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Exit Scenarios: Understanding Preference Rights

Understanding the legal economic rights on terms sheets for preferred shares – and how they affect founders and other shareholders – is critical for any new financing round or exit strategy.

It is commonly perceived that startups will either completely fail, or enjoy a huge exit. When researching actual startup exits, however, (M&A, IPO or other liquidation) we can see that most of them are on the low end of this range.

A recent article by The Marker, an Israeli economic journal, shows the distribution of Israeli startup exits by sale amount in 2016:

As we can see here, more than 80% of the exits were below $50M (with 54% below $5M).

In the low range of exit values, the liquidation preferences given to investors significantly impact the cash distribution to founders and other shareholders. Another common perception is that Non-Participating preferences will give a better cash distribution to founders than any other liquidation preference right. In the following example, however, we will demonstrate that this is not necessarily the case.

Use Case Example: An Undervalued Startup Exit

Assume that company XYZ has so far raised $30M in three financing rounds. The last round C of $20M was two years ago. All preferred shares received Non-Participating preferred shares (Cap 1X with an option to convert into common shares).

The table below describes the current cap table of the company:

The company did not meet its revenue expectations, and its investors negotiate to sell it to a strategic partner for $40M. Meanwhile, the company’s founders were frustrated because they thought it could be negotiated more and could be sold for $50M.

The chart below describes the payoff of every share class for an exit of $40M (generated by our Terms Sheet Analyzer):

As we see in the charts below, share classes B and C are not interested in negotiating a $50M exit, since they won’t get any additional dollars based on their Non-Participating preference rights:

Next, let’s assume that all preferred share classes received 2X Cap participating preferred. Let’s simulate this with our Terms Sheet Analyzer at $40M and $50M exits:

As you can see, at a $40M exit with 2X cap participating rights, the founders get much less cash ($5.35M compared to $10M). On the other hand, the preferred share class investors had an incentive to sell the company for $50M, with the founders benefiting as well ($10.83M as compared to $10M).

Conclusion

As demonstrated above, understanding the legal economic rights for preferred shares – and how they affect founders and other shareholders – is critical for any exit strategy. AlgoValue’s Term Sheet Analyzer tool can help startups and investors correctly simulate their terms sheet’s negotiations, and become better prepared to handle the many complexities that come with various next financing rounds or exit scenarios today.

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