Liquidation Preferences

Hey there,

Welcome to Week 20 of TechExec - the newsletter that turbocharges your growth to become a Tech Executive!

As always, we are sharing a new set of BLTs this week

• 💼 B - a Business concept / theory / story

• 💝 L - a lifestyle advice

• 🤖 T - a Tech explainer

Here is the schedule:

Monday —>💼 B - a Business concept / theory / story

Wednesday —> 💝 L - a lifestyle advice

Friday —> 🤖 T - a Tech explainer

This week we will cover Professional Introductions on Wednesday and DevOps on Friday.

Today’s Business Concept is the Liquidation Preferences!

💼 B - Liquidation Preferences

In the glitzy world of start-ups and venture capital, there's a little something called "liquidation preferences" that tends to sneak up on starry-eyed employees like a cunning fox in a hen house. Understanding liquidation preferences can mean the difference between buying a tropical island or a tropical smoothie with your employee stock options.

So what exactly are liquidation preferences?

Simply put, liquidation preferences are a type of clause in investment contracts that guarantee venture capital firms will be the first to recoup their investment in case of a company's sale or liquidation. VCs get to swan through the exit first, pocketing their investment and then some, leaving regular Joes and Janes clutching their employee stock options and wondering where all the money went.

Let's dive into an example to clear things up. Say you're working for Unicorn Start-up Ltd., which has just raised $10 million from Deep Pockets Venture Capital at a $30 million valuation. So, basically they own one-third (=$10M/$30M) of the company. Let’s also assume that you were one of the early employees, and that you now hold 1% of the outstanding shares. You're already dreaming about that tropical island, aren't you? But hold onto your coconuts! Deep Pockets VC has negotiated a 2X liquidation preference with participation as part of their deal.

Let’s say the startup does well, and over time it’s value increases by another $20 million. So when Unicorn Start-up Ltd. is sold for $50 million, you would think you were going to get richer by $500K (=1% x $50 million). But guess who gets to fill their boots first? That's right, our friends at Deep Pockets VC swoop in and snatch up two times their initial investment, i.e., $20 million (liquidation preference), off the top. Only then does the remaining $30 million get divided among the rest of the shareholders, including you and your slightly less shiny employee stock options. Since, the Deep Pockets VC are also participating, they get to claim another one-third of the remaining $30 million based on their ownership, thus pocketing a total of $30 million from the $50 million proceeds. Your 1% claim is worth $300K, 40% less than the $500K you are hoping for.

Notice that the above example was actually a good scenario. Imagine an alternative universe, where a downturn arises and Unicorn Start-Up Ltd. gets sold for $25 million. Even though it was a down round, you would think you were still going to get $250K (=1% x $25 million). Be prepared to be shocked! In that case, Deep Pockets VC gets $20M (liquidation preference) plus $1.67 million (participation). Your 1% claim would be worth only $50K, a far cry from the $250K you were hoping for.

Of course, it doesn't mean that liquidation preferences render your stock options worthless or that working for a start-up is akin to selling seashells by the seashore. But it does mean that when it comes to cashing in on those options, you might be further back in the line than you initially thought.

Thus, liquidation preferences can dramatically reduce the upside of your employee stock options if you're not careful. So next time you're offered stock options as part of your compensation package, remember to ask about liquidation preferences. It could be the difference between sipping margaritas on your private beach or sipping them at your local bar while dreaming about what could have been.

📈 Want your product/business featured in this newsletter?

For an extremely small fee, advertise to TechExec readers who are in positions of influence at Fortune 500 companies. Fill this form

🥰 Your feedback matters!

Thanks for reading! What did you think of today's newsletter? Reply to this email and let me know what you'd like to see more of.

If you ❤️ today’s edition, consider forwarding this to a friend or a family member.

Thanks for reading.

Until next time!

Gaurav