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Back in the summer of 2009 we were out trying to raise venture capital for Pardot (we didn’t end up raising any money). During the fundraising process we pitched over 30 different VCs including several famous ones. At one point we were out on Sand Hill Road meeting with a well-known venture capitalist and yesterday’s topic of liquidity preferences came up.

Mid-way through the conversation he stopped us and said, “You know guys, it’s a liquidity preference and not a liquidation preference. I have another entrepreneur in our portfolio who constantly refers to it as a liquidation preference. Liquidations are bad. Liquidations are when the company goes out of business and all the assets are sold. Liquidity preferences come into play when the company is bought, and it’s usually in a positive context.”

From that day forward, whenever someone mentions a liquidity preference, I always think of the VC and his comments that a liquidity preference is not a liquidation preference.

What else? Have you heard someone confuse the term liquidity with liquidation?

Recently an entrepreneur asked me what the current market was for liquidity preferences and dividends for institutional investors funding startups in the region. As a background, liquidity preferences are a provision investors often ask for as part of a preferred security that guarantees them some amount of money before other shareholders receive any money in the event of a sale.

Within the concept of liquidity preferences there are non-participating preferred and participating preferred. Non-participating preferred means that the investor gets some amount of money back first (usually the amount invested) and if the amount of the sale is large enough, then everyone participates based on their percent ownership. So, if an investor invests $1 million and has a 1x non-participating preferred equity and owns 25%, if the company sells for at least $4 million, then everyone gets paid based on the percent of the company they own. If the company sells for less than $4 million, the investor gets their $1 million back first and the remaining amount of money is split amongst the other shareholders based on the percent they own.

Participating preferred is where the investor gets some amount of return on their investment (usually the amount invested) and gets the percent ownership of the remaining amount of the proceeds regardless of the amount of money. These types of investments effectively reduce the valuation of the company by the amount of the participating preferred investment. So, if a company raises $1 million with a 1x participating preferred investment at a $3 million pre-money valuation, the valuation is effectively $2 million pre-money due to the participating preferred equity. If the company sells for $4 million, and the investor owns 25%, the investor gets $1 million plus 25% of the remaining $3 million, which equals $750,000, for a total of $1,750,000. You can see that 25% ownership of a $4 million exit doesn’t normally equal $1,750,000 unless they have this type of provision.

Dividends are typically in the form of cumulative and non-cumulative with the difference being if the dividends compound every year or stays fixed based on the original investment. With a $1 million investment and non-cumulative dividends of 8%, the effective amount owed for the dividends goes to $80,000 per year. With a $1 million investment and cumulative dividends of 8%, the effective amount owed goes to $80,000 in year one, $86,400 in year two, $89,000 in year three, etc.

The current market for the region is a 1x participating-preferred liquidity preference with an 8% cumulative dividend. On a simple level this means investors are offering valuations higher than might be expected for entrepreneurs with a tradeoff of serious downside protection in the event the investment doesn’t do well. Again, this is more for institutional investors and not as typical with angel investors and seed rounds.

What else? What are some other thoughts on the current market for liquidity preferences and dividends?

A little over a year ago I was talking with a super successful tech entrepreneur and I asked about his thoughts on angel investing. He immediately replied that 19 out of his 20 angel investments had lost him money and that the one that made money didn’t make him whole across all his investments. Next, he offered up something that’s always stuck with me: successful tech entrepreneurs are as rare as pro athletes.

Think about it for a second: how many pro athletes, ones that actually made/make a great living doing their sport, do you know? For me, the answer is zero. How many kids from the high school baseball/basketball/football team go on to become pros that make a good living? Nearly zero. Now, in that same context, how many tech entrepreneurs make it big (e.g. make $10 million personally within seven years)? Nearly zero.

Perhaps the next analogy here is that the well-known tech accelerator Y Combinator is the IMG Sports Academy of the startup world. Regardless, the next time you think of successful tech entrepreneurs, consider them as rare as pro athletes — it’ll change your perspective.

What else? What are some other thoughts on the idea that successful tech entrepreneurs are as rare as pro athletes?

There’s a strange phenomenon in the startup world where entrepreneurs work hard to justify a valuation for a pre-revenue seed round based on the team, market dynamics, etc.. In the end, seed round valuations are often in the $1.5 to $3 million range, and there’s little rhyme or reason from one to the next.

Now, that same entrepreneur who was able to raise a $500,000 seed round at a $1.5 million pre-money valuation goes out to raise a Series A round. Only, this time it’s different. This time the investors look at the startup’s metrics. Things like annual recurring revenue, trailing twelve months revenue, daily active users, growth rate, renewal rate, etc. become the main discussion points for valuation.

Say, as an example, the entrepreneur has $1 million in annual recurring revenue with strong growth and renewal rates. For an institutional investor, the valuation would typically be 4-8x run rate. Competitive deals with multiple investors fighting to lead the round ultimately lead to higher valuations. So, that same company 18 months earlier with little-to-no revenue raises money at a $2 million post-money valuation now has a million dollars in recurring revenue and raises $3 million at a pre-money value of $5 million for a post-money valuation of $8 million. While $8 million is dramatically more than the $2 million from 18 months prior, in reality the business is worth many times more than the seed since it has serious revenue and customers, and is much more likely to be successful long term.

There’s a valuation disconnect between seed rounds based on dreams and A rounds based on metrics. As an entrepreneur, it’s important to understand this and understand the psychology of investors.

What else? What are some other thoughts on the valuation disconnect between seed rounds and A rounds?

After my post Only Doing Seed Investments Without Follow-On Funding I received a number of interesting comments. The one that resonated the most with me was that I shouldn’t have a one-and-done investing strategy, rather, I should set up a defined strategy for follow-on funding so that it’s transparent to all the entrepreneurs and it’s more methodical. Yes, if I do it, it would partially defeat the goal of seeding as many startups as possible, but if I did follow-on funding based on a strategy, and the strategy generated greater returns in a reasonable amount of time, then there’s more money available to seed startups. Having a defined strategy also helps with the signaling problem where subsequent investors would see it as a negative if I didn’t participate in the follow-on funding, assuming I did some follow-on funding with other investments.

Here are a few ideas around a defined strategy for follow-on funding as an angel investor:

• Decide on an investment ratio for follow-on dollars in the 1:20 range (e.g. if the startup raises another round of $1 million, only participate pro-rata up to $50,000 since it’s 1/20th of $1 million)
• Participate pro-rata in subsequent rounds until a defined cap is reached (e.g. no more than $750,000 total in any single company, much like venture capitalists have in their limited partner agreements that no more than a designated percentage of the fund can go into any single company)
• Require a certain annual recurring revenue threshold of $1 million to participate, so that pro-rata rights are only exercised once the startup reaches a certain size (even if that means skipping a round where they weren’t at the threshold yet)

Over time I’ll evaluate these ideas and others to decide if I want to do follow-on funding based on a defined strategy.

What else? What are some ideas to incorporate into a defined strategy for follow-on funding as an angel investor?