Liquidation Analysis (Continued)
Last week I pointed out that when your company is sold at price points around or below prices where you have financed your company then your proceeds in a sale transaction will not equal your fully diluted ownership percentage times the sale price. You will get less because some or all of the preferred shareholders will choose to take their liquidation preference instead of their percentage of the company.
And in that post last week, I promised to show you all how to model this out.
Before I do that, a couple acknowledgements. Andrew Parker and Christina Cacioppo had a hand in helping me put this liquidation model together (its the second tab in the google spreadsheet). Andrew built the original template when he was at USV and Christina modified it before sharing it with me.
One of the jobs of an analyst or an associate at a venture capital firm is building these models. They are complicated and time consuming. I took a close look at Andrew and Christina's work before creating this model. I built it from scratch (driven off the cap table model I shared a few weeks ago) and it took me a couple hours to do it. It's not a simple thing to build one of these.
I did it from scratch for a few reasons. First, I wanted it to be driven off the sample cap table and be part of that shared spreadsheet. Second, I wanted to do it slightly differently than Andrew and Christina's model. And mostly, I wanted to prove to myself that I can still do this work. I passed that final test by the way.
Ok, so with all of that out of the way, here's how you model out a liquidation scenario. First lay out the capitalization of the company. List each class of stock, how many shares there are, what the cost of that class was, what the liquidation preference of that class is, and how much of the company each class owns. You can see that work at the top of the liquidation analysis in the section called "shareholdings".
As part of that work, you need to figure out what the terms of the various classes of preferred are. You need to know if they are straight preferred or participating preferred. And you need to know if there are any dividends paid in liquidation. And you need to know if any of the classes have a liquidation mutiple (1.5x, 2x, etc). If any of those things are present, put them into the shareholdings section as well.
For the sake of this model, I assumed that all three classes of preferred (Srs A, Srs B, and Srs C) are straight preferred with no multiple or dividends. That makes all of this much simpler. I also assumed the Srs C is senior to the Series B which is senior to the Series A.
If you don't know what any of this stuff means, then I would suggest you head over to Brad Feld's awesome term sheet series and read the section on liquidation preference.
Ok, back to the model (again, its the second tab). The next thing you do is lay out across multiple columns a range of exit values (sale prices). I chose $5mm to $55mm in $5mm increments.
Then in the rows under those sale price headings, you lay out the liquidation waterfall. Start with the most senior class of stock (in this case Srs C), and figure out how much of the liquidation preference would be paid out in the specific sale price. Then figure out how much is left for the rest of the shareholder base after that class is liquidated. And then figure out how many fully diluted shares are outstanding after that class is liquidated and taken out of the cap table. And finally figure out what the value of that residual is per remaining share.
That residual value per fully diluted share number is imporant. If that number is higher than the cost per share of the next class, the next class will convert to common in a sale and will not take its liquidation preference. If that number is lower than the cost per share of the next class, the next class in the waterfall will choose to take its liquidation preference as well.
You do this work class by class until you get to the common and option holders. They do not have a liquidation preference so they simply share the remaining residual (if there is any) on the basis of how many shares they own divided by how many fully diluted shares are left in the cap table after the liquidation of various classes of preferred.
Once you have worked through the waterfall by class, you then sum up the proceeds by class of stock. There are a couple reasons you want to do this. First, you want to show how much each class is getting in each sale price scenario. But this also serves as a great check on your work. If the total proceeds of all the classes equals the sale price, your formulas are working right (that doesn't mean the model is right but it is one good check).
Finally, you should add up the proceeds for each shareholder (or major shareholder). Each major shareholder will want to see how much they are getting in the various sale price scenarios. And this is again a great check on your work.
A few final comments. First, I assumed that all of the options that are listed as "unissued" in the model cap table eventually get issued before the sale happens but that no additional options are added to the cap table. That is an unlikely scenario. Usually there are unissued options in the cap table at the time of sale and you need to take them out of the cap table before doing the liquidation analysis.
And the choice of $55mm for the final sale price was not accidental. That is the next price increment above the point where all the preferred will choose to convert to common. That scenario has every class taking their fully diluted ownership percentage of the sale price. From that point on, there is no need for a liquidation model. That is why I ended there.
Again, this is complex stuff. There are likely to be a ton of questions in the comments. And it is entirely possible that there are bugs in this model. If you find them, please point them out and I will fix them.
But as complicated as this is, it can get even more complicated. Things like participating preferred shares and dividends and multiples make this even worse. A good reason to avoid all of that when you set up your cap table!
Comments (Archived):
Hi Fred, Good morning and Thanks a lot for this.My aim when I look at these is to get an overview and not necessarily detailed understanding. I guess there will come a time when I’ll have many more questions (perhaps when I’m in B school!). So, more to come..And I think the sheet does give a clear enough overview. Sorry I’m not looking for bugs. But I’m sure you’ll hear from the rest.. 🙂
1X LP by all VC’s…that is a fair and clean xl-sheet.btw, that is one of the longest post you have written in the recent past…thanx again for the free education
Fred, thank you very much for sharing your invaluable knowledge that helps us to figure out how world of venture capital (investment capital) really works.
Thank you for creating/sharing this model and spend visible effort in explaining it. You’re passion is appreciated even far away, in the “old” continent – Europe.
Sounds pretty straight forward based on your explanation with tiers of preference, will double check the sheet tonight as practice.*update* after a quick eyeball it looks good, paying out the rounds 9mil, 4mil and 1mil until common shares begin elevating above the floor/zero. Hooray for google docs working fine on the phone.Interesting trend, LIFO (last in first out). Is it standard for seed investors to get very little in fire sales? Also does this (standard preference) act as a forcing function to promote liquidation by Angel/Seed investors in later rounds?
Is it common for the CEO or the executive team to have the same amount of equity as the rest of the team combined?
i wouldn’t say it is “common”when i laid out the template cap table a few weeks ago, i was not trying to show a “standard situation”there really isn’t such a thingbut it is true that the CEO will own the most equity among the non-founder employees
Slightly off topic but what is your expectation for the analyst you are looking to hire in terms of cap table/liquidation modeling?
Cap table / liquidation modeling isn’t like building an entire LBO model, so it is definitely something that can be taught on the job. I don’t want to speak for Fred, but when we do hires having a lot of experience doing this isn’t a prerequisite. That said when VCs start having crazy terms like sliding liquidation preferences and participation with caps, things can get messy.
just that they can pick this up as quickly as andrew and christina did
If nothing else, this post is a perfect example of how education can (and should) be done in the Internet Age. Good, structured content derived from practical experience, shared examples (is it me or did 1,000 people opened the spreadsheets by 10am?), and of course – community feedback – which is where the “sauce” of the lesson comes out.Based on the cost of an MBA and percent practical value in a 2 year MBA curriculum, what do you think is the value of this post? I think a couple hundred bucks at least, probably more.
#hackingeducation
please let me know when the next event is. I want so much to be a part of it…
At the $55mm sale price, I understand that the preferredshareholders are forgoing their liquidation preference in favor of convertingto common stock. My question is concerning how this is represented in themodel.For each class of preferred in column L, the remaining shares decreases, butthe residual remains constant at $55mm. After the Srs A liquidationround, the model suggests that $55mm would be split among 3,000,000 common andoptions. However, It seems as though the $55mm is split among 1mm optionsand 4.1mm common (after preferred are converted to common).When the sale price per fully diluted share exceeds the share price of thepreferred, is the liquidation preference section of column L meant to bedisregarded? As always, thank you for the supreme education.
yes, you can disregard all the liquidation preference figures once all the preferreds convert to common
**I should note that this is extremely knit-picky to — perhaps — the point of why bother** “That residual value per fully diluted share number is important. If that number is higher than the cost per share of the next class, the next class will convert to common in a sale and will not take its liquidation preference. If that number is lower than the cost per share of the next class, the next class in the waterfall will choose to take its liquidation preference as well.”Fred: This table is great. My only feedback would be to build the logic of the above statement into the spreadsheet with a nested IF statement. I believe in Excel it would be (but, please double-check as I’ve made mistakes on things much simple before):If(b20>=$c$7,0,min($E$7,if(b$14-b17>=0,$b14-b17,0))Your note in the model clearly illustrates the logic. Putting the equation would only allow it to be more dynamic, thus if any last second changes in a sale negotiation affects the price, your model is ready to move swiftly.PS– @RonnieRendel I Agree completely :)@RonnieRendel:disqus
yup. that’s the ideal way to do iti just didn’t want to take the time to figure out how to write those statements in google spreadsheetthe last time i did that kind of spreadsheet work, i was working in excel and my advanced knowledge of google spreadsheet is not up to the task
This post was really interesting to me. As a pre-MBA working in industry, where can I read more about these kinds of valuations? Any good books you’d recommend?
This is a great concrete example of why its important to understand from an entrepreneurs perspective, just because you raised money at X valuation your shares are not worth X until you sell for more than that.As you point out this gets much more complicated and from the entrepreneurs perspective painful when there are more terms.Question: On a deal that has raised three rounds how many “easy” ones like this do you see??? In my limited experience it seems that by the time you get to the third round there is some “hair” on the deal, but maybe I’m wrong..
If we do the rounds “around the table” it stays cleanWhen we introduce new investors in the later rounds it can get hairy but it doesnt have toFrankly it should be our job to help the entrepreneur keep the cap table clean
Yes simple and clean is good, makes me realize one of the reasons you must do this blog is in response to having to explain why look my $9M at a $51M valuation with a 1X preference is actually better than their $18M at a $100M valuation with a 2X participating preferred with a 12% compounding accrued dividend.
maybe we can get someone to build that liquidation model in the next tab i’m done with building liquidation models for a while nowit’s hard work!!!
a) why last in, first out. Isn’t last in taking on the least risk? In my own head, this seems off, even if the math works.b) just to make sure I understand, after 25 million Series A people take common, after 30 million Series B people take common, because they would make more money that way. c) Thank you Christina and Andrew.
Golden Rule: “he who has the gold makes the rules” Last in has most leverage. They can choose to fund or not.
Last in first out because “money talks”
Great post. I have a question about the Proceeds section: How are the Proceeds Per Shareholder calculated? The gross proceeds give the appearance that in the minimum sale price scenario, only the Series C investors would get paid. However, all three investment groups get paid in the per shareholder calculation with the CVC making 66% of the proceeds. Wouldn’t the liquidation preference for Series C just give all $5mm to the CVC investors?Thanks!
If you look at the cap table tab you will notice that all three VC firms own a piece of the Srs C
@Fred:disqus Why does Series C not earn a return until the sale price is $55M?
There are no preferences other than 1X. Which led to my question, because usually by the time you get to somebody putting up $9M at a $51M valuation, they start to want some guarantees they are going to make a decent return if you sell for $50M, certainly more than just their money back.
Therein lies the role of the VCs i mentioned in my earlier reply to you We advise entrepreneurs not to push vsluations do they can keep the terms cleanSometimes they heed that advice
Because they paid a 51mm post money value when they priced the Srs C round
Awesome info on stock classes!Of course, during an M&A it’s all paperwork and negotiation… There is also the case where the company sells at a price point where common is worth $0, but you have a great team that the acquiring company really wants. If you are in this sort of acqui-hire scenario, common shareholders and the acquiring company can use the team as leverage against those with preference. Common may technically be worth nothing but employees holding options, for example, may receive a hefty consideration for willingly canceling those options during the transaction. And the acquiring company may figure those employee considerations into their total purchase price and reduce the amount that is allocated to the preferred shareholders.
Absolutely.Having been the person in the middle of the two sides on this VC’s/Common as the only outside BOD member, I can tell you there is a lot of pain involved!
YesVery true
Good post. As a suggestion for making the modelling much easier, calculate where the tipping point is for each instrument / series, then plot the cumulative of these compared to the exit valuation using a simple scatter chart option. And voila, you have the result (albeit graphically) for every exit valuation rather than e.g. just multiples of $5mm. And it takes about 20-30mins rather than 2 hours.Happy to share a spreadsheet if there’s appetite.
Would you add a new tab to the google spreadsheet if i permissioned you?
Would be very happy to- although not sure if Google docs has the graphical capabilities yet (I’ll take a look…). If not, am happy to send an MS excel model and/or screenshots directly for you to use or repost as you wish.
Unfortunately Google Docs doesn’t have the graph feature required to make this a sensible output. I have recreated this in excel and have sent to the general info@ address for Union Square, marked for your attention. Hope you receive it and it makes sense…
thanksi will look for iti don’t use excel anymore and don’t have it on any of my machinesi’m all cloud nowbut i will see if i can open in a google spreadsheet
Equally- am a very strong advocate of the cloud. But unfortunately some software still has a greater utility. Until that changes I suspect I’ll settle for a hybrid, and kid myself that storing those files in the cloud achieves a similar outcome….
PS For the benefit of everyone have attached the output chart here.If you like I can cut and paste the underlying analysis into your google spreadsheet.
Hi Stephen – this looks great. I was hoping you could send this over to my google doc as well
This entire set of discussions on liquidation is immensely valuable. I imagine there may not be as many comments due to the complexity of the topic. When you have so many factors, it can get very confusing.And it is important for everyone involved in a startup to understand this, including employees. These MBA Monday posts on Cap Table and Liquidation Analysis and the linked Brad Feld series should be required reading for anyone thinking about any type of role at a startup. In a previous life, I joined a startup. (I’ll spare all the details!) I had a faint glimmer of an idea that I had to understand how capitalization would work so that I could hypothesize a value range for my stock options. I thought I had a fair grasp of the basics of valuation. Little did I know at the time, but there were at least four-to-five classes of preferred stock (along with aggressive dividends and multiple liquidation preferences). It wasn’t until a few months in that I was able to understand the details and create a model. And it wasn’t pretty as the company had a high burn rate and was short on capital. The company would have had to sell for several times valuation before there would be any scraps for the common shareholders, including employees. In the end, I left for greener pastures. I know this topic can be dry and dense but it is essential! I wish this information had been available back then. Thanks for tackling a complex subject.
Personally, I love the MBA Mondays and am more likely to read those over others when pressed for tine, especially when travelling.Perhaps they appeal to a difference audience here on AVC ie those still learning vs the those experienced hands who might prefer the more regular posts?
Just used this spreadsheet to analyze a proposed IPO for an Entrepreneurial Seminar I’m in. Thanks Fred!
This is a huge part of the institutional knowledge that is better served in the public. Its definitely amazing that because there is such a small market for VC’s there are very few software solutions for firms. 100% market share would not be large enough to support a business unless the monthly/yearly costs were extremely high. Posts like this are very entrepreneur friendly and something that gets asked behind closed doors and not talked about enough. I am preaching to the choir here – but great post!
thanks Eric
Still got it, Fred! The only thing that I would perhaps add is the strike price for the options and the distributed share of cash proceeds from the exercise of all those options that are in-the-money.Of course, I could see why you left this out. A full treatment of the options would quickly add a complicated layer to the model, since you’d need a separate waterfall for all of the different options according to strike price (not to mention expiration dates, forfeitures, and the terms around which classes of stock benefit from unvested/unissued/forfeited options).
the comments on MBA Mondays posts are way lighter than the normal postswhich suggests it is a different cohorti’d love for the comments on MBA Mondays to be stronger because the comments are usually very strong and additive to the work that i do
I noticed that too. A factor might be that these are transactional related mostly therefore interest only a segment of the readers, and also these are less controversial than other subjects being discussed. Plus, diving into a Google spreadsheet maybe wasn’t necessarily appealing for a Monday morning :). Nonetheless, how about a Pitch post day, where a slide pitch is posted and gets discussed by all with your weighing in on it. I’ll volunteer for one, and let everybody pick it apart.
I like that it has a “locals” feel.
That’d be fun. I recon these boards are full of participants willing to volunteer their work for the sake of reviewing and strengthening it.