawyered.