The other day I discussed liquidation preferences with an entrepreneur who just got his first round of proper funding. As he was eternally optimistic about his business and it’s potential success he couldn’t find anything wrong with the 2x preference his investor had negotiated into the contract.
Let me tell you a story how a 2.5x liquidation preference Dong Chim’ed me in my first startup (and do yourself a favor and watch Mike’s fantastic TEDx talk — which has nothing to do with liquidation preferences and all with Dong Chim’ing life):
I founded my first startup out of college; raised $2.5M on a nicely designed pitch, a couple of ludicrous Excel spreadsheets and a crude prototype. It was 1997 and those were the days. We had a 2.5x liquidation preference in our contracts. What this means in simple terms is that in the event of an exit (say: we sell the company) the investor first gets 2.5x his initial investment back before anyone else gets any money. Sell for less than $6.25M and you’re Dong Chim’ed.
Life looked pretty rosy for a while. We had awesome clients, we grew, we worked hard and had fun. And then boo.com happened. Suddenly life looked pretty bleak. We knew that times would get tough. What I didn’t realize was how desperate our investor became. As I made a few other mistakes in the way I negotiated our terms he essentially forced us to sell the company. So we sold. For less than $6.25M. Which meant: Nobody, other than our investor, made any money. Three years of incredibly hard work and all we got was a “Thanks. Now clear your desk please.”
That is all to say: When you negotiate your terms spend a bit of time thinking about the worst case scenarios and how they will affect you. It might come handy in the future.