Liquidation Preferences

As shareholders of startups, we all know how it’s supposed to work. We make an investment. The company grows. The company is acquired or goes public. Our initial investment yields a stupendous return.

Let’s do the math! Suppose we invest $25K at a $2.5M valuation. We own 1% of the company. A few years later, it is sold for $100M. We get 1% of $100M = $1M; a remarkable 40x our initial investment. Yay!

But, what if the company is sold for only $1M? Then, we get just 1% of $1M = $10K. Not so good, but it’s not like the math is any different. Right?

Well, that depends. Were there any liquidation preferences?

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Bridges Need Blueprints

Over the last year, I’ve observed a recurring pattern:

Unfinished highway bridges, Czech republic

  • A pre-revenue (or low-revenue) start-up pitches an exciting new product or service. The start-up asks for a seed investment, with a budget showing that the new capital will provide approximately 18 months of runway. Projections show the start-up achieving target metrics for revenue, active users, customers, or the like within a year. After those milestones are reached, the start-up plans to raise additional financing at a significantly higher valuation.
  • The team is impressive, the market seems substantial, and due diligence indicates that potential customers are eager to work with the start-up. Investors invest.
  • 15 months later, the start-up is back. Everything is going great — but the software development scheduled slipped and the pilot customer loves the product but can’t make a decision on a purchase because of a management transition. The company’s success is inevitable. It just needs more time — and, therefore, more capital. Would the initial investors please provide a “bridge” investment?

My question is always “A bridge to where, exactly?”

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Just a Different Kind of Customer

As a Sand Hill Angels member, I sometimes have the privilege of being the Director of a portfolio company, and, as such, get to work closely with the CEO. I recently spoke with a CEO who was struggling to communicate effectively with the company’s investors.

We started by talking about the appropriate items to include in a monthly investor update, using Jason Calacanisblog post on the topic as a guideline. Using a suitable template is a good step, but I also wanted the CEO to have a good mental framework for thinking about investors. Communication is not just about what is said but also about why it is said.

Over a decade ago, I had a conversation with Dick Hardt, who was at the time the Founder & CEO of ActiveState. He told me that (to paraphrase) “Investors are just a different kind of customer.” I didn’t understand what he meant at the time, but Dick’s insight is profound, and one that every CEO should understand.

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