Pawel’s blog

Contract clauses and financial models illustrating how proceeds are distributed among different shareholders at exit are frequently referred to as waterfalls. They can be very complicated.

It seems that the VC funding market cooled off a little after reaching a peak in 2015. In colder markets, investors have a stronger tendency to get creative on terms, especially if not much competitive pressure is felt around a deal. One of the the things investors like getting creative about is liquidation preferences. In this post I will outline why I think you should try to push back hard on complicated and aggressive liquidation preferences during your financing round.

A lot has been written about liquidation preferences and you can check out this post by Brad Feld for a good intro. In short, the liquidation preference language describes how the proceeds are distributed between shareholders at exit. It describes what the holders of individual preferred share classes are entitled to receive before the rest gets served.

It typically has two components, (1) a minimum multiple or interest relating to the original investment amount and (2) a participation or lack thereof which describes whether the preference represents a minimum return threshold after which everyone gets served pro-rata or whether it comes ‘on top’.

A simple (1x) non-participating liquidation preference ensures that, at an exit event, investors get the money they invested into a company returned to them first, before proceeds are distributed to everyone else according to ownership %-tages. I do believe that a simple 1x non-participating liquidation preference is absolutely the right thing in early stage VC deals. Fred Wilson outlines nicely why in this post. Anything beyond that for the investors, however, is tricky, not always fair and full with potential for unintended consequences.

We believe, and our experience and industry statistics prove it, that in early stage venture investments money is not made with contracts. You typically either make a lot with an investment, lose all or most of it, or make very little. In a bigger picture, even if liquidation preferences at exit come into effect in a way that benefits the investor, this does not increase his or her overall returns materially.

Yet, many investors will ask for liquidation preferences, because, in theory, a liquidation preference sounds great. After all, it reads like a guarantee to lock in returns. An investor might think: let's ask for a participating liquidation preference and I’ll make quite some return even if the valuation does not increase. Or, even better, let’s ask for a participating liquidation preference with an interest. How about 8% per year? After all, this is my hurdle rate (minimum fund return below which no profit participation is paid to fund managers), so I need to make at least that much in every deal.

Sometimes entrepreneurs may be happy to agree to a participating, growing or multiple liquidation preferences, typically in exchange for a higher headline valuation. Here are five reasons why I think that such structures are a bad thing, especially in early stage VC deals (Seed, A, B):

• By design, every liquidation preference skews the distribution of exit proceeds away from ownership %-tages. I think this works OK in case of 1x non-participating liquidation preferences, which are irrelevant if the exit price is above the entry price of a negotiated funding round. Multiple and / or participating liquidation preferences can skew distributions much more heavily, even at higher outcomes. This leads to sometimes very different financial incentives for investors vs founders or ESOP holders and in consequence is likely to result in conflicts. An example could be a discussion around a  proposed sale of a company at a price that will allow investors to make a nice return, but due to the liquidation preference structure not much would be left on the table for common shareholders. Since we believe that the VC game is all about aligning interests, everything that misaligns them should be avoided.

• Early deal structures frequently create a precedent for later stage financings. Later stage investors often ask for (at least) the terms that the early investors got...and add some things on top. So if you create a multiple / growing liquidation preference as part of your early financing you can expect that all future money will come-in at these terms, or worse. Thus, if considered long term, aggressive terms are not only disadvantageous to the founders, but can also be disadvantageous to the very early stage investors that ask for them in the first place.

• The terms around a liquidation preference are frequently a heavily negotiated topic. Entrepreneurs may struggle with understanding the idea when confronted with it for the first time. It just makes negotiations and contracts longer, more complicated and more emotional.

• Modelling liquidation preference waterfalls :-) in the contracts and later in Excel can become extremely complex, time consuming and very prone to misunderstandings.

• If too much money goes into a company with aggressive liquidation preferences attached to them, it can become very demotivating to the founders and team members owning stock, thus hurting the company overall or triggering a discussion around increasing or restructuring the ESOP, e.g. through carving it out from the liquidation preference stack (have fun modeling that!).

The above are just some of the issues that come to mind when you think about the impact of aggressive liquidation preferences. In the past we made a few investments where we got participating liquidation preferences ourselves, but because of all these issues we stopped asking for them a few years ago.

If you ended up with an aggressive liquidation preference stack at your company, you might still be able to negotiate it away in your next financing round, if your position is strong enough. Or if you cannot get rid of it, you might manage to introduce a cap or minimum return threshold after which it disappears. We have seen and supported such restructurings in the past - they can sometimes be achieved, frequently to the benefit of everyone involved.

I would recommend to any venture funded entrepreneur to try to keep the liquidation preference stack as simple (ideally 1x non-participating) as long as possible. Even if it should be at the cost of a lower valuation. It will pay off in the long term.

If you are not sure you understood the concept of a liquidation preference well enough you might wanna check out the cheatsheet below prepared by Clement. He reviewed a version of this post and thought a cheatsheet will do a better job at explaining the basic concept of the liquidation preference than my text :-) Thanks Clement, and Christoph, for reviewing this post.

I recently met an entrepreneur for dinner. He is currently working on his fourth company and thus has a lot of experience in various areas of entrepreneurship and (business) life in general. Among many things, we discussed fundraising for startups. He mentioned to me a metaphor that I would now like to share with you.

He said: startup fundraising is similar to the job of an imaginary train conductor stopping his train by a train station and having the task to depart without delay, but also to take a required minimum number of passengers with him. The hard part is that he cannot depart without passengers who, as is often the case, might be running late or stand on the wrong platform.

Now, imagine a train station where there are a few guys (potential passengers) hanging around and smoking cigarettes. These guys are VCs. They want to get on a train, but are unsure which one brings them toward their destination (a good exit). In fact, they do not care so much about the type of the train or where it comes from as long as they know that the destination is reachable on time. The conductor’s task is to make them want to get on his train quickly, so that he can depart on time.

The job is challenging, because even if the guys smoking cigarettes like your train, they will rarely jump on it quickly, if they believe it will not depart without them or is not departing immediately. They will hang around and smoke a few more cigarettes…until the train starts moving.

So if the conductor wants them to take his train, he has to convince them that the train is about to depart or is already slowly moving. The problem is that you cannot start moving if you don’t know how many, if any, passengers will jump on it. The train cannot depart empty.

The way to solve this paradox is to maximise the number of folks at the train station with whom the conductor chats about the upcoming journey. In that way he can quickly figure out who is convinced that the train will most likely take him to his destination and is therefore most likely to take it. Once that’s done, and some of them start making first steps toward the train, the conductor needs to quickly blow his whistle and shout (very loudly!) that the train is about to leave the station or even slowly start moving the train (this is known as "we are now closing the round"). In most circumstances, those that started walking towards the train will start running, and those still pondering upon their decision will swiftly throw away their cigarettes and try to jump on the train as well (this is known as fomo :-)).

Two months ago Christoph attempted to answer the question on what it takes to raise money in SaaS in 2016. The result was a table outlining ballpark indicators across startup development stages that need to be met to get to the next financing stage in SaaS, i.e. from Seed to A, from A to B, etc.

It seems the SaaS fundraising napkin, as Christoph called it, was very helpful to SaaS founders out there. The feedback from the community was very good and many interesting discussions evolved.

Given that marketplaces are also a strong focus area for us, we immediately thought that it would be great to have a fundraising napkin for marketplaces too. After thinking about it for a bit, we came to the conclusion that this might be a bit more tricky, due to marketplaces being a less homogenous group than SaaS startups. Here are a number of areas in which the differences are visible:

• Geography - SaaS startups tend to be global from day one, frequently go after the US market and raise funding from the same group of international SaaS investors. Marketplaces, on the other hand, are frequently multi-local, scale country by country - and have to raise funds, especially in the early stages, from local investors - who might vary in standards.

• B2B vs B2C - when we talk about SaaS we typically talk about startups selling software to businesses. In contrast, marketplaces can be B2B, B2C, B2B2C..

• Business model mechanics - marketplaces can have varying take rates, some own some do not own the transactions that happen on them, some are platforms for trading products versus others are about services and may or may not involve a SaaS component.

I strongly believe that Berlin is a great startup hub for European tech founders. This has been true for some time, even though relatively little VC / startup capital has been available from sources based in the city, especially compared to other startup hubs out there. London, for example, has an order of magnitude more capital available that sits on the ground (like 10x more?), but the number of startups that get created and funded in London is not that much higher than the number of startups in Berlin. For example, according to CBInsights, there were 150 funding rounds at London based startups in 2014, vs. 91 in Berlin.

Berlin has become a startup hub despite not having a startup financing infrastructure in place. People have been coming to Berlin for many reasons, but startup funding availability has not been one of them. Founders wanted to build their companies in Berlin, but largely relied on funding from sources outside of it. 

Times are changing and capital is following the talent, so that there are more and more local financing sources available on the ground in Berlin. I would argue that you can now raise a good Seed (a few hundred thousand to million-ish) or a smaller Series A round (up to 2-3 million) entirely in Berlin and this from people who really know what they are doing and can be helpful.

This is important for Berlin as a hub, because I think this will give an additional boost to the scene, as founders from all around Europe, especially from the east and south of it, will be able to add 'financing' to the list of reasons to come to Berlin.

Here is a quick list of Berlin-based folks to talk to re startup financing on your next fundraising trip to Berlin. I think all of them have at least one person in Berlin on a (nearly) full-time basis. I am sorry if I forgot someone.

• AtlanticLabs
• Berlin Holding
• BMP
• B-To-V
• BVP
• Cherry VC
• DCM
• Earlybird
• eventures
• GSG 
• Heilemann Ventures
• IBB
• Lakestar
• Paua Ventures
• Partech
• Project A
• Rheingau Founders
• Rocket Internet
• WestTech
• last, but not least, yours truly, i.e. Point Nine Capital

On top of that, as has been the case over last years, VCs from other parts of Germany and Europe continue to visit Berlin frequently. It feels like every significant European VC (incl. the three biggest European VC brands, i.e. Accel, Index and Balderton) has at least one investment in Berlin and is coming by on a regular basis. Also, as exits are slowly but surely happening in Berlin, the number of business angels actively investing is continually increasing. I crowdsourced this list of Seed investors interested to invest in Berlin some time ago and whereas it is not entirely up to date, you might still find it interesting.

On the Series B side of things and later (aka growth financing) you will still have to travel to London or other places, but the good news is that later stage capital tends to be more mobile and international than early stage capital and it will travel to the other end of the world (literally) to meet with a good company. The fact that US investors are quite active in European late stage financings, but much less so in Seed and A, illustrates this point well.

I am not trying to say that early stage fundraising in Berlin is a walk in a park and everyone will be successful - this is nowhere the case and raising money is hard in general. Nor do I mean that there is enough capital available - there are not very many 'classic' VC funds on the ground that can write multi-million Euro checks (Point Nine does up to 1m in the first step). But it is increasingly possible to fundraise in Berlin, especially for Seed and A, without having to fly to London, other European cities or the US. I am sure this trend will persist and the financing landscape in Berlin will continue improving. 

I look forward to having coffee with you on your next fundraising trip to Berlin!

Conventional wisdom suggests that companies should try to raise as much as they can as soon as they can in bull markets like the one we are witnessing now. The theory goes that a good market has to end, maybe very soon, which will worsen fundraising conditions for a bunch of years to come.

This seems a logical thing to do and we find ourselves giving this advice to companies too. Even if you do not need it yet, go out and get it now - it has not been so "easy" for a while and it might end as soon as next year.

The flip side of this is the following: if companies raise more than they need, they will start burning more than they would otherwise do. And if everyone follows this advice we will end up with an overfunded and "over-burning" startup landscape that is even more dependent on future financings to sustain the burn-rates and thus very vulnerable to market hiccups.

So I had this thought that this type of behaviour (raising because you can) might be what ultimately leads to trouble and that it is not smart advice after all. The smart advice seems to be: try to secure the money you need, or a bit more, but not much more, just because you can.