Balancing Diverse Interests with Blended Liquidation Preferences

Blended preferences are a type of liquidation preference used in venture capital financing to balance the interests of different investor classes. Unlike traditional liquidation preferences, which grant preferred shareholders priority payout up to a certain multiple return on their investment, blended preferences aim to provide a more equitable distribution of proceeds between earlier and later investors.

With blended preferences, holders of preferred stock do not have full priority over common stockholders. Instead, the preferred shareholders share pro rata in the distribution of proceeds until they recoup their initial investment. After the initial capital has been returned, the remaining proceeds are shared on an as-converted basis between all shareholders.

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This contrasts with a traditional 1x preference, where preferred shareholders have priority on the first 1x return. Blended preferences can utilize participating preferred shares of common stock first, enabling preferred shareholders to double-dip by first getting their initial capital back and then sharing in the remaining proceeds like their common shares of stock. However, non-participating blended preferences are more common.

Overall, blended liquidation preferences aim to balance the liquidity goals of earlier investors with the reward potential for later common shareholders. The blended approach levels the playing field and improves alignment across the cap table.

Advantages of Blended Preferences

Blended preferences offer several key advantages for both investors and founders in a venture capital financing round. For investors, blended preferences allow for differentiated liquidation treatment between earlier and later investors. Earlier investors typically want a liquidation preference to get their money back first in an exit event. However, they may accept partial participation rights to provide better returns for later investors. This improves the alignment of incentives between multiple investor classes. At the same time, blended preferences provide benefits for founders by limiting the liquidation overhang from a full participation feature. With blended preferences, founders don't have to fully redeem the liquidation stack before receiving proceeds. This gives founders more upside if the company has a high-value exit.

Overall, blended preferences balance the interests of both parties. Investors get preferential treatment downside while still offering reasonable upside potential. And founders don't have their proceeds overly diluted by full participating preferred stock. The blended approach allows for a compromise on liquidation rights.

Disadvantages of Blended Preferences

Blended preferences add complexity in modeling potential outcomes. With traditional liquidation preferences, investors can easily forecast returns based on a single multiple. Blended preferences require more scenarios and assumptions to analyze possible returns. This makes it harder for investors to evaluate the merits of a deal.

Similarly, the negotiation process gets more complicated with blended preferences. There are more terms to define and agree upon between founders and investors. For example, negotiating the percentage split between participating and non-participating preferences requires aligning interests.

Lastly, blended preferences can create conflicts between shareholder classes. Preferred shareholders may push for a higher participating percentage, reducing potential gains for common shareholders. This can cause friction and misaligned incentives. Clear communication is key to setting expectations and ensuring all parties feel treated fairly.

Impact on Liquidation Waterfall

Blended preferences can significantly impact the distribution of proceeds in a liquidity event like an acquisition or IPO. Unlike traditional liquidation preferences which are defined per share class, blended preferences blend together all investors to determine payouts.

By blending preferences, neither investor group is made whole before the other. This can incentivize investors to price future rounds fairly and avoid excessive preferences. However, it also eliminates the senior rights earlier investors bargained for. The impact on an IPO can be even more significant, as blended preferences are applied to all cumulative dividends as well. Modeling various exit scenarios is critical for investors to evaluate the tradeoffs of blended versus traditional preferences.

When Are Blended Preferences Used?

Blended preferences are most commonly used in later-stage venture capital financings, such as Series B rounds and beyond. They become more prevalent as companies mature and take on additional investors. Earlier stage rounds like seed and Series A financings more often utilize full ratchet anti-dilution protections or broad-based weighted average anti-dilution. But as the capitalization table grows more complex with each new round, blended preferences help balance the interests of both earlier and later investors. Specifically, blended preferences are useful when:

• A company has raised multiple rounds of financing with different liquidation preferences. Blending these preferences into one structure helps simplify the cap table.
• New investors want some downside protection, but earlier investors don't want to be diluted too much. Blended preferences enable reasonable preference stacking while still rewarding earlier risk capital.
• There are multiple classes of preferred stock with differing preferences. Blending them reduces complexity while appeasing various stakeholders.
• The company needs to raise a large round with a high valuation step-up from prior rounds. Blended preferences limit the impact on early shareholders.
• Founders want to distribute some liquidity to common shareholders in an exit, rather than having 100% of proceeds go to the preferred holders.

In general, blended liquidation preferences balance the needs of both earlier and later stage investors in a fair, transparent manner. They provide flexibility when negotiating complex financing rounds and cap table dynamics.

Structuring Blended Preferences

Structuring blended preferences requires carefully balancing the interests of common and preferred shareholders. The two key terms that impact how blended preferences are structured are participation caps and liquidation multiples. The participation cap determines the maximum amount preferred shareholders can receive relative to common shareholders in a liquidation event.

Typically, the cap is set between 1x and 3x the original investment amount. Setting a lower cap reduces the preferred shareholders' payout while allowing common shareholders to retain more of the proceeds. The liquidation multiple specifies how much preferred shareholders will receive before common shareholders are paid out. Common multiples are 1x, 2x, or 3x. A 2x multiple means preferred shareholders get 2 times their original investment before common shareholders receive proceeds. Higher multiples favor the preferred while lower multiples favor the common holders.

When structuring blended preferences, investors will push for higher caps and multiples while founders/common will argue for lower ones. The agreed terms depend on negotiation leverage. Tradeoffs can be made - i.e. higher liquidation multiples but lower participation caps. Legal counsel is key to ensure the preferences align with company goals.

Negotiating Blended Preferences

The negotiation of blended preferences can create interesting dynamics between founders and investors. On one hand, founders generally want to limit preferences to maintain more equity and control. Investors on the other hand, want strong preferences to reduce risk and optimize returns. This inherent tension requires finding middle ground through compromise and creativity. Some strategies for navigating these negotiations include:

• Modeling different blended preference scenarios to assess the impact on potential exit proceeds. This allows both sides to understand tradeoffs.
• Offering blended preferences in between full participating and non-participating structures. This balances investor upside with founder equity.
• Linking preference strength to milestones or performance targets. This incentivizes the founders to reach goals for investors to give up preferences.
• Granting founders the ability to vote as common shareholders after hitting milestones. This maintains founder control while rewarding investor capital.
• Implementing a dynamic or step-down structure where preferences decrease over time or with milestones. This steadily aligns incentives between the parties.
• Allowing for flexibility on preferences in future rounds to preserve the relationship. Leaving options open can facilitate finding a middle ground.

With creativity and open communication, blended preferences can be negotiated to align incentives and satisfy the core interests of both founders and investors. Rather than a zero-sum game, the right blended structure benefits all parties in the long run.

Examples of Blended Preference Deals

Blended preferences have been used by companies across various industries and stages of growth. Here are some examples:

Company A - This early stage SaaS company raised a $5 million Series A round from VC Firm 1 and VC Firm 2. The terms included a 1.5x blended preference with 50% participating and 50% non-participating. This enabled the founders to retain more equity while providing downside protection for investors. The company was later acquired for $50 million.

Company B - This biotech startup raised a $20 million Series B round led by Healthcare Fund 1. The round included a 2x blended liquidation preference, with 30% participating and 70% non-participating. This structure incentivized the founders and allowed the VCs to get more than their initial investment in an exit. Company B went public two years later via an IPO.

Company C - The e-commerce startup raised $8 million in a Series C round led by Growth Equity Fund 1, with a 1.8x blended preference comprising 40% participating and 60% non-participating shares. The flexibility supported Company C's high growth while providing investors with upside. The company was acquired by a strategic acquirer for $80 million.

Company D - This late stage enterprise SaaS company raised $50 million led by Private Equity Firm 1. The round had a 2.5x blended liquidation preference structure to incentivize the founder-CEO. The company remains private and fast growing. These examples illustrate how blended liquidation preferences can enable mutually beneficial deal terms between founders and investors in companies at various stages and industries. The blended structures provide flexibility to align incentives and share in upside.

Legal and Tax Considerations

Blended preferences can have important legal and tax implications that founders and investors need to consider. From a legal perspective, the rights and preferences granted to investors through blended preferences need to be properly disclosed and documented. Most venture financings are structured as preferred stock, which allows companies to grant special rights and preferences to investors. The blended preference terms should be clearly outlined in the company's certificate of incorporation and the preferred stock purchase agreements. Companies need to follow applicable corporate law requirements in their jurisdiction for creating a new class of preferred stock with blended preferences. There are also tax considerations that come into play with blended preferences.

One key issue is Section 83(b) elections. With standard vesting terms for founder stock, the receipt of shares is treated as deferred compensation, so it is taxed at ordinary income rates when the stock vests. Founders can make an 83(b) election to accelerate this tax obligation at grant, which converts it to capital gains treatment. However, the existence of liquidation preferences complicates the 83(b) election because of uncertainty around the true fair market value.

With blended preferences instead of a standard 1x liquidation preference, the valuation becomes more complex. Another tax issue is the potential alternative minimum tax triggered by blended preferences. If the liquidation preference is sufficiently high, it can result in "phantom income" where the founders have to pay alternative minimum tax on the value of the preference over their cost basis even before an actual liquidity event. So the structure of the blended preferences needs to be evaluated closely to model the tax consequences.

Overall, startups should involve counsel experienced in venture capital financings when implementing blended liquidation preferences. Navigating the legal and tax implications will be critical to avoiding potential issues down the road. With the right guidance, blended preferences can provide flexibility while staying compliant with applicable laws.

Best Practices for Implementation

When structuring and implementing blended preferences in a financing round, there are several best practices that can help avoid issues down the line:

Investor Communications and Shareholder Rights

• Clearly communicate the blended preference structure and impact on proceeds to all existing and incoming investors. Make sure everyone understands how their shares will be treated in an exit event.
• Ensure shareholder voting rights are clear, especially if both common and preferred shareholders have voting power. Define any special voting rights granted to certain share classes.
• Allow reasonable information rights for major shareholders to stay updated on company financials and operations.

Avoiding Potential Disputes

• Model various exit scenarios to test the blended preference calculations. Ensure the math works as intended under different outcomes.
• Define the order of payouts precisely to prevent conflicting interpretations. Ambiguity can lead to messy disputes.
• Establish a fair and objective process for independent valuations in case of any conflicts over preference calculations.

Proper Documentation

• Document the preferences thoroughly in the company's articles of incorporation and investment agreements. Avoid verbal agreements.
• Have legal counsel review all documentation to identify any loopholes or inconsistencies with blended preference terms.
• Consider allowing limited amendments to the preferences under pre-defined circumstances, through shareholder approval.

Following structured processes for communications, governance and documentation can help minimize the risks of blended preferences and create alignment between shareholders.

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