Does downside protection, such as liquidation preferences, meaningfully change venture investment outcomes?

Michael Eisenberg · Dec 6, 2021

In a market reset, unwinding the accumulated liquidation preference stack will be expensive for common shareholders and for investors whose funds are too small to keep large reserves

Today's venture rounds all carry pari passu preferences on top of a huge quantum of capital; peeling that off is costly to those holding common and lacking reserves

Scope: no senior preferences today, everything is pari passu; less of a problem for giant funds like Tiger or Altimeter

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Michael Eisenberg · Jun 19, 2024

Investors are not going to get liquid the way they expect; liquidation preferences will absorb the proceeds and leave little for the rest of the cap table, as happened in 2001-2004

Higher cost of capital means buyers pay lower multiples, and at lower valuations the top of the cap table takes its liquidation preference (historically with an 8% coupon) before anything flows down

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Harry Stebbings · Sep 6, 2024

Protective provisions matter precisely in non-boom times, where recovering 1x instead of 0.2x across several companies can be worth half a turn on a fund — the difference between a 0.8x and a 1.6x fund.

In hard markets downside recovery across multiple companies compounds into a materially different fund multiple.

24:45 Protective provisions materially improve fund multiple in down markets though not boom times

Cem Sertoglu · Nov 20, 2024

Downside protection in venture is overrated and rarely changes an outcome

Venture deals are long-term contracts around a vision rather than securities purchases; structures like liquidation preferences typically get renegotiated at the point of liquidity, and he has never seen downside protection make a big difference to an outcome

49:54 Downside protection rarely changes outcomes because terms get renegotiated at liquidity

Harry Stebbings · Jan 13, 2023

Downside protection and preference terms don't really matter to investors, but they badly matter to employees, who end up underwater when a highly valued company sells low.

Growth investors who only put in $250M are made whole on a $500M sale, while employees who joined at a $1.5B valuation get nothing.

21:17 Liquidation preferences dont matter to investors but leave employees underwater in down exits

Emil Michael · Oct 24, 2022

Structured rounds are a better near-term option than down rounds optically, but they poison the next round because liquidation preference demands compound across every subsequent investor

Once one investor has downside protection the next one wants it too, so a 2x liquidation preference starts to eat the whole cap table

27:56 Structured rounds avoid down round optics but poison future rounds via compounding liquidation preferences

Emil Michael · Oct 24, 2022

Over the next two quarters investors will demand higher liquidation preferences, warrants and senior preferences, effectively bastardizing pari passu terms

Companies that planned to raise $100M and missed growth now need $50M, and those investors will insist on sweeteners; a 2x preference alongside a 1x isn't really equal even when nominally pari passu

28:42 Pari passu terms erode as successive investors demand senior preferences and warrants

Harry Stebbings · Oct 24, 2022

Early-stage funds, which hold no liquidation preferences and are not structured to win, are the ones hurt most when down rounds and liquidation events happen.

They have no structural protection in the preference stack when liquidity events happen

29:16 Early stage funds with no liquidation preference protection are hurt most by down rounds

Emil Michael · Oct 24, 2022

Early-stage funds get somewhat crushed in these environments but should be fine because their cost basis is so low — it's the life they chose

Series A funds are small by definition, can't participate in late-stage rounds, and don't have to pony up; their low basis protects their returns

29:31 Low cost basis protects early stage funds from being crushed by down rounds