A number of provisions in venture capital financing rounds are based on the fact that valuating startups – the basis for investor investments – is inherently difficult.
The valuation of a startup is determined by various factors that provide insight into the startup’s potential and the validity of its business model. The biggest difference between valuating startups and mature companies is that, especially for early-stage startups, there are naturally (almost) no historical figures. This often applies not only to the individual startup but, in the case of particularly innovative business models, to the entire market in which the startup operates. In contrast to mature companies, which have an extensive financial history, forecasting the financial returns of young startups is therefore challenging. Put simply, the valuation of startups at this stage can be derived far less from existing figures and is therefore much more “arbitrary”. It is based on soft factors, such as the track record of a serial founder, the investor’s “belief” in the (founder) team and the business plan, or is ultimately simply a matter of negotiation between the investor and the founder team. The valuation underlying a financing round is therefore ultimately the result of negotiations between the investor and the startup (the founders).
As the company matures and in later financing rounds, hard metrics also gain importance: achieved revenue, growth rate, profitability trends, and relevant KPIs (such as churn or retention rates) play a greater role in the valuation. The company valuation thus gradually evolves from a primarily negotiation-driven figure to a more numbers-based assessment, which, however, still involves uncertainties.
Investors seek to mitigate uncertainties in company valuation and the associated uncertainties regarding the potential for value appreciation of the startup – and thus their investments – by agreeing on so-called proceeds and liquidation preferences (often simply referred to as “liquidation preference”) and down round protection (often called “anti-dilution protection”, what is not quite right). However, there are various models or methods for both proceeds and liquidation preferences and down round protection, whose economic consequences can differ significantly. This article provides an overview of these different models and methods.
A. Proceeds and Liquidation Preferences
I. Background
The distribution of proceeds and liquidation proceeds is a central negotiation point in venture capital financing rounds. The primary purpose of agreeing on a proceeds and liquidation preference is to secure the investor’s investment.
In principle, the preference relates to the respective investment of the investor. However, it is also possible to agree on a different amount, increased by a so-called multiple, such as 1.5 or 2 times the investment. Interest on the investment is also possible. Such multiples or interest-bearing proceeds and liquidation preferences have rarely been demanded in recent years. However, in our advisory practice, we have recently seen an increase in such multiples or interest. High proceeds and liquidation preferences can result in founders receiving little or no money in an exit if the sale proceeds are not high enough to satisfy the investors’ preferences. When structuring proceeds and liquidation preferences, care must therefore be taken to ensure that sufficient incentives remain for the founders.
In addition to protecting the investment for new investors, agreeing on proceeds and liquidation preferences also serves an important tax function: it prevents an increase in the value of the existing shareholders’ shares free of charge during a financing round. This should avoid the tax authorities treating the new investor’s contribution as a taxable gift under Section 7(8) of the German Inheritance and Gift Tax Act (ErbStG).
The background is that in a financing round in which a new (or already existing) shareholder is admitted with a so-called disproportionate contribution – that is, a contribution not proportional to the existing shareholdings – there can easily be a transfer of values between shareholders. This is relevant for tax purposes because Section 7(8) ErbStG deems a taxable gift to have occurred as soon as the value of other shareholders’ shares increases due to a shareholder’s contribution. For the fiction of a gift, an objectively ascertainable increase in value is sufficient; a subjective intention to make a gift is expressly not required.
As described above, the price per share in a financing round is based on an agreed company valuation. If this price is above the actual company value, not only does the company benefit economically, but so do the existing shareholders: their share remains the same, but the value of their shares increases without them investing themselves. This increase in value can be considered a taxable gift within the meaning of Section 7(8) ErbStG. Even with an apparently “fair” valuation, especially in light of the significant uncertainties regarding company valuation for startups., it may later turn out that the new investor paid a premium. This possibility alone creates the risk of a deemed gift.
However, the tax authorities do not only examine the price per share, but also consider all rights the new shareholder receives as part of the capital increase. This includes, in particular, special rights such as a proceeds and liquidation preference. This ensures that the investor receives a certain amount in priority in the event of an exit. As a result, the increase in value of the existing shares is economically offset, since the existing shareholders are subordinated in the event of an exit. There is therefore no final, gratuitous enrichment of the existing shareholders and the risk of a deemed gift avoided.
Agreeing on a proceeds and liquidation preference is therefore not only sensible from the investor’s perspective to protect the investment, but also important for tax purposes: it prevents the tax authorities from assuming a taxable gift and thus creates legal certainty for all parties involved.
II. Types of Proceeds and Liquidation Preferences
A distinction is made between so-called participating preference and non-participating preference. It is also possible to agree on a switch from a participating preference to a non-participating preference once a certain valuation or exit proceeds have been reached, particularly to provide founders with further incentives to increase value.
If several investors are involved, the most recent investor usually receives a proceeds and liquidation preference that takes priority over the other investors (“last in, first out”). Alternatively, it can be agreed that, according to the pari passu principle, several share classes and thus proceeds and liquidation preferences are paid out pro rata at the same time.
Especially when applying the last-in-first-out principle, investors should bear in mind when negotiating multiples that in the next financing round, the next new investor will likely also seek such a multiple. The new investor will then receive the preference in priority to the old investor, who moves to the second level of proceeds distribution.
1. Participating Preference
With a participating preference, the investor is granted a kind of premium on their investment in the event of an exit. Specifically, the investor first receives an amount equal to their investment (the preference amount) – or an amount increased by the agreed multiple and/or interest – from the proceeds.
On a second level, the investor then receives from the remaining proceeds the amount corresponding to their percentage share of the share capital (pro rata), resulting in so-called “double dipping” (the investor participates above their pro rata share). This model reduces the share of proceeds for all other shareholders.
Example: The investor invests EUR 5 million at a pre-money valuation of EUR 20 million and receives a 20 percent stake in the startup’s share capital. The exit later takes place at a purchase price of EUR 50 million for 100 percent of the startup’s shares. The investor first receives their investment of EUR 5 million from the proceeds due to their preference. In addition, they receive 20 percent of the remaining EUR 45 million, i.e., EUR 9 million. In total, the investor receives EUR 14 million from the exit proceeds. The two founders, each holding 10 percent of the share capital at exit, have no preference and each receive EUR 4.5 million on the second level.
2. Non-Participating Preference
The non-participating preference also secures the investor a distribution of proceeds equal to their investment – or an amount increased by the agreed multiple and/or interest – on the first level. In contrast to the participating preference, however, the preference is “credited” on the second level, so that – if the proceeds are high enough – the investor ultimately receives as much as they would have without the preference.
Example: Compared to the example of the participating preference, the following changes: The investor also first receives their investment of EUR 5 million on the first level. However, this amount is “credited” against their pro rata share on the second level. In total, the investor receives EUR 10 million in the case of a non-participating preference. This corresponds to their pro rata share of the exit proceeds (20 percent of EUR 50 million). The two founders, each holding 10 percent of the share capital at exit, each receive EUR 5 million on the second level.
The non-participating preference thus becomes irrelevant above a certain level of exit proceeds – when the amount to which the investor is entitled in a pro rata distribution exceeds the preference amount; it functions as pure downside protection. Shareholders’ agreements therefore often state that the investor receives “the higher of (i) the preference amount and (ii) the pro rata proceeds.”
A hybrid structure can also be based on the previously mentioned variant, in which, above a certain valuation of the startup at exit, there is a switch from a participating to a non-participating preference. This protects the investor from falling short of their return expectations, while also incentivizing the founders to achieve the highest possible exit proceeds, as avoiding double dipping increases their share of the remaining exit proceeds on the second level.
B. Down Round Protection
I. Background
Another classic instrument in VC contracts is the so-called down round protection. A down round is a subsequent financing round in which the price per share is lower than in the previous financing round, meaning the investor retrospectively paid a “too high” price for the subscribed shares. This scenario is secured for the investor by granting them additional shares in the startup at nominal value in the event of a down round, resulting in a retroactive valuation adjustment. These so-called compensation shares are created by a further increase in share capital. The resulting change in shareholdings comes at the expense of the founders and other shareholders, as the increase in the share capital by issuing compensation shares to the investor dilutes the existing shares.
II. Types of Down Round Protection
There are also various methods of down round protection to take the parties’ interests into account, with the full ratchet and average methods being distinguished first. If the average method also takes into account the different volumes of the financing rounds, this is referred to as the weighted average method, which is further divided into the so-called narrow-based weighted average and broad-based weighted average methods.
1. Full Ratchet Valuation Adjustment
Full ratchet means that, in the event of a future down round, the investor is put in the position as if they had invested at the subsequently lower valuation by issuing additional shares. With this method, the founders and other existing shareholders are fully diluted based on the last (lower) valuation.
Example: Investor A joins a startup with share capital of EUR 25,000 at a pre-money valuation of EUR 10 million with an investment of EUR 1 million. The share price is therefore EUR 400.00. They receive 2,500 shares for their investment. Investor B later invests at a pre-money valuation of “only” EUR 9 million, also investing EUR 1 million, so the share price is “only” EUR 327.27. Had Investor A only had to pay the lower price, they would have received 3,056 shares for their EUR 1 million. Since the full ratchet method is applied, Investor A receives 556 additional shares at nominal value in the down round (without the obligation to pay any additional payment to the free capital reserve of the startup).
2. Average Valuation Adjustment
A reconciliation of interests between investor and founder (or other existing shareholders) is achieved by broadening the reference valuation (average method). Not only the valuation of the startup in the down round itself, but also the valuation of the previous financing round is used to calculate an average price.
Example: Compared to the full ratchet method, the average price of EUR 400.00 and EUR 327.27 is calculated, i.e., EUR 363.64. For this price, Investor A would have received 2,750 shares. With the agreed average method, they therefore receive “only” 250 additional shares at nominal value (without the obligation to pay an additional payment to the free capital reserve of the startup).
With the weighted average method, unlike the pure average method, the volume of the two financing rounds is also taken into account. Here, a distinction is made between the broad-based weighted average and the narrow-based weighted average methods. The broad-based weighted average method takes into account all common and preferred shares as well as, for example, virtual options (e.g., for employee participation programs), whereas the (currently most commonly used) narrow-based weighted average method usually only considers the preferred shares of the respective series. The broad-based weighted average method is the most favorable variant for the founders and, if applicable, other existing shareholders.
As a rule of thumb: the more shares included in the calculation, the lower the number of compensation shares to be issued in a down round and thus the lower the dilution of the founders and other existing shareholders.
III. Limiting Down Round Protection
There are also further ways to limit down round protection, e.g., by limiting the protection in time or by including a so-called pay-to-play provision, according to which the protected investor must participate pro rata in the down round in order to assert their rights under the down round protection.
IV. Adjustment of Share Price After a Down Round
Since new shares are issued at a price that is at least lower than the price per share in the previous financing round as part of down round protection, the price of the shares affected by the down round is adjusted accordingly (downwards) after the issue of the compensation shares for down round protection. This has an impact on future down round protection (if granted). For the question of when a down round exists in the future, the lower adjusted price is then decisive. In addition, the adjustment is particularly relevant for proceeds and liquidation preferences, which must be adjusted accordingly.
V. Exceptions to Down Round Protection
Certain measures in which new shares are issued should be excluded from the scope of down round protection according to the purpose of the provision or the economic objective of the respective measure. These include, in particular, the issuance of shares as part of employee participation programs or as part of compensatory capital increases due to warranty breaches.
The above examples show that the different models or methods of proceeds and liquidation preferences and down round protection can lead to significant economic differences in the event of an exit or a down round. These differences should be known to all parties – already at the stage of negotiating the term sheet for the financing round.
*The examples in this article are simplified and are intended solely to illustrate the economic effects of the different models or methods.
