Exit preference – problems down the line
In our last post we briefly introduced exit preference structures and how they work in a first-round of funding.
In this post, we are going to take a brief look at how exit preference can work in a second or subsequent funding round.
The issues
Let’s recap on the last post. A VC or angel has invested with an exit preference. That means they get their money back ahead of the ordinary shareholders when the company is bought.
Time passes and dear old SaaSco persuades some new investors to fill up the tank again. Question: how do the new investors structure their investment, and how does it rank against the previous backers? The question can be split up:
- Do the second-round investors take exit preference as well?
- If so, is it structured the same as the first-round exit preference?
- Do all the exit preference entitlements get pooled and shared on an exit and, if not, who gets their money back first?
The answers
Well, as we’ve noted in a few posts on various issues, there are no single answers to these questions: it’s all up for negotiation. So, whether the new investors, or the existing shareholders, or management, get their way depends on their relative negotiating strength, and how much ground has been won or lost on other key terms – like headline valuation.
But there are some ground rules, even if not absolutely industry-standard. Incidentally, be aware that in venture deal negotiations, you should always present your own position as “absolutely industry standard” whereas the other party’s position is a “nonsense. It’s the first time in my long career I’ve ever heard of that ridiculous requirement.”
So what are these sort-of standards:
- Usually, if earlier round investors have taken an exit preference, most follow-on investors will require exit preference as well. This makes sense. Otherwise, the new monies will go in by default as ordinary shares ranking behind the earlier round investors. So, not only is the company in a better position after being recapitalised, but also the existing investors are now sitting on top of a buffer of cash invested by the newbies, who as vanilla ordinary shareholders are last in the queue for exit proceeds.
- Often, the new investors will adopt the existing exit preference structure. This is more likely if the earlier round investors knew what they were doing, are respected, and put in a workable exit preference arrangement. It also helps set the tone for later rounds if substantial money has already been invested rather than, say, a small SEIS angel investment.
- New money ranks ahead of old money. So on the sale of SaaSco, if there’s not much money on the table, the latest investors get to feast first. If there are enough proceeds for them to get their money back, then the previous investors are allowed to the dinner table. If the exit is not a complete disaster, there’s even enough to cut-in the founders. And a successful exit allows for second helpings to all shareholders. When a company accumulates a set of investors with different-ranking exit preference rights in this way, these are called stacked preferences.
Exceptions to the rules
- So the rules are pretty hazy, and exceptions isn’t perhaps the right word. Variations might be a better description. Here are a few variations we’ve seen, and the circumstances:
- Follow-on investors don’t always take an exit preference. An example of the principle is BrewDog. We covered their complex capital structure in a previous post. TSG Capital Partners have invested in preferred capital in BrewDog. This gets repaid on an exit, plus an 18% baked-in return, plus a share of the equity. Wouldn’t anyone investing subsequently want at least the same? Evidently not. Retail investors keep subscribing for new ordinary shares. Those monies are improving the chances of TSG getting their money back. I’m not absolutely sure the retail investors will get their own monies back. Maybe that IPO will happen.
- Sometimes follow-on investors don’t follow the existing structure. I’ve seen a SaaS data business, which had been funded with a straight one-times money back non-participating (soft) exit preference. Then they went on to raise a massive round from a major tech VC with a prior-ranking five-times participating (baked-in) exit preference. “Why did you do that ?” I asked the CEO. “Because the headline price was twice what anyone else was offering”. Fair enough. Sadly, in this case, the business lost major clients, went backwards, the CEO stood down, and the existing shareholders were wiped out. You pay your money, you take your choice.
- The preference rankings are up for grabs. If they argue hard enough, get enough interest in the round, and maybe go easy on the headline price, then the existing investors might get to rank in a pool alongside the new investors. Who knows, maybe they could get to rank ahead. The arguments are usually as follows. Existing investors: “We were in early, we took all the risk. Now you want to sit ahead of us?” Usual response: “You paid £1 a share. We’re paying £5 a share and investing ten times as much. We’re taking all the risk!” Existing investors: “£5 a share? The shares are worth £10 easily. If management had run this round properly, we wouldn’t even be talking to you!”. And so on, till the dawn of time, or at least until one or other group realises that it probably doesn’t matter very much anyway…
Does it really matter?
It does, a bit.
Most exits work out two ways:
- SaaSco fails absolutely. No-one gets anything. The exit preferences make no difference.
- SaaSco succeeds – a bit, or a lot. There are enough exit proceeds to make the preference rankings irrelevant. Everyone shares alike.
So how often does an exit produce a result in the middle ground between these two situations? Well, in practice, not very often. That’s worth bearing in mind when you’re dying in a ditch on the point of principle about exit preferences. What else might you get instead in the negotiations?
When there are participating or multiple-of-money exit preferences at stake, though, it’s a different matter – see below.
Round-up
The first rule of exit preference negotiations is …….. there are no rules. Well, maybe a few, But you can break them.
In the next post we will look at follow on rounds when there are toxic exit preferences already in place, and how to deal with them.
Partner, DSW Ventures