Start-up employees: Read the fine print

You've worked at the company since it was five engineers in a garage. You've put your social life on hold, and you've given 100 percent since day one. Finally, the company is getting off the ground. You hold options, so if the company gets acquired, you'll get a big payoff. Not necessarily.

That's because of liquidation preferences. Buried in the legalese of a venture capitalist's term sheet, a liquidation preference is a predetermined rate of return that the VC requires in the event of sale or liquidation of your company. The liquidation preference--employed more often in later stage deals when more capital is at risk--can be either a fixed amount, such as one to two times initial investment, or a compounding rate of return over time. Now that IPOs are no longer a given and acquisition values aren't the bonanza they once were, VCs want to protect their investments. As a result, liquidation preferences are trending upward.

Timothy Tomlinson, founder of law firm Tomlinson Zisko Morosoli & Maser and Managing Director of VC firm Tierra del Oro says the trend is "from two to four times, sometimes with participation." With participation means the investors get to share in the remaining proceeds over and above the preference amount, sometimes to the tune of their pro rata share of the company.

This does not bode well for a start-up's common shareholders. Take a fairly common deal today of a company with a $30 million pre-money valuation receiving a $30 million investment with a two times liquidation preference and a full participation right. If the company sells for $60 million, the common stockholders get zero. If it sells for $120 million (a quadruple) the common stockholders get $30 million and the preferred stockholders get $90 million.

Note that before the deal, the company was valued at $30 million. This means that even though the company quadrupled in value, none of the increase in value was given to the common stockholders. "If executive and nonexecutive employees really understood what these types of liquidation preferences do, I suspect they would look for more secure employment," Tomlinson said.

Why would start-up executives agree to such a deal? In some cases they don't have a choice--either accept the terms or go out of business. "The entrepreneur does not have a lot of negotiating strength when the company is about to run out of money and only has one deal on the table," explains Sara Richmond, a partner at Lucash Gesmer & Updegrove, a high-technology law firm.

Some do choose to go broke rather than accept the VC's terms. In the case of a media event showdown between wireless start-up Livemind and VC firm Technology Crossover Ventures, the company opted to go out of business rather than agree to a four times liquidation preference on a proposed bridge loan.

In other cases, a start-up's executives will agree to onerous terms because they are confident they will be "taken care of" in the case of a company sale.

Frequently, acquiring companies carve out a portion of the sale price to use as management bonuses and employee incentives for the common shareholders. While hopes of generous bonuses in the event of a sale might be enough to convince managers to accept VCs' liquidation preferences, it's likely that option-holding employees would not fare as well, and therefore would be less inclined to accept the deal.

"In situations like this, the incentives of the top-level people are no longer aligned with the incentives of the rest of the common stockholders," Richmond said.

What can employees do to protect themselves?

Chuck Ott, General Counsel and CFO of Financial Technology Ventures, a VC firm focused on later-stage investing in the financial technology industry, advises understanding the capital structure of the company. For prospective start-up employees, he suggests learning more about the true value of the options package to compare apples to apples. "An offer for 100,000 options might not be as attractive as one for 20,000, depending on the liquidation preferences already in place," Ott warns.

So, start-up employees, beware of liquidation preferences. You may not be in for the windfall you thought you were.