Day 5 What is "liquidation preference"?

Today is my fifth day at CoreNetwork Fund, and the Monday of second week. As usual, I arrived the office around 9 A.M. and started my daily reading of Venture Deals while waiting for my meeting with Erik at 10 A.M. Today’s reading was on The Capitalization Table. A capitalization table is a table (usually on a spreadsheet) for a start up or early stage venture. It shows capitalization, or ownership stakes, in a company, including equity shares, options, the various prices paid by stakeholders for these securities, and preferred shares (a super important yet it had been a confusing concept for me, but I decided to figure it out since it had occurred twice in the reading already, I will share it once I understand in my today’s blog as well.

After reading, it was around 10 A.M. and I had a meeting with Erik to go over the executive summary and report I wrote, ask questions I had in my weekend reading, and talk about the final project. Erik said the writings were good, so he decided to let me start working on my final project today. But before that, I had some questions in the book that I wanted to make sure I understand.

So far, I am still not very used to the language in Venture Deals. The book described some scenarios to explain some strategies of VC investing when it comes to setting up terms and agreement. I was confused about those conclusions of those scenarios but they were important because understanding them could help the VC investment to maximize the win or it loose a lot of money. So it was essentially to understand one important term: “liquidation preference”. So what in the world is Liquidation Preference?

Something like this?

Of course not like that! Now you see the importance of understanding financial terms? Otherwise, your money get "sinked in water" (literally).

Back to the real topic, after Erik had explained it to me more professionally, I had digested it and came up with a simple example to explain it in common life language. However, still prepare for some fun math! Suppose a VC holds 25% of a company’s value ($3M in this example) and has a 1x liquidation preference. The other 75% ($9 M) is held by common stock (which can be purchased by anyone who was wondering on a stock trading center). Then the big news came (perhaps bad this time): the company would be bought at the value of 6M. I wondered why would the company take that offer since it was definitely worth at least 6M more. But if the company had a lot of due debt or was facing bankruptcy, it would still make sense that they would take the offer. So the VC might had foreseen this storm coming and luckily they had a 1x liquidation preference when they set up the deal. This means the VC gets 3M, instead of 25% of the value (which would be 1.5M, losing half) the company was bought at. So as you can see, the VC did not lose money because their liquidation was “prefered”.

So maybe things do not go wrong all the time, and the company happened to get an offer of $24 M instead. If the VC only could only get $3M, they lost big. So lucky them that if they had liquidation preference, they got to convert their return in form of percentage, which in this case, they would get $24M x 25% =$ 6M (doubled what they would have gotten without liquidation preference).

I felt so good after finally understanding it because I got lost in the book very often and had to read over and over. But I think it helped if someone professional could walk me through it with an example.Though taking 10 minutes of a venture capitalist to explain some “simple concept” (for them) is quite much to ask for, Erik seemed happy that it helped me.

Then we also talked about my Final Project, which will be a VC Fundraising project for EnosiX (software integration company) and 7Signal (enhanced WI-FI performance company). A more specific description will be available on the project page on the website as well. What I did today was to first downloaded Excel (as an Apple user, I relied on Numbers a lot but Erik said sooner or later, every business person needs Excel). I took about an hour to learn about the basics in Excel using Youtube and the excel manual book, and 10 minutes in, I was mind blown of how many things Excel can do (it truly was 100000 times more than a table’s function). Then, I started creating a list of contacts (of Bob highlighted names) who could potentially be VC investors for EnosiX and 7Signal. Then I did some website research of those VC firms and wrote some bullet points of their investment criteria by utilizing the summarization skill I had been working on last week.

Today I have reached my overall goal of learning How Venture Capital Works through getting started on my final project (and taking initiative to understand the confusing terms!). The final project satisfies my first goal of learning about how to determine whether an investment is good or not through looking at the criterias VC firms have for investing. As for my second goal of knowing the process of a VC deal, I think I hit that by working on my final project as well because doing research of VC funds is a big process a lot of companies have to go through to get the investment deal. As for third goal, by reading chapter 7 in Venture Deals, I understand how entrepreneurs utilize the capitalization table to organize the terms with VC investors in a deal.