Exit preference – simple in theory
VCs and some angels like to invest with some downside protection or a built-in return. They can do this in various ways. One way is by using exit preference (sometimes called liquidation preference). The concept is pretty simple, but in practice the mechanisms can become frighteningly complex.
We’re going to post a short series on the subject, starting off in this post with an explanation of how exit preference works.
What is exit preference and how does it work?
Exit preference gives the investors the first call on any proceeds when the business is sold.
Most exits are through a sale of the company’s shares. So when SaaSco gets an offer from USBigTechCorp, the deal is almost always effected by SaaSco shareholders tendering their shares for cash. The exit preference is usually documented in SaaSco’s articles of association, and stipulates who gets what, and in what order.
Every so often, maybe when SaaSco’s stakeholders have had a rough time and have just given up, the residual assets and IP might be sold off by SaaSco itself. Cash flows into the company, not directly to the shareholders, and SaaSco distributes the cash to them through a liquidation. Again, the articles of association determine how the monies should be split between the shareholders. In this context, investors’ preference is correctly called liquidation preference. Generally, that’s a misnomer: the solvent liquidation of a tech company happens hardly ever.
At its heart, the mechanism is quite simple: investors get their money back first. If there’s enough left over, the other shareholders get a distribution as well.
There are many variations on the theme. We’ll cover more of them later in the series but for the moment let’s just take one permutation – participating or non-participating preference. Sometimes these are known as hard, or soft, exit preferences.
- Non-participating exit preference allows the investor to get their money back ahead of the founders or other ordinary shareholders by effectively granting the investor the option to take their money back (to the extent proceeds allow) or share rateable to equity shareholding on exit. So, if the exit is disappointing, the investors may get back some or all of their monies, whilst the founders might get nothing. If, however, SaaSco sells for the same or more that the entry price per share, the exit preference makes no difference whatsoever. It’s that aspect that makes the soft exit preference our favoured mechanism for new investments, but we’ll come back to that in a later post.
- Participating exit preference is altogether more aggressive. Investors get their money back, then they and all the other shareholders share the balance pro rata to the number of shares. The effect is as though the investor has subscribed for a redeemable preference share that pays out on an exit, plus a free option over a chunk of the equity.
You might imagine that founders and early-stage investors would choose the soft exit preference every time. All other things being equal, that makes sense, but you need to factor in the gains that founders might make by securing a higher headline valuation and suffering less dilution. We covered this off in an earlier post on gearing in venture deals.
Why have exit preference?
Either type of exit preference allows investors to boost their returns at lower valuations – making the investment less risky. Founders sit on a leveraged structure, take more risk, but hold onto more equity. That all makes sense.
But there’s a more fundamental principle at work. Exit preference stops founders from sitting back on a heap of someone else’s cash. To illustrate what can happen when a venture investment has no exit preference in place, look back (for those old enough) to the dotcom era, at some of those IPOs whose business was a slide deck, nothing more, backed by tens of millions of quoted market investors’ monies. After the bubble popped and the slide deck was binned, management still had a heap of cash to pay salaries. Then, after a while, they liquidated the business and pocketed the majority of the investors’ cash.
That’s one drawback of funding venture stage companies on the public markets, and a very good reason for investors to insist on some form of exit preference.
Exit preference and EIS
Investors and companies alike need to take proper tax advice on this matter, and ideally get pre-clearance on their proposed investment structure. That said, currently, HMRC seem happy to allow EIS for investments made with an exit preference – but not a true liquidation preference.
Exit preference is a standard mechanism in the sophisticated venture stage investor’s toolbox. Structured intelligently, it smooths the transaction by ensuring founders and directors are pointing in the right direction, and by allowing options to allow some latitude on pricing and dilution.
Next post and we will be going into more detail on some of the issues that arise in follow-on funding when there’s an exit preference structure in place.
Partner, DSW Ventures