VC-backed entrepreneurs regularly — and rightly — bitch about liquidation preferences, and how they can belie the notion that were all in this together. Its kind of like the Titanic captain and steerage passengers all being in the same boat. True for a while, but not necessarily when the going gets tough.
But entrepreneurs are not necessarily slaves to liquidation preferences, according to a new study from Jesse Fried and Brian Broughman of UC Berkeley. In fact, VCs receive less than their contractual entitlement in over 25% of [company] sales. In such cases, the carve out is typically 11% of what the VC is contractually entitled (which works out to $3.7 million in the Berkley sample of 42 VC-backed companies incorporated in Calfornia and Delaware).
How do entrepreneurs negotiate a carveout? Well, its not by appealing to a VCs charitable nature. The first two are obvious: (1) Maintain board control, which is extremely difficult if the company has been backed by VCs since inception; and (2) Maintain a close relationship to the CEO (assuming the CEO is no longer a founder), since the sale is much less likely to close without CEO cooperation.
The third, however, is far more interesting: Incorporate in a state that provides optimum leverage to common shareholders. The study only examines companies incorporated in California and Delaware, but found that carve-outs for Cali-incorporated companies were around $1.75 million higher than for their Delaware-incorporate counterparts.
Ive got to wonder how many VCs already are aware of this disparity, and have considered it when persuading startups to incorporate in Delaware
In a semi-related blog post, check out Matt McColl of Portage Ventures on The Myth of 51%.