One of the “standard” terms in VC term sheets is the liquidation preference. Google it, learn it, love to hate it and learn to live with it, because it’s unlikely you’ll get a deal without it. I call it the “have-your-cake-and-eat-it-too clause for VCs”.

Here’s how it works (or, How 20% becomes 28% without even trying).

Let’s say you raise $1 million from a VC at a miraculous $4 million pre-money valuation. Your post-money valuation is $5 million, and the VC stake is 20%. The next week you sell the company for $10 million (because you’re so amazing). How much does the VC get?

$2 million. Wrong! Yes, but 20% of $10 million is $2 million, right?

Well, yes and no. The liquidation preference means that the investor gets the$1 million back first, leaving you with $9 million, and then you take 20% in addition to the initial investment, making it $2.8 million total, or 28%.

So instead of merely doubling its money, the VC firm has almost tripled its money, with 180% return.  And that’s only if you have negotiated a 1x liquidation preference; 2x and above are back in fashion given the economic collapse and the pound of flesh investors are trying to extract from their portfolio.

If you have a 2x liquidation preference, the VC gets $2 million, then 20% of the remaining $8 million, for a total of $3.6 million or 36% of the deal, leaving you with $6.4 million, just $2.4 million more than your pre-money valuation and only $1.4 million more than your post-money valuation. In fact, the VC gets the bulk of the gain in that case.

So before you sign the deal, you might want to consider whether it’s worth it, because you could perhaps as easily (it’s not guaranteed) sell the company for $7 million and do better than if you sell for $10 million with VC on board.

So why do liquidation preferences exist?

Primarily, this term is designed to give the venture firm downside protection. Let’s say you sell for $2 million and your liquidation preference is just 1x. The VC firm gets its $1 million, plus 20% for a total of $1.2 million, leaving other shareholders with $800,000 to be distributed. They’ve still made 20%.

If you sell for $500,000, though, you get nothing, the VC gets $500,000, and has lost 50%.

I’ve always been ok with liquidation preferences as a downside protection, but I don’t like it when venture firms get the preference when they are already getting a positive return on investment that matches their internal targets.

I’m guessing the term was introduced for downside protection, but somewhere it turned into a nice bonus for the VC firms and nobody challenged it, so it became standard. I ‘m not a fan of standard.

WHAT CAN YOU DO?
Accept the terms, but limit participation to a certain level. Set a limit where the liquidation preference goes away–if the sale is greater than $10 million, they can choose the preference or the percentage, but not both. They will not likely agree to that number (my numbers here are arbitrary), because they want you to have extra incentive to push the number as high as possible.

So how much is enough? Well, first of all, if you only have one firm pushing a term sheet at you, you don’t have a lot of strength to negotiate besides your ability to appeal to their belief in you and their reasonableness. When you talk about any term, suggest an alternative and say it’s “fair and reasonable”–nobody likes to be considered unfair and unreasonable. But make sure the alternative matches the rhetoric.

Id’ say doubling their money is reasonable. They’ll disagree. Suggest an exit level that is 3X the post-money valuation (Keep in mind I’m not saying a 3x liquidation preference, but a 3x post-money exit. The difference is huge).

Liquidation preferences aren’t likely to go away, and it’s unlikely you’ll negotiate them away. But you can contain them in a way that feels to both you and the VC that your interests are aligned.

Please comment on this if you have other insights, questions, corrections, or challenges.