Let’s start with how VCs fund startups. Lots of digital ink has been spilled on VC funding, so we’ll limit ourselves to the aspects germane to the liquidation overhang. A VC investor will be issued preferred stock, not common stock, which is what founders and employees get (the latter usually by way of options). Preferred stock simply means that its holders have certain rights above and beyond those of holders of common stock. Among those rights is the liquidation preference, which is nearly as important as the price (or valuation) at which a VC invests. The liquidation preference gives the VC a priority in being paid in the event of a liquidation. For these purposes, liquidation includes not only the bad stuff (e.g., bankruptcy), but it also includes any event in which shareholders receive proceeds for their equity, such as a merger, acquisition, or sale of substantially all of the company’s assets. The preference allows the holder to get paid before the holders of the common stock; meaning, if a company were sold, the VC investor receives proceeds from the sale before common stock holders.
The market standard for liquidation preference is a 1x multiple, which means that the VC investor receives 100% of its investment back in a liquidity event before holders of common stock (i.e., employees) can get any proceeds from that event. If a VC has invested $10 million dollars with a 1x liquidation preference, it will receive the first $10 million dollars resulting from a liquidity event.
When a liquidity event occurs, the VC investors have the option of taking the liquidation preference or converting their preferred shares to common shares and participating in the distribution as common stock holders. Naturally, they will do whichever results in more money.
To be fair, there is a strong argument for why VCs should get a liquidation preference. They assume a lot of risk by pouring in millions of dollars into an early-stage company and legitimately need to protect that investment. The liquidation preference essentially gives the VC downside protection to get its investment back (most of the other owners are “sweat” equity, while it’s the VCs who are writing the big checks the company needs to grow).
HOW DOES THIS IMPACT EMPLOYEES?
This is where the “overhang” part comes in. Effectively, the liquidation preference overhang comes into play where the valuation of the company is less than the outside money that has been invested by VCs. Let’s use an example to crystallize the point. You’ve worked for a company for 5 years (meaning you’ve put in your time and all of your options have vested) and it’s just been announced that the company will be sold for $50 million. Let’s say that you and the other employees own 10% of the company, the founders own 10%, and the VCs have invested $40 million for an 80% stake.
With a 1x liquidation preference, the VCs would get their $40 million back, and the founders and employees would participate ratably in the remaining $10 million. In this scenario, the founders would get $5 million and the employees would receive $5 million. But remember that the VCs have the option to take their liquidation preference or convert their preferred shares into common shares and participate in the proceeds from the liquidation as common stock holders. In this example, the VC would actually be indifferent (assuming that the holders of preferred stock do not receive any dividends) between taking the liquidation preference or converting to common (80% of $50 million is $40 million).
Now let’s say the company is going to be sold for $40 million. The VCs would take their liquidation preference, which means they get their $40 million investment back, leaving the founders and employees with nothing. In this example, the VCs would rather take their liquidation preference than convert to common because if they converted, they would get only $32 million ($40 million *.8).
WHAT CAN EMPLOYEES DO?
The brutally honest answer to this question is not much. Employees collectively don’t wield enough power to influence decisions relating to how much VC funding to take on and what form that funding should take. And we get it–it’s quite the scary proposition to take a haircut in salary to work for a startup, get paid heavily in illiquid company stock, and when you finally get to that exit, there’s a possibility that your equity is worth nothing, even if the company is sold for many millions of dollars.
The best thing an employee can do is to go in eyes wide open–try to get the most information before taking the job. In addition to the “smart” questions to ask during compensation negotiations, which we previously covered in these pages, a prospective employee can also ask his suitor how much VC capital has been invested in the company (CrunchBase or AngelList may also have this information, but you will get more reliable information directly from the company). The questions we have recommended asking in the past will help you approximate valuation. Once you know how much VC money has been put into the company, you can develop an informed view about the threat of an overhang scenario.
There is a silver lining here. The cost of building a tech company has come down over time. This means that less outside investment is required than in the past, which in turn lowers the likelihood for an overhang situation.