For years there was a common belief amongst venture capitalists that participating preferred is always better for investors.Here’s a brief overview of the various liquidation preferences investors may ask for:
VCs have one common goal - they all aim to increase shareholder value. Luckily, many Israeli entrepreneurs share this dream as they want to build long-lasting companies. This alignment of interests between VCs and entrepreneurs is crucial to make sure all shareholders are working to achieve the same goal.
The problem with participating preferred is that it creates an inherent misalignment of interest between VCs and entrepreneurs.
Take for example an entrepreneur, who raised $21M and is subject to participating preferred plus interest rate . This entrepreneur is now faced with a decision whether or not to sell the company for $80M. The shareholders agree that the company’s potential could be much higher in 2-3 years, but the company would have to raise another $20M in order to reach said potential.
Luckily, there is a late stage VC who is eager to invest in the company at a reasonable valuation (i.e. - $120M pre money). The decision, therefore, should be simple - on the surface this a good opportunity to increase the value of the company at a reasonable price. But here is where the participating preferred misalignment kicks in. For the entrepreneur, raising another $20M means that upon an exit, he/she will have to pay back the investors $41M plus interest before seeing any profits. If the entrepreneur suspects that the chances of substantially increasing the value at exit are not high enough, he/she will be hesitant to bear more risk. In order to match the entrepreneur's current return, the next potential exit would need to be at least $200M, in order to compensate the extra dilution from the D round and the added preferences. As such, many entrepreneurs at this stage will decide to sell the company and reduce their personal risk. The loss of potential value for all shareholders in this scenario could be huge, by far exceeding the potential profit stemming from the participating preferred.
Cloud computing is an area we find especially exciting. It has brought enormous change to the world of applications and it would be no exaggeration to say that most of the innovation in IT over the past decade has been enabled, catalyzed, or caused by cloud computing. Currently, we are in the midst of a microservices revolution, one that has, until now, been championed by containers. Through our investment in Aqua Security over a year ago, we have witnessed first hand the rapid growth this market is experiencing, and believe it will continue to proliferate enterprises across the globe. We are now on the cusp of another revolution in cloud infrastructure: the move to serverless computing.