Exit preference – yet more problems down the line
In our last post we covered what kind of follow-on round structures were likely to follow, when an earlier round contained exit preference rights.
In this post, let’s consider the position when that earlier-round exit preference was badly structured.
Sometimes the early-round investors just got too good a deal. That can be seen in all sorts of ways – maybe they got too much of the equity and left management disenfranchised (see our post on the re-up). In the context of exit preference, the concern is that the initial exit preference structure was so aggressive that it has the same effect – of potentially disenfranchising management. And because exit preferences have a gearing effect, it can transform just a slight blip in the company’s progress into a wipe-out of the founders’ equity value.
Illustrating the problem
We’ve set out an example below but, first, a quick re-cap on what exit preference means:
- Non-participating (“soft”) exit preference: the investor gets their monies back OR a share of the proceeds on exit, BUT NOT BOTH.
- Participating (“hard”) exit preference: on an exit, the investor gets all or a multiple of their money back AND they share in any remaining exit proceeds.
- Both types of preference can have baked-in multiples or annual percentage returns. So, a 2X non-participating preference holder gets to choose between 2X their money back (if there’s enough proceeds) or their equity share of proceeds.
So, to illustrate the point:
- let’s say SaaSco raised £500k of start-up capital from angels for a 20% shareholding. That left the founders with 80%. Great! The founders still have the vast majority of the upside.
- Here’s the catch: the angels negotiated a 2X baked-in return through a hard exit preference. So, on an exit, the investors get twice their money back, and then share the remaining proceeds 80:20 with the founders. That’s less of a problem if SaaSco raises no more equity. A 2X return on £500k isn’t going to kill the founders if they exit for tens of millions – and who doesn’t think they’re going to do that?
- Then comes the problem. SaaSco gets some traction and attracts VC interest. The VCs plan to invest £1m, and value the company at £5m. So, how do the VCs plan to structure the deal?
- If they don’t adopt the 2X hard exit preference structure, then they get a worse deal than the previous investors. That doesn’t seem fair.
- On the other hand, if they do adopt the structure, that leaves £1.5m of exit preference ranking ahead of management with a 2X baked-in return. So, when they sell SaaSco, the founders must deliver £3m of exit proceeds before they get a penny. And, as of today, everyone agrees that SaaSco is only worth £5m. Why bother?
- Maybe the VCs could reflect management’s concern by taking just a tiny sliver of equity to compensate the founders. But hold on a minute – the VCs need a decent slug of equity. There’s no point having just a tiny slice of the occasional massive success – that’s really the only time when you get your portfolio return.
Potentially this is a deal-breaker that stops SaaSco from raising follow-on finance. The existing exit-preference structure is so rich that the founders cannot afford to issue more shares on those terms. What’s the solution?
Fixing the legacy
One theme of our various posts is the malleability of an existing position. Bad cap tables, disenfranchised management, poorly considered capital structures. Let’s take that same approach in this case – everything is up for grabs. The angels can play dog-in-the-manger, but that way SaaSco never gets funded and quietly dies. So, they need to fix the problem as much as the founders. Let’s assume that the angels are rational (we’ll soon find out) and are happy to negotiate.
So, the simple solution is to redline the existing articles of association and investment agreements: eliminate the exit preference structure. Then write your own terms – maybe a 1X soft preference that keeps management incentivised.
The angels may push back – “we took only 20% because of the exit preference structure. Without it, we would have taken more”. The easy response is: “tough, swallow it”. This might not be entirely fair, and the shareholdings can be adjusted retrospectively – maybe through some share-buy-ins for nominal value – but there can be tax implications.
To avoid the above problems, DSW Ventures prefers a simple 1X non-participating (“soft”) preference as our default funding structure. It’s easy to follow and keeps management and investors broadly on the same page.
Investors and founders should both try to keep their structures simple and fair. Hard exit preference structures and baked-in multiples of money can create a toxic legacy.
Partner, DSW Ventures