angel investing

Liquidation Preferences

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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

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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

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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 Calacanis‘ blog 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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