Liquidation Preference and Avoiding Dilution

For me, as an early investor, straight dilution is not a scary thing. Since I have no interest in “control,” owning 10% of a $1,000,000 company is identical to owning 2% of a $5,000,000 company. What scares me as an early investor is the idea of later investors demanding liquidation preferences greater than 1x. When they get such preferences, they end up taking more than their fair share, and squeezing out the earlier investors down to zero ownership. Here is an example:

  • Let’s assume 1,000,000 shares currently exist.
  • We invest $250,000 (let’s call it Series A) and acquire 20% of the company with a pre-money valuation of $750,000 (post-money valuation of $1,000,000). We’ll be purchasing 250,000 shares at $1/share. Let’s assume we negotiate 1x liquidation preferences.
  • At the next round (let’s call it Series B) one year later, the company has a pre-money valuation of $3,200,000 (post-money valuation of $4,000,000), and other investors invest $1,000,000 to purchase 20% of the company with 2.5x liquidation preferences. They’ll be purchasing 312,500 shares at $3.20/share. We decide to not invest.
  • If the company is acquired with a huge windfall, everybody will be thrilled, but let’s say the company gets acquired for $4,312,500 after 2 more years. The first thing that happens is we (the Series A investors) get $250,000 and the Series B investors get $2.5M. Next, the remaining $1,562,500 gets divided on a pro rata basis among all shareholders. There are currently 1,562,500 outstanding shares, so each receives $1.00 per share. Thus founders receive $1,000,000 (i.e., $1.00 x 1,000,000 shares). We receive $500,000 (i.e., $250,000 preference, plus $1.00 x 250,000). The Series B investors receive $2,812,500 ($2,500,000 preference, plus $1.00 x 312,500). 
  • As you see, that liquidation preference really screwed the earlier investors. The Series A investors received just a 19% IRR while the Series B investors received a 41% IRR even though the Series B investors presumably took a much lower risk having invested later in the company’s life.

So, bottom line is, dilution is not a fear. Liquidation preferences by future investors who demand high liquidation multiples is a great fear. Just my two cents.