Before moving back from the Silicon Valley to Israel and joining Gemini V as General Partner early 2011, I met with quite a few VC friends in the Bay Area and asked them for advice on how to be a good investor. To my surprise, instead of providing guidance on technology trends or venture selection, they all mentioned deal terms as one of the things that almost always surprised them negatively about Israeli companies. They all mentioned “complicated” or “non-market” articles with terms set by Israeli Seed/A Round investors as the cause for delays in closing or even in extreme cases for not closing at all.
When I started doing deals in Israel I got to the conclusion that a significant gap, albeit not the only one, was around Liquidation Preferences. Israeli investors were still into Participating Preferred (1x or even more), what some people call “double dipping”, while investors in the US were mostly doing Non-Participating Preferred deals. You can learn all about this in a detailed blogpost by TLV Partners’ Rona Segev Gal from 2017 (yes, this was still a topic for discussion in Israel in 2017).
It took a while but finally Israeli investors, too, figured out that Participating Preferred Liquidation Preferences are a double-edged sword. Whatever preferences the Seed investors demand from the Common Shareholders in the Seed round, those will serve as the starting point for what investors will ask of them in the A round and so forth. The mountain of preferences that will come ahead of those early stage investors may cause mis-alignment of interests among different classes of shareholders, cause unproductive friction when a deal is on the table (under certain circumstances) and can significantly impact their returns.
It is important to note that sometime it’s the founders, betting on the best-case scenario and trying to solve for valuation, that are basically forcing investors to add down-side protection to the liquidation preferences. However, in my experience, this is typically not the case in the Seed rounds which is where investors and founders have the opportunity to set the tone for future rounds.
So, what’s next?
Well, apparently this is just the beginning of this story. Here is a quote from the Trends in Legal Terms in Venture Financing in Israel H1 2020 Survey by Shibolet Law in collaboration with Fenwick & West LLP.
“…As expected, in contrast to Silicon Valley, in Israel, harsher conditions were observed, as a consequence of risk assessment in assessing company valuations, hence a steep rise (79% of rounds surveyed!) was observed in the use of senior liquidation preferences. This finding is interesting to note, considering that our 2019 survey actually observed a decrease in the use of senior liquidation preferences, to 51% — the lowest rate observed in our surveys! In Silicon Valley, however, the rate of use of senior liquidation preferences continued to drop to only 19%… The rate of use of “participation rights” of the preference shares, which in 2019 dropped precipitously to a mere 16%, witnessed a dramatic increase and was applied in a quarter of the rounds surveyed…”
It seems like, again, there is a gap between the liquidation preferences Israeli investors are asking for vs. what their peers in the Silicon Valley are doing. Let’s ignore the fact that the Israelis are going back to “participation rights” for the sake of this post, and focus on Senior Liquidation Preferences. According to the survey only 19% of Silicon Valley deals include Senior Liquidation Preferences, while in Israel the number is as high as 79%. This is a huge gap.
Pari-Passu Liquidation Preferences
Liquidation Preferences can be complicated and have a few important parts including the multiple, participating vs. non-participating, cap and seniority. You can learn more about Liquidation Preferences from this Blogpost by Bling Capital’s Charles Yu.
Everyone agrees, it seems, that investors are entitled to get their money back in case of liquidation before non-investor shareholders but how do you stack the different investor classes? Seems like stacking them using a LIFO (Last-In-First-Out) order is problematic as mentioned before and in order to simplify things another mechanism is needed.
One such mechanism, called Pari-Passu (side by side or equal footing) Liquidation Preferences puts all investors in the exact same boat and basically creates two main exit scenarios:
- Total proceeds at exit are below total investments — in this case distribution of the proceeds among investors is done in direct correlation with the original amount invested regardless of the round or the timing or the investment.
- Total proceeds at exit are above total investments — in this case distribution is done according to the fully diluted holdings.
At first only the best or “hottest” companies, those that enjoy the benefit of selecting their investors and chose from a variety of term sheets, were able to negotiate down Senior Liquidation Preferences but in time this has become the norm in the US and most deals nowadays use Pari-Passu Liquidation Preferences. It is important to note that this is true also for very large rounds and very high valuations where later stage investors are willing to share the down scenario with the early stage investors.
In order to streamline the process of turning startups into great companies the market prefers standard terms for deals. Standard terms do not require lawyers to decipher complex legal language and interpret them for their clients. They save time spent on negotiations focusing everyone on a few important things and allow more energy and money to be invested in creating new technologies, building products and taking them to market.
Liquidation Preferences, and specifically the attitude vis-à-vis the topic of Seniority, are critical to the ongoing operation of the company. Pari-Passu is a mechanism that helps align investor interests and prevent potential conflicts from leaking into board meetings, decisions on new rounds, and M&A.
So, who should care?
- Founders must be aware of the downside of solving for valuation and the signals they send investors with non-standard articles
- Seed investors should standardize on 1x Non-Participating Liquidation Preferences
- Series A investors should use Pari-Passu Seniority Liquidation Preferences whenever possible
- In general Israeli early stage investors should be more aware of market trends in the later stage arena in order to be “easy to do business with”
And one final note. In my personal view standardizing on the type of Liquidation Preferences mentioned above creates a positive pressure toward right-pricing assets and allows startup companies to grow and create value in a way that is more transparent and more aligned with their actual status. In addition it also pushes the entire ecosystem toward better alignment among stakeholders, simple signaling both internally as well as externally and overall honest business making.
Special thanks to @Inbal Marciano (Shibolet Law) and @Dror Nahumi (NVP) for reviewing my drafts and for making great suggestions.