Should I Push Back On My VC?

I just got a term sheet for a Series A financing. The VC accepted the valuation I proposed, which was aggressive, but added a 2x liquidation preference, which he said was his compromise for my valuation. Should I push back on him?

All financing proposals contain trades. Whether this trade is fair depends upon the range of outcomes you project for your business, as hindsight will make you look foolish or brilliant. Also, your true bargaining power is tied to how many other options you really have, so think carefully about the downside if this investor walks away. Entrepreneurs bluff too much in these situations. The difference between being funded or unfunded is stark compared with the comparatively minor differences in the normal range of financing terms. 

I do not know your specific numbers, so let me make up two extreme scenarios. In the first scenario, the investor invests $2 million on a pre-money valuation of $3 million and takes 40% of your company with a 1x liquidation preference. In the second scenario, the investor invests the same $2 million, but on a pre-money valuation of $8 million and therefore takes 20% of your company. This time, however, he takes a 2x liquidation preference.

I am going to assume you have no option pool, employees, other investors, transaction expenses or creditors, or future financing rounds for this example just to simplify things, although you should create a more realistic model. Here is a simple table of outcomes:

  1x 2x
Sale (millions)YouInvestorYou Investor

The investor is asking for downside protection for giving you the upside. If you sell for less than $20 million, he wants the first $4 million back for the risk he is taking. Beyond that, his 20% will be worth more, so the 2x liquidation preference will not matter. The good news is you get a huge amount of the upside if you grow big. For example, if you sell the company for $100 million, you make $20 million more. 

However, you make less on the downside. For a sale less than $10 million, you are worse off. The 2x liquidation preferences scenario also makes the investor indifferent to sales between $4 million and $20 million, as he will get the same. That may not be beneficial for you. You may desperately want to go big since you have disproportionate upside at higher exit prices, but your investor may be unwilling to invest more in your growth if your growth metrics are middling, settling for the safe 2x return now.

When I personally model outcomes, I model ranges and attach a percent likelihood to each range to calculate both blended expected value and see the concrete outcomes at more sober exit valuations. Ultimately, you have to decide what you are willing to trade and assess your confidence in your chances for a large exit.

See also: 4.104: Venture Terms: Economics and 4.106: Creating Cap Tables

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