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The impact of preference stacks (pref stacks) on liquidation events

Published 3 months ago • 6 min read

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I hosted a bootstrapped founder on my podcast (usually that is not the case as I am more focused on VC backed) to talk about her exit. She raised $125k only from friends and family, and walked away with the majority of the sale.

Her exact words were ‘no VC gave us a chance and we have no option’- our conversation led to the discussion of pref stack. Surprisingly, someone who sold a company for tens of millions $ had very little idea of the topic. So, I thought lets try to share some more knowledge around the topic.


What is Pref Stack?

It is a critical lesson in the world of venture capital financing – the impact of preference stacks (pref stacks) on liquidation events and early-stage investors. This is a topic that is often overlooked or misunderstood, but it can have far-reaching consequences for your startup's future and the fortunes of those who believed in your vision from the very beginning.


At the heart of pref stacks lies the concept of liquidation preferences – a set of negotiated terms that determine the order and amount of payouts to investors in the event of a liquidation event, such as an acquisition or bankruptcy. These preferences typically include a multiple on the invested amount (e.g., 1x, 2x, etc.) and a participation cap, which can significantly impact the distribution of proceeds.

Examples and scenarios

Let's start with a simple example: Imagine you've raised $1 million from an angel investor for a 20% equity stake in your company, with a 1x pref stack.

In the event of a liquidation, this angel investor has the right to receive their initial $1 million investment back before any other shareholders (including you, the founder) receive a payout. If the liquidation proceeds exceed $1 million, the remaining amount is distributed among all shareholders based on their equity ownership percentage

Now, let's introduce a twist: Your startup secures a $5 million Series A round from a venture capital firm, with a 2x pref stack. In a liquidation event, these Series A investors have the right to receive 2 times their initial investment ($10 million) before any other shareholders receive a payout.

If the liquidation proceeds exceed $10 million, the remaining amount is distributed among all shareholders based on their equity ownership percentages.

Here's where things get complicated: Suppose your startup raises a $20 million Series B round, with a 3x pref stack. In a liquidation event, these Series B investors have the right to receive 3 times their initial investment ($60 million) before any other shareholders receive a payout.

If the liquidation proceeds exceed $60 million, the remaining amount is distributed among all shareholders based on their equity ownership percentages.

Now, let's consider a scenario where your startup is acquired for $50 million. In this case, the Series B investors would receive the entire $50 million, leaving nothing for the Series A investors, the angel investors, or you, the founder.

Is Pref Stack always bad?

These scenario highlights the harsh reality that a high pref stack, combined with a less-than-ideal acquisition price, can effectively wipe out the equity holdings of early-stage investors and even founders themselves.

But pref stacks aren't inherently good or bad; they are a negotiated term that reflects the risk and potential return for each investor.

Early-stage investors typically accept lower pref stacks (or even no preferences) because they are taking on more risk by investing when the company is just an idea or has minimal traction. Later-stage investors, on the other hand, demand higher pref stacks to compensate for the perceived lower risk and to ensure a certain level of return on their investment.

The mathematics behind pref stacks can get complex, especially when dealing with multiple rounds of financing, varying pref stacks, and participation caps. However, understanding the impact of pref stacks on liquidation events is crucial for both founders and investors to navigate the venture capital landscape and align their interests.

Founders, it's essential to understand the implications of pref stacks from the outset. Negotiate terms that balance the interests of all stakeholders, including early-stage investors and yourselves. Remember, these individuals believed in your vision when it was just a glimmer, and their support was instrumental in your startup's journey.

Is there a way around? I believe so. Two ways that I can think of are structuring the incentives and exit strategies considerations.

Structuring Investor Incentives:

Liquidation preference structures

To mitigate the potential negative impact of pref stacks and balance the interests of different investor groups, founders should explore alternative liquidation preference structures.

One option is capped participating preferred, where investors receive their pref stack payout up to a certain cap, and then participate in the remaining proceeds based on their equity ownership percentage.

For example, let's say the Series B investors have a capped participating preferred structure with a 3x pref stack capped at $80 million. In an acquisition for $100 million, they would receive their $60 million pref stack payout (3x their $20 million investment), and then participate in the remaining $20 million based on their equity ownership, allowing earlier investors and founders to receive a portion of the proceeds as well.

Tranched investments

Another strategy is tranched investments, where different portions of an investment round have different pref stack terms. This allows founders to offer higher pref stacks to later investors while preserving more favorable terms for earlier investors.

Implementing vesting schedules for founder equity is also crucial to align incentives and ensure long-term commitment. For instance, if a founder's equity vests over four years, with a one-year cliff, they would only receive a portion of their equity if they leave the company before the vesting period is complete.

Performance-based milestones

Lastly, founders can establish performance-based milestones that adjust pref stacks based on the company's progress and valuation growth. For example, if the company achieves certain revenue or valuation targets, earlier investors' pref stacks could be reduced, giving them more upside in a successful exit.

Exit Strategy Considerations:

Payouts

It's crucial for founders to analyze various exit scenarios and their potential impact on pref stack payouts. In an IPO, for instance, pref stacks typically convert to common stock, eliminating their liquidation preferences. However, in a trade sale or acquisition, pref stack terms come into play.

Liquidation events

Educating investors on the implications of different exit pathways and managing expectations is essential. For example, if the company is aiming for an IPO, earlier investors may be more willing to accept lower pref stacks in exchange for the potential upside of a public market valuation.

Secondary Markets

Additionally, founders should explore alternative liquidity options, such as tender offers or secondary markets, to provide partial liquidity for early investors without triggering a full liquidation event. This can help incentivize early investors to stay committed to the company's long-term success.

Let's illustrate this with an example: Suppose your startup is valued at $100 million in a secondary market transaction, and you offer to buy back 10% of the shares held by early investors at that valuation. An angel investor who initially invested $1 million for a 20% stake could receive $2 million (10% of their 20% stake at a $100 million valuation) without triggering a full liquidation event and the associated pref stack implications.

By incorporating these strategies for structuring investor incentives and considering exit strategy implications, founders can navigate the complexities of pref stacks while balancing the interests of various stakeholders, including early-stage investors and themselves.

Remember, pref stacks are a double-edged sword that can provide downside protection for later-stage investors but can also significantly dilute or even eliminate the holdings of early-stage investors and founders in certain liquidation scenarios. It's a delicate balance that requires careful consideration, transparency, and negotiation to ensure a fair and mutually beneficial outcome for all parties involved.


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Watch the full episode here


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Until next time,

M.

Prodcircle Insider

Mudassir Mustafa (Founder | Angel Investor | Podcast Host)

I'm a 4x founder and Angel investor. Building a private community of founders and an angel syndicate to invest between $30k to $100k in great founders.

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