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Why Investing In “Preferred Stock” Become a Favorite Tool of VCs

Last week I had a discussion with one of our clients, a founder of what seems to be a very promising and dynamic technology venture, who had just begun negotiating with several groups of venture capitalists (VCs).

During our conversation, it became clear that many technology entrepreneurs, like this client, still do not fully understand the implications of a particular feature of “preferred stock” sought by most investors – namely liquidation preferences.


Notably, it is not an issue of fairness.  Technology entrepreneurs have to understand that investing in start-up ventures is a risky business.  If a venture is successful in bringing to market an innovation that is both useful and desirable, such an investment can sometimes pay off in time. However, statistics as well as the history of technology ventures show that not all succeed in this game.


So, why has investing in “preferred stock” become a favorite tool of VCs?


Almost always it comes down to special rights usually received by owners of preferred stock – “liquidation preferences.”  This means that when the startup sells, or liquidates, the owners of preferred stock get a guaranteed amount of money from the sale.  Oftentimes, owners of preferred stocks get a guaranteed return of their initial investment.


The most common liquidation preference for VC firms investing in startups is a so-called 1X liquidation preference.  For instance, lets say a VC buys 50% of a company for $100 million, for a $200 million post-money valuation. If the company at some point sells for $150 million, the VC gets more than 50% of that amount.  The VC gets its $100 million out first and then receives half of the balance of the sale price, or another $25 million.  The overall return for the VC is $125 million.  Notably, the common stock holders have to share the remaining $25 million among themselves.  This gives investors who provide the early high-risk capital an extra level of protection plus an added return on their investment.


However, lately, some technology deals have seen a 2X liquidation preference.  In these cases, VCs reap all the benefits of a deal.


Taking the scenario discussed above, when a company sells for $150 million, the VC in this case takes the entire $150 million!  Though there may be some special provisions for the company’s founders, the rest of the employees of the technology venture are likely to receive nothing.


Note for technology entrepreneurs – be mindful of liquidation preferences and their potentially serious implications for both the founders of your company and your employees.