Punitive liquidation preferences return to VC — don’t do it

As silently and swiftly as it has devastated families and communities around the world, COVID-19 has also left many startups gasping for air. Emerging companies with strong 2020 revenue forecasts have seen their high-confidence plans reduced by 60%-80% in a matter of days. Even in the best of times, startups must reach value-unlocking milestones to successfully raise new capital. But today, a globally synchronized halt to business activity has made irrelevant normal benchmarks for financing rounds.

Obtaining payroll support from the recently enacted special government programs for small businesses will not resolve the cascading problems startups are grappling with, regardless of whether or not they are VC-backed.

Product development roadmaps in many innovation-driven industries are changing in ways that may permanently alter a company’s future strategic direction. Merger and acquisition discussions are being shelved. Normal financing rounds, in process and contemplated, are contracting or being abandoned altogether. Many venture funds, including corporate venture programs, have unilaterally “taken a pause” to reevaluate the radically changing landscape for their early-stage company portfolios.

I last experienced this phenomenon in the aftermath of the Great Technology Bubble: 2002-2003. And all signs show that we are at the beginning of a new round of punitive “incentives” for venture investors to keep their companies alive.

Several of my current portfolio companies have recently proposed “emergency bridge” convertible note financings of between $5 million and $15 million, each featuring a painful feature for non-participants: multiple liquidation preferences benefiting only the new money above 3x, with discounts greater than 20% on conversion in a new equity financing. Of course, these financings are open to both existing and new investors. But the likelihood of another round is actually diminished by this type of structure.

While there is nothing technically wrong with this structure, it creates severe disincentives for any new investors to consider investing in the company after this bridge, and it misaligns the economic interests between the existing investors who play and those who don’t.

The losers — those who don’t participate in the bridge and who are company directors — are still required to act in the best interests of all shareholders while personally being moved below the new senior liquidation preferences. They will naturally want to hold out for better times before seeking a liquidity event, but they don’t have the capital to support the company.

In stark contrast, the check writers stand to make a short-term return equal to several times their most recent invested capital. These winners will naturally advocate a quick exit, especially in continuing uncertain times.

This uncomfortable combination will not only cause great stress in the boardroom, it may also force a sub-optimal sale under distressed circumstances. And new investors will not want to touch this messy capitalization table without a restructuring — which means eliminating the unnatural liquidation preference structure after much unpleasant and legally expensive negotiating. Sadly, we’ve been here before.

In the post-technology bubble period of 2002-2003, venture capitalists who were the last to invest in companies found themselves in increasingly powerful positions, often able to wrest board control. Many were able to guarantee themselves a return on their investment at the expense of early investors, company founders or employees who were either washed out or left with significantly reduced equity stakes.

In a report covering 2002 and the first quarter of 2003, Alternative Investor, an industry research firm based in San Francisco, found that 42% of respondents saw their company’s valuation decline in the most recent financing from the prior round, on par with 41% reporting up-rounds. Companies raising a third or later financing were hit hardest, with more than 50% experiencing a down round. Those deals often came with onerous, preferential terms that gave the most recent investors priority over earlier investors, or anti-dilution clauses guaranteeing investors a return of their capital at the expense of founders and employees.

Boards of directors considering these types of financings today need to understand that they are creating misalignments and raising serious fiduciary duty issues. Going down this path is also likely to force the premature sale of the company. These unnatural bridge financings are simply masking what is, in effect, a down round by loading preference multiples on the last money in.

Companies, investors, entrepreneurs and employees will all be better served by honestly pricing a down round that reflects business reality, keeps the capital table clean and won’t scare off future investors when global business conditions stabilize.