Sunday, March 26, 2006
Questions to Ask a Startup
Guy Kawasaki posts a series of questions that a job candidate should ask a potential start-up employer. The list offers implicit advice for the employer (for the would-be start-up entrepreneur, investor, and innovator): Make sure that you know the answers to these questions, and whether and when you're willing to share this information.
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#8 on his list is a bit of a reach. Liquidation preference really only matters if the company is not meeting expectations at the point where there is a change of control (merger/acquisition). If the company is doing well at this point, preferred shareholders typically exercise their right to convert to common stock because they make more money that way. Accordingly, the liquidation preference is no longer a factor as it only is only a privilege for preferred shareholders.
Let's take a simple example. A VC invests $5M in Zowie Inc. during a Series A financing at a pre-money valuation of $10M. That means the company is worth $15M dollars post money ($5M in + $10M pre-money). That means that the VC owns roughly 33% of Zowie Inc. following the close of the deal. Let's assume that the management of Zowie Inc. agreed to a 2X liquidation preference as part of the deal.
If Google decides to swoop in during the next 6 months and buy the company for $60M, the VC has two options. The first option is that, as a preferred shareholder, he can get his liquidation preference back - $10M (2 x $5M). His second option, however, is to convert his preferred shares to common stock. Why on earth would he do that? Well, recall that the VC owns 33% of the company. If they company sells for $100M (great deal after 6 months), that means the VC gets back $33M (33% x 100M). As the investor is in it to get the most bang for his (limited partners) buck, clearly he is going to pick the second option because $33M > $10M (duh).
This is a really simple example, but should reinforce that if a company is doing well, liquidation preference is not that big a deal unless the liquidation preference is insanely high. If it is insanely high, however, my guess would be that the founder negotiated a really high pre-money valuation. As such, the VC set a bar high for an exit because the terms of the exit were implicit in the pre-money calculation.
Bottom line is that, if you are considering working for a startup, do not make liquidation preference your primary concern. Pick a company you think is really cool, has potential to kick @$$, and treats people equitably. Things should work out fine if people there are focused on performance, not exits.
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