The Pre-Seed Angel Fund for SaaS Startups

There are mainly two different ways to come to an agreement on the terms & conditions of your early stage funding rounds.


1.   either you follow the ancient, still alive and agile, negotiation habits which you can best study at one of the oldest Arabian markets, the Matrah Souk in downtown Muscat, Oman, or
2.   you try  a more contemporary, speedy, opportunity cost aware approach towards a win-win financing agreement.


It was a great pleasure watching the two gentlemen during their deal negotiations at the Matrah souk in Muscat. It was particularly amusing to watch the ceremony because the two gentlemen were experienced tradesmen, both knowing quite well from the beginning  how a fair “deal” would look like. But it is not the tradition to meet and put the win – win deal on the table right before the ceremony would begin. Quite the contrary, it is a deeply ingrained  in the behavior of the population to show mutual respect for each other by yielding to somebody and finally compromise to make a deal come true. This method of reaching a win-win deal is undoubtedly a very admirable skill and it is exciting to watch such a process.
Nevertheless I am not quite certain that this is indeed the right practice in our rapidly moving information technology ecosystem where any week or month earlier to the market can become the make or break for your company. With that in mind I coach my portfolio companies to bypass some of the ineffective “start far left – defend far right – meet in the middle” actions which, after all, spit out the universally known “balanced agreements”.

The below write up of, more or less typical, contract terms is neither another complete list of legal terms nor a cookbook  for the best deal you could ever strike with your investors. I am focusing on those terms which repeatedly cause confusion, if not friction between founders and investors.  I disclose my 18+ years of investing experience for all those founders and investors who desire to bypass endless negotiations and bargaining by putting the right balanced terms and conditions on the table from the beginning. This will safe all of us months. Months that we can use to gain further traction, convert our pipeline or conquer new markets.

The best preparation for a rapid finalization of financing contracts is a mutual deep understanding of the desires and needs of the other party. Founders as well as investors often don’t really know what certain claims and requests can trigger at the other party. The below write up shall help to find win – win compromises in a short period of time.

Anti Dilution Protection

last updated: 12.2016


Anti Dilution Protection is a classic term from Series A, Series B and later stage equity financing. The mechanism of any Anti Dilution Protection only comes into force in the event the current price per share (i.e. the current company valuation) is lower than the price which has been paid by the holders of such Anti Dilution Protection rights.

It shall protect new investors from potential future Down Rounds (i.e any future financing rounds for a lower valuation than the current one). In the event that the company needs to raise additional equity for a lower price per share than the current price, an Anti Dilution Protection clause would allow the holders of Anti Dilution Protection rights to purchase a number of additional shares for nominal. The number of this share purchase right depends on the agreed upon kind of Anti Dilution Protection.

The right to buy a number of shares for nominal has the effect that the actual valuation of the previous funding round gets reduced. The more shares the holder of Anti Dilution Protection rights can purchase for nominal at any later point in time, the more the valuation gets reduced retrospectively.

There are in principal two commonly used Anti Dilution Protection versions available. Needless to mention that one is the more founder friendly, “softer” version, the other one is the investor friendly, “punitive” version.

Full Ratchet Anti Dilution Protection

After the execution of a Fully Ratchet Anti Dilution Protection provision the investors of a previous financing round (or even of any previous financing rounds) are treated as if they had invested in the current round, where the price per share is lower than the price in previous rounds.The holder of a Full Ratchet Anti Dilution Protection is authorized to buy as many shares for nominal value as needed to reduce holders averaged price per share to the price of this current round.

The implementation of a Full Ratchet Anti Dilution Protection can have extremely punitive effects for the founders and other Common Stock holders. They are usually the ones without any Anti Dilution Protection, which means only the Common Stock holders need to “pay the price” in such a Capital Increase, where holders of Anti Dilution Rights can buy many shares for nominal, which can result in significant dilution of the founders’ percentage ownership.

Weighted Average Anti Dilution Protection

A far less drastic implementation of some investor protection against future down-rounds is the Weighted Average Anti Dilution Protection. As the name suggests, this protection mechanism spreads the risk of future down rounds across investors and founders (any any other common stock holders). In principal this Anti Dilution Protection takes the average of the two (or sometimes even more) relevant funding rounds and compensates the investors of the previous round as if they had invested at this average price per share. In order to put the compared funding rounds in a fair perspective, the average is calculated by the price per share and the number of issued shares in the respective rounds. The result would then be the Weighted Average between the two funding rounds. Slightly simplified this Anti Dilution Protection can be descried as the “meet in the middle” approach and is usually implemented like this:

Formula For A Weighted Average Anti Dilution Protection

Assuming the same number of newly issued shares per funding round, a Weighted Average Anti Dilution would dilute founders and other common stock holders 50% less than the Full Ratchet Anti Dilution protection.

The Founders View

The investors spent a lot of time with us prior to their final decision to join us. They did tons of DD (Due Diligence) and came to the conclusion that they would invest at a certain valuation which adequately reflects the current risk profile. Why should investors get a protection for events that may happen in the future, aren’t we all in the same boat once the investors have decided to invest in us and are on board?

The Investors View

We finally accepted a rather high valuation for this early stage funding. In case the founders have slightly oversold their company, we would at least want to have a mechanism in place which allows us some adequate adjustment of the valuation. After all, we are willing to accept the valuation, but we need full adjustment, i.e. a Full Ratchet Anti Dilution Protection in case the next round is a down round.

My Thoughts

This is a very usual term in most Series A, B and beyond Venture Capital financing contracts. I would question if an Anti Dilution Protection makes much sense in very early stage Seed Financing such as Seed I or Seed II. The valuations of companies in that stage are usually still rather modest. Should a future funding round be even lower priced than the a current round, I am not sure if an Anti Dilution Protection is really the hole grail to protected in already invested money in case of a future down round.

If an early stage company focuses on building further value over 9 – 12 months (which is usually the time between Seed I and a Seed II or Pre-A financing round), and new investors still value the company below the valuation of the previous round, it is probably fair to say that that there might be a more fundamental problem to the business. The problem is not resolved by getting.

An early stage company must not raise money below the valuation of the previous round. I encourage founders to raise enough money in any seed financing financing to be sure that the company is financed long enough to have a realistic chance to deliver all those KPIs required to successfully complete a subsequent funding round.

A Compromise

Institutional early stage investors are very used to the Anti Dilution Protection provision for their Series A/B financing. They may just demand such a protection no matter what.

I would not spend too much time on this part of a seed contract. A well balanced compromise would be to agree on the Weighted Average Anti Dilution Protection as described above. In all Seed I, Seed II and/or Pre-Series A financing rounds within my SaaS portfolio, there was either no anti dilution protection or the parties agreed for the weighted average variant.

Details and Advanced Considerations

It can also be discussed how long such an Anti Dilution Protection would be in force. Anti Dilution Protection may only be in force until a given future date or the completion of the next funding round.

Drag Along Right

last updated: 12.2016


This term is well known and was initially introduced to protect the majority shareholders from being blocked by minority shareholders during the sale of a company. Since buyers in most cases demand to purchase 100% of all outstanding shares, a few small shareholders could block a transaction. For that particular reason the majority shareholders have been given the right to drag along the minority shareholders, which means the minority shareholders are contractually forced to co-sell their shares under defined circumstances. 

The founders View

What if some shareholders have changed their investment strategy which motivates them to sell their shares earlier than initially anticipated? We may not agree with the timing of the sale of our company or we may not be comfortable with the valuation at which our company shall be sold. At least we would need some protection to feel more comfortable, that such a “forced” sale of the company would happen within acceptable boundaries.

The Investors View

We need such a clause to ensure that we have the freedom to sell the company along with the majority of the shareholders. We cannot accept the risk to be “caught” in a company just because a few minority shareholders don’t want to sell.

My Thoughts

In principal a well structured Drag Along Right is not very critical. Investors have the legitimate desire to be able to sell a company (provided the majority supports the sale). The majority should ideally be defined such, that a large group of different shareholders is required to form the majority.

Unfortunately the Drag Along Right can force founders to support the sale of the company even if they would prefer not to sell at a given point in time. On the others side founders should understand that investors provide a lot of money without any coverage and therefor they need to have some rights when it comes to returning the money.

Does this already have to be in a Seed I or Seed II contract? It doesn’t really matter. If you plan to build a big company, you will raise money in several rounds. At latest, the Series A will be the time when there is no way to not accept Drag Along.

A Compromise

The best way to provide investors with good comfort and at the same time leave some influence with the founders, is to

·  define the majority shareholder group such, that all shareholder classes are adequately represented.
Example: (i) At least 66% of all shareholders or (ii) at least 2 out of 3 share classes (common, Series-A, -B, …)

·  agree on events or laps-times triggering the right to drag along others.
Examples: (i)  A minimal enterprise value to be reached before a Drag Along Right comes into force or (ii) a Drag Along Right can only be exercised after a given date.

Details and Advanced Considerations

Drag-Along is a powerful term, which needs to be very carefully thought through. A thorough planning of the right majority definition along the lines of “who would need to team up with who” can be a valuable exercise. According to my experience the most effective way towards a balanced Drag Along Right is a very open and transparent discussion with the investors how the right triggers for the Drag Along Right should look like.

Founder Shares

last updated: 12.2016


Positive investment decisions within institutional investors are usually based on a combination of things, all above the experience and execution power of the founding team. One of the most senior and successful investment principals at Atlas Venture once said: “A company with a great market opportunity and a good product ran by a mediocre management team will never be successful, however a great management team in a mediocre market and a good product will prevail.”

With that in mind it is clear that investors do not want to see founders leave any time soon. There is no way to legally bind people to a certain operational role in a company. Investors believe that the only way to build some “professional comfort”, beyond trust and good faith, is the introduction of so called Founder Shares. In principal Founder Shares are all or a part of the shares owned by the founders which would become subject to a future vesting over a period of three to five years. Only if the holders of Founder Shares stay in an operational, active role in the company, they continue to – over time – earn back such shares put on a vesting schedule.

The Founders View

We started our business a few years ago and we hold 90+% of all outstanding shares of our company. Those shares legally belong to us, after we registered the company and paid in the minimal nominal capital. We did not pay us salaries for the last two years. Now we should not only dilute for the fresh money we raise (which is fine), we should also give away some of our shares.

The Investors View

Of course we trust the founders that they are honest people, eager to build a great business. However we need to show our investors that we have introduced a mechanism which goes beyond trust and good faith and incentivizes founders to stay involved for a number of years. The founders are the main asset of any startup company, we must not loose that asset.

My Thoughts

I think it is indeed a legitimate concern from investors to loose the key team and remain left alone with the shell of a, once promising, business. I coached the founders of my portfolio companies and recommended them to remain cooperative to find an acceptable implementation of Founder Shares. It is all about how such a provision is implemented.

A Compromise

A balanced, in my opinion fair, implementation of Founder Shares may consider some of the below points

·  not all shares owned by the founders will be put on a vesting schedule. One way to find the right number of shares subject to future vesting could be found if the start-day of the vesting is set back to the day when the founders started the business. Example: The founders started the company 12 months ago. The agreed vesting is four years. Hence 25% of the shares would already be considered vested at the time when the financing agreement gets signed.

·  have a fair treatment of founders and their respective Founder Shares in case a founder is asked to leave the company.

·  define what happens to the vesting of shares at the event of the sale of the company. I usually recommend the following compromise: At the time of an exit all non-vested Founder Shares shall immediately vest (so called Accelerated Vesting) in case the buyer does not require the founders to remain actively involved in the business post merger/acquisition. In case the buying company does want the founders to remain actively involved, the remaining, not yet vested, shares shall continue to vest but with a maximum period between six to twelve months until all remaining shares would be vested. This gives the buying company the solid comfort that the founders remain incentivized and committed for a given period of time. Any time beyond that requires new incentives.

Future Investment Option

also known as: Installments, Co-Investment Option, Super Pro-Rata
last updated: 12.2016


For larger institutional investment funds Seed financing with amounts of 0.5 – 2m doesn’t really make a lot of sense for them.  The only way to make Seed funding work for larger funds is to allocate more money in future financing rounds. Usually that would require them to go beyond any shareholder’s right to participate pro-rata in any future capital increases.

Some funds have therefore invented the Future Investment Option, which allows them to invest larger amounts of money in future financing rounds, regardless what their pro-rata amount would be.

At a first glance such a provision may appear like a nice compliment to the founders and their company and it looks like an early commitment for a strong participation in a future Series A financing. However, such agreements hide a number of issues founders should at least be aware of.

The Founders View

[Usually founders don’t really have a clear view on that. The potential complications arising in future funding processes are not obvious and require some funding experience which founders may not yet have.]

The Investors View

Such a small investment doesn’t make sense for us and we need to make sure we have the possibility to put more money into play in case things go well and a larger financing is anticipated. Most new, external investors appreciate the strong commitment from existing investors, so our early commitment can only help a company to raise a great Series A financing.

My Thoughts

Assume you want to raise 5 to 6 Million in a future Series A funding. Furthermore assume that you are doing really well and some top tier Venture Capital funds are show serious interest to lead your Series A financing round.

Usually successful, top tier, Venture Capital funds have relatively large funds. As a consequence of that, they need to invest relatively large amounts and own solid stakes in each company they back. Only then a company becomes worth for them to invest time to actively help you to grow your business and open up their network for you. Usually successful companies would raise their Series A financing at pre-money valuations between 15 to 20 Million. If such top tier investors want to hold at least 20% (but up to 25%) of your company, they would need to invest at minimum of 4 Million of your 6 Million round. It is obvious that this amounts can be in conflict with any Future Investment Option held by existing shareholders. Needless to mention that the motivation to trigger such an Investment Option is proportional to the quality and brand of the new investor showing interest in the Series A round. In other words, the issue may increase the more prominent your potential Series A investor is. I have seen top tier funds not entering any detailed dialog with startup who cannot give a clear statement about the yet available amount to invest in the round.

My recommendation. Keep things simple. Don’t add any contractual provisions today, which have no relevancy to the current funding.  Investors with great track record, who can demonstrate their value-add to founders, co-investors and new investors do not need any contractual rights related to future funding rounds.

A Compromise

If your Seed investor insists on such a provision I would recommend to

·  not use fixed investment amounts but multiple of their current pro-rata share. Example: Suggest 2 times their pro-rata share. That way such investors may have some motivation to invest a bit more in the Seed round in order to obtain the option to take a larger stake in the next round.

·  phrase such a provision as a Best Effort clause. This gives the investor some confidence that you will do your best to negotiate a higher stake for him, but not to the point where a deal may be in jeopardy.

Liquidation Preference (LP)

last updated: 12.2016


Description – in general

Liquidation Preference is a classic term from Series A, Series B (and beyond) financing rounds. Investors try to protect themselves from low acquisition which would not even return them their money while founders and other holders of common shares would already receive their pro-rata part of the proceeds.

Example: Investors buys 10% of the company for a 1m investment. Already one year later the company gets an offer for be acquired for 8 Million. The founders still hold 50% and get 4m  of the 8m proceeds. The investors get 10% of the proceeds which is 0.8m. That would be 0.2m less than what they have invested a year ago.

I Liquidation Preference was initially designed to avoid such scenarios by ensuring that the investors would first get their money back, before any other shareholders would receive their pro-rata share of the proceeds.

The mechanism is quite simple. Once a company gets acquired for a certain cash amount, the investors first get back the invested capital, irrespective of their percentage ownership. The remaining proceeds will then be distributed according to the respective shareholder’s percentage ownership (as defined in the CAP table). In case the exit proceeds are less than the invested capital, all proceeds would be distributed to the investors.

By now, many different flavors of Liquidation Preferences have proliferated. Some more, some less favorable for those who do not have a Liquidation Preference attached to their shares. The two most commonly used implementations are called Participating Preferred Liquidation Preference and Non-Participating Preferred Liquidation Preference. Either one of them in turn can be structured as a 1x or a multiple Liquidation Preference.

1x versus multiple Liquidation Preference  

A Liquidation Preference was initially introduced as an investor protection against losing money while others already receive their share of the proceeds. After the first big internet bubble burst in the late 90s, investors tried to not only protect their invested capital against a loss; they also tried to secure a certain return on their investment by introducing multiple Liquidation Preferences which would allow the investors to first receive 2-5 times their money, before any other shareholders would receive their pro-rata share of the proceeds.

Interest Bearing Liquidation Preference

In recent years the notion of Interest Bearing Liquidation Preferences became more and more popular. The reason can be found in more demanding terms from the Limited Partners (LPs), the private or public investors, who provide the money for institutional Venture Capital funds.  Since those LPs demanded a minimum %-age return on the provided money (hurdle rate) prior to any bonus payments (carried interest) to the Venture Capital funds, some of those funds just pass this through to the startup companies.

The mechanism works like this. The Liquidation Preference amount is no longer fixed to the amount invested but grows over time with a certain %, the hurdle rate. Example: The Liquidation Preference Amount of a 1m investment, with a hurdle rate of 8% range grows to almost 1.5m (50%) from the initially invested capital. Most hurdle rates – if any – range from 3 – 6%, but even 8 – 10% are seen.

The danger with a growing Liquidation Preference Amount over time is, that the interests of the founders start to be misaligned. Investors in general want to wait for the best time to liquidate their investments. Sometimes a few years more of proper execution can increase the exit value. For the founders it means that they have to weigh up the increasing Liquidation Preference Amount against the possible future increase of the exit value.

Liquidation Preference Waterfall   

Since Liquidation Preferences are part of most financing agreements, most companies will, over time, have to deal with a number of Liquidation Preferences. It that case the amount of money payed back to investors prior to any pro-rata distribution to all shareholders stacks up as follows:

Formula For Calculating The Liquidation Preference Waterfall

(with Total LP = the total preferred distribution of proceeds prior to any pro-rata distribution to holder of common shares;  n1,2,x = the multiple of the LP, usually 1; IA = the invested capital in a specific financing round, Seed, Series A,B,X)

Should the total exit proceeds be less than the total LP, the entire proceeds will be distributed according to the last in – first out principal, also known as “seniority” of a Liquidation Preference or Liquidation Preference Waterfall. Alternatively the investors may have agreed to a  pro-rata distribution of the available proceeds, which would allow all investors to get some money back in case the proceeds are not sufficient to pay out all Liquidation Preference amounts. To the founders and other holders of common shares it is irrelevant how the investors share the amount of proceeds, as (in this case) there will be no money left for pro-rata distribution.

Description – Non Participating Preferred LP

In the United States, the Non Participating Preferred Liquidation Preference is a rather common way to protect investors from the scenarios described in the section above. The Non Participating Preferred Liquidation Preference is a more founder (and other holders of common shares)  friendly implementation than the Participating Preferred Liquidation Preference, described below. The “Non Participating” hints that there are some restrictions related to the participation in the pro-rata distribution. In fact this version of a liquidation preference gives the investor the choice to

either  →  claim the Liquidation Preference Amount

       or  →  participate in the pro-rata distribution of the available proceeds.

In practice this means that the investor will claim the Liquidation Preference Amount only as long as the pro-rata proceeds according to his %-age ownership would not return the Liquidation Preference Amount. Upon receipt of the Liquidation Preference Amount, the investor is no longer participating (“Non Participating …”)  in the subsequent pro-rata distribution of the remaining proceeds. Consequently, as soon as the pro-rata proceeds of the exit proceeds would exceed the Liquidation Preference Amount, the investors would waive their right to receive this amount, but would request to be part of the pro-rata distribution.

A liquidation preference has an impact on a companies “actual” pre-money valuation. The Actual Pre-Money Valuation shall be the ex-post re-calculation of the pre-money valuation at which an investor actually had to invest in order to receive the same exit proceeds as if he had invested without any liquidation preference rights. The formula to calculate the Actual Pre-money Valuation looks like this:

Formula For Calculating The Actual Pre Money Valuation Taking All Liquidation Preferences Into Account

(with InvestAmount = the amount an investor invested previously with any liquidation preference right attached; Total Proceeds = the total exit proceeds for 100% of the company’s shares; Investor Proceeds = the total proceeds the investor has received from liquidation preferences and/or pro-rata distributions and/or any other payments, e.g. occurred interests, related to the invested capital)

The below example diagram illustrates an investment scenario with an investment amount of 1m at a 3m Pre-money Valuation and a 1x Non Participating Preferred Liquidation Preferred Liquidation Preference. The grey line shows the flow of money at exit values between zero and 10m. The blue line highlights the correlation of a Non Participating Preferred Liquidation Preference and the Actual Pre-money Valuation.

Chart To Illustrate The Actual Pre Money Valuation Taking A Non Participating Preferred Liquidation Preference Into Account

There are three distinct ranges/segments which need to be discussed separately.

Segment 1 describes the range up to 1m exit proceeds. As per definition of a Non Participating Preferred Liquidation Preference, any proceeds up to the Investment Amount would first be distributed to the investor.

–  The Non Participating Preferred Liquidation Preference ensures investors that they can minimize their losses should the exit proceeds be less or equal to the invested capital.
– The re-calculated pre-money valuation is therefore zero, the investor receives 100% of any proceeds.
– Without the liquidation preference, the investors would only receive back a very small part of the invested capital while founders and other holders of common shares would receive the lion share of the exit proceeds (see chart above, gap between the two blue lines).

Segment 2 shows the range between exit proceeds equal to the invested capital of 1m up to the respective financing round’s post-money valuation of 4m (pre-money + invested capital). Since a Non Participating Preferred Liquidation Preference allows an investor to either trigger the liquidation preference rights or to participate at a pro-rata distribution, he would not receive any proceeds on top of the Liquidation Preference Amount of 1m at exit proceeds within Segment 2.

– Within segment 2, founders and holders of common shares start to receive any proceeds which go beyond the 1m Liquidation Preference Amount
– The Actual Pre-money Valuation raises from zero to the actually agreed and exercised pre-money valuation of 3m.
– Without the liquidation preference, the investors would still not have received back the invested capital. They would finally receive the total invested capital at the beginning of Segment 3.

Segment 3 describes the scenario at which the investor would receive more than his invested capital if he would waive the liquidation preference right and therefore participate in the pro-rata distribution of the exit proceeds.

– The investor’s percentage ownership would return him the invested capital at total exit proceeds equal to the respective financing round’s post-money valuation.
– The investor would therefore waive his Non Participating Preferred Liquidation Preference rights, no liquidation preference rights will be exercised.
– Since the distribution of proceeds is done on the basis of the pro-rata shareholdings of all shareholders, the Actual Pre-money Valuation matches the agreed and exercised pre-money valuation of the respective financing round.

Description – Participating Preferred LP

The Participating Preferred Liquidation Preference is a derivative of the Non Participating Preferred Liquidation Preference. While the Non Participating Preferred Liquidation Preference grants investors the right to choose between the payment of the Liquidation Preference Amount senior to (i.e. prior to) any pro-rata distribution or the pro-rata participation in the distribution of the total exit proceeds, the Participating Preferred Liquidation Preference allows the investor

→  to claim the Liquidation Preference Amount

→  and to participate in the pro-rata distribution of the available proceeds.

This version of a liquidation preference is following European (predominantly German) investment practices which consisted of (a) the purchase of equity at nominal value and (b) the granting of a loan (mostly implemented as subordinated debt). In other words, such funds received shares as if the loan was given as equity and in addition the provided funds were kept in the balance sheet as subordinate debt. Institutional investors (VC funds) did invest their funds as pure equity, no debt on the balance sheet. An elegant way to implement the same rights and benefits as public investors was the Participating Preferred Liquidation Preference. Investors got first their money back and subsequently participated in the pro-rata distribution, just like public funds who first received the yet outstanding loan (mostly including interest) plus the pro-rata proceeds according to their shareholdings.

In practice this means that the investor will be eligible to claim both, the Liquidation Preference Amount and their pro-rata share of the then remaining proceeds. A Participating Preferred Liquidation Preference is legitimately described as a right for “double dipping”.

The below example diagram illustrates the same investment scenario as shown above with a Non Participating Liquidation Preference however with a Participating Preferred Liquidation Preference right.  The grey line shows the flow of money at exit values between zero and 10m. The blue line highlights the correlation of a Non Participating Preferred Liquidation Preference and the Actual Pre-money Valuation.

Chart To Illustrate The Actual Pre Money Valuation Taking A Participating Preferred Liquidation Preference Into Account

Again, the three distinct ranges/segments shall be discussed separately.

Segment 1 describes the range up to 1m exit proceeds. As per definition of both, the Non Participating as well as the Participating Preferred Liquidation Preference, any proceeds up to the Investment Amount would first be distributed to the investor.

See Segment 1 of the above description of a Non Participating Preferred Liquidation Preference.

Segment 2 and 3 show the range of any exit proceeds higher than the invested capital of 1m. Since a Participating Preferred Liquidation Preference allows an investor to trigger the liquidation preference rights and to participate at a pro-rata distribution.

– The investors continue to receive a higher return than their pro-rata participation would have suggested. At exit proceeds of 4m, which would, without any liquidation preference, return the invested capital, the investors would already receive their 1m investment plus 0.75m on top.
– The Actual Pre-money Valuation continues to remain below the agreed and exercised pre-money valuation of 3m. Unlike with a Non Participating Preferred Liquidation Preference, the Actual Pre-Money Valuation will never completely level up with the agreed and exercised pre-money valuation of the respective financing round.

The Founders View

This is really a complicated term. We hear that a liquidation preferences  are common practice one way or another. We understand and accept the initial motivation to protect investors against situations were they wouldn’t even return the invested capital which is the case at very low exit proceeds. However we think a liquidation preference shall not go far beyond the original purpose.

The Investors View

We need to protect ourselves against low exit valuations where we don’t get our money back but others may already have an acceptable return on their investment. Therefore we need a Participating Preferred Liquidation Preference. Some investors may also argue: In addition we want to make sure that the invested capital remains in line with the global money markets, therefore we need to add a 5 – 10% annual interest rate on the Liquidation Preference Amount.

My Thoughts

In general the introduction of a liquidation preference right is a legitimate request. It is all about implementing the right derivative of a liquidation preference. The two most commonly used liquidation preferences have been described.

The initial idea of a liquidation preference was the protection of investors at low exit valuations. I such cases it can happen that an investor doesn’t receive back the invested capital, while others may already have some attractive return on their investment, which may eventually be derived from sweat-equity, i.e. shares which they received for their work or for starting the business, but with rather little money.

Non Participating Preferred Liquidation Preference

If you want to give investors the legitimate comfort that their money is considered senior to any other distribution of the exit proceeds, than you should have no problem with the classic 1x Non Participating Preferred Liquidation Preference as described above.

If you look at the chart above you can see that this derivative of a liquidation preference addresses exactly the actual matter without any negative or unwanted impact once the matter is addressed. A Non Participating Preferred Liquidation Preference kicks in as long as an investor would not reach the return of the invested capital from a normal pro-rata distribution of the available exit proceeds. As soon as the investor would receive back the invested capital with the pro-rata distribution, the liquidation preference has no impact.

I would consider a Non Participating Preferred Liquidation Preference a spot landing regarding the matter to be addressed.

Participating Preferred Liquidation Preference

Looking at the related charts above it becomes obvious that the implementation of a Participating Preferred Liquidation Preference goes well beyond the actual spirit of returning the invested capital prior to other shareholders receiving proceeds. In fact man could consider this derivative of a liquidation preference a camouflaged adjustment of the offered pre-money valuation. Owed to the “double dipping” in the distribution of the exit proceeds, the investor will always receive exit proceeds which go nicely beyond what his %-age ownership would suggest.

I like open and transparent negotiations and simple terms. Therefore I think it is fair to openly discuss what this liquidation preference really is and eventually re-visit the agreed upon pre-money valuation instead of introducing terms which poise the simplicity of Seed Contracts and act as precedence in subsequent financing rounds.

Interest Bearing Liquidation Preferences

I find it quite undesirable to participate in internal discussions about potential offers for a merger or an acquisition with an Excel spreadsheet projected to the wall, showing the actual Liquidation Preference Amount at certain time stamps, growing day by day, re-defining the actual cap table (capitalization table) daily. The conflict of interest between founders and investors is evident.

My recommendation: Try to avoid it. If future investors would request another interest bearing liquidation preference, the shareholders will soon loose sight on what their shares are actually worth. That is not a desirable situation to be in. Keep it simple.

A Compromise

The chart below shows two green lines which I have seen as reasonable compromises for liquidation preferences. Consider a Participating Preferred Liquidation Preference which allows investors to increase their return within segment 2, while a Non Participating Preferred Liquidation Preference would basically keep investors out of any additional returns within that segment. Alternatively you may want to think about a Participating Preferred Liquidation Preference which ceases as soon as investors have received 2 – 3  times their invested capital.

If founders and investors share the opinion that a good and fair liquidation preference shall not remain valid at any, high exit valuations, there should be a number of possibilities to compromise. Feel free to contact me either with a comment within this publication or via email if you have any specific questions or recommendations.


Comparision Chart To Illustrate The Actual Pre Money Valuation With Different Liquidation Preferences


Payment Schedule

also known as: Tranched Investments, Installments


It is not unusual that the investment amount is paid out in two or more tranches. Investors consider tranching a way to mitigate risk. The first tranche is usually paid a few working days after the notarized closing of the investment agreement. Subsequent tranches are paid out upon achievement of agreed performance milestones.

The Founders View

Its OK, because we might be able to raise a bigger round which gives us more time before we need to spend time on raising the next round. But what  if we miss the milestone, who will give us money?

The Investors View

We can agree for a larger financing round, but we want to mitigate our risk by injecting the money as we can see progress.

My Thought

If investor and management want to work hand in hand and in good faith, skip milestones. The problem with milestone based investments is rather obvious. Responsible founders and managers must plan according to the funds available, hence they cannot assume that the next funding tranche will be paid. As good businessmen they must not include future payment tranches in their plannings, therefore future tranches are less attractive, they may allow for spontaneous investments in the business, once the tranche is indeed payed. Alternatively founders can execute as if the entire funding amount was available as assumed in the initial business plan, but then they do run the risk to be out of money in a few months in the event that the next milestone is not met.

→ A Compromise

I have done many milestone based deals myself in Series A and B rounds. What usually works well for both sides is an open and fair discussions about what needs to be achieved to meet future milestones. In order to come up with acceptable wording, it needs to be understood what investors want to achieve and what founders and managers want to avoid with Payment Schedules. Multiple installments shall protect the investor from being forced to put money into a business which doesn’t seem to work. At the same time, any Payment Schedule must provide founders with enough confidence that the milestone can realistically be met. Consider some of the below ideas.

·  In Seed I financing rounds milestones should be connected to MBO-like achievements such as product availability (alpha, beta) or operational goals such as successful hiring of key people.

·  From Seed II onward, milestones will very likely need to be connect to some sales performance. The right levels of budget achievements ( 70/80% of budget ) would give investors the confidence that the business can get legs, while there is still enough room for the founders to maneuver.

·  Consider defining more than just one achievement per milestone and allow either one to trigger the payment of the related payment.

Details and Advanced Considerations

It should be a mutual interest to not overload a startup company with too many small milestones. More than one milestone after the initial payment will distract management from the actual mid to longer term goals. They should be given enough room to build a business, which also means to try, learn, conclude before they can win.

Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.