/* aggregate_options_strike_price = your options strike price per share * number of shares you own
company sale price is 1) if private transaction: amount paid by acquirer plus any funds in startup returned to investors, 2) if IPO = market capitalization.
note: if you assume all financings were 1x preferred, investor preferences == total amount of money the company has raised
to do: add condition for participating preferred, graph various scenarios
*/
function my_exit_payout( company_sale_price, your_percent_ownership, your_aggregate_options_strike_price, investor_preferences, investors_ownership_percent)
{
if (investors_ownership_percent * company_sale_price < investor_preferences) investor_converts=FALSE;
else investor_converts=TRUE;
if (investor_converts) return your_percent_ownership * company_sale_price – your_aggregate_options_strike_price;
else {
common_stock_proceeds = company_sale_price – investors_preferences.
your_percent_common = your_percent_ownership / ( 1 – investor_ownership_percent );
return common_stock_proceeds * your_percent_common – your_aggregate_options_strike_price;
}
}
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That’s why I hate liquidation preferences. I can understand why they exist (the quick flip) but, beyond that, there is no economic rationale for them. There are much *fairer* ways to protect the VC against the quick flip.
At the end of the day, the VC sets the value of the company. Assuming the founders are prevented from flipping, the VC should respect the implied % ownership all the way down.
Sometimes it’s nobody’s fault things don’t work out. If the founders brought valuable IP to the table (which the VC valued accordingly) then it’s only fair they get their chunk in a fire sale.
There is absolutely no economic rationale for viewing capital above (conferred) IP. In fact, there is a strong case for the opposite argument.
You pay your money, you take your chance.
@david – it is naive to think that the VCs control the exit. when the founders and management want to sell, you sell. so the founders and management control the timing and valuation at exit and the VC is along for the ride. that is why we need a liquidation preference.
Hi @fred. It didn’t mean to imply VCs control the exit valuation (I actually meant to write “At the end of the day, the VC sets the *valuation* of the company” – i.e. they invest at a valuation they are comfortable with, which implies a corresponding percentage ownership by the parties).
If a company’s IP is valued £5m pre (by the VC) and the VC adds another $5m, then they’re 50:50 partners come rain, come shine.
I’m talking about prior work here, not just ideas. I see a separation in the pre valuation between conferred IP and potential growth. The founder’s prior work deserves just as much protection as the VC’s capital.
In certain instances a founder (who has dedicated a big part of his life to an idea) could be totally wiped out through no fault of his own, even if his original IP is the only asset in the fire sale.
I have been through this (sort of) so I know how it feels.
Fred is right – founders have much more control than they think, unless they’ve made themselves irrelevant (rarely the case).
If you take any investor’s money, they should be paid back first. If you aren’t confident that you can clear the amount of capital you take in, you shouldn’t take in that capital. If the capital is deployed badly, the founder doesn’t deserve to make money.
Take the following example – a company raises $50 million and the founder still owns 10% after the money comes in and the option pool is allocated. The $50m is wasted, the company performs poorly and the company sells for $10m. Should the founder walk away a millionaire (10% of $10m)?
@jeff Allow me to present David’s first law on any discussion regarding liquidation preferences: each side will provide a compelling (and equally heart rendering) example to prove his case.
So here’s mine: a founder undergoes all manner of (self-funded) hardship for a number of years to develop an idea. He creates code, patents, etc but needs capital to roll it out.
He goes to a VC who says “Great! We value your IP at $5m, here’s another $5m, let’s go for it”.
Unfortunately, six months after funding Google decides to compete for free with the company. Is that any more the founder’s fault than the VCs?
You could argue that both were *equally* unlucky/dumb.
An offer comes in at $5m which is probably more than the company’s now worth, the founder just wants to move on.
The VC exercises his 1x pref and gets out whole, whereas the founder has bet the ranch and lost absolutely evertything.
How can the risk/reward ratio possibly make sense in this context?
“”"when the founders and management want to sell, you sell”"”
Even when the founders hold the minority board seat?
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Allow me to present David’s second law on any discussion regarding liquidation preferences: after the entrepreneur presents his own (totally heart rendering) example of why they are bad, all the VCs disappear from the discussion…
David – I think 1x non-participating preferred are fair. Usually in a fire sale the employees with ongoing value get a carve out anyways. In the scenario you describe, if the company gets $5M in cash and ends up being worth $5M, feels fair to me that IP is valued at a very low price.
Chris – just a quick reply to wrap this up. In my fire sale scenario the cash has been burned (I should have made that clearer).
The company’s only real asset is the original IP – but it’s the VC who gets paid.
In this scenario I firmly believe the % ownerships should still be respected.
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