Rules of the Road, Part 1: Liquidation Preference in China & Asia
With nearly two decades of technology investment experience, I’ve seen a lot of deals—and I’ve found that the investment terms in Asia, especially China, are the least entrepreneur-friendly in the world.
Surprisingly, Singapore and Hong Kong can at times be worse than mainland China, since investors in these markets have little early stage investment experience. And because they are coming from a private equity background where capital preservation is almost as important as capital appreciation, they include many investor “protections” in their deal documents.
To be fair, venture capitalists in China have traditionally had reason to be less friendly, because entrepreneurs in China have been known to do some unsavory things to their investors, relying in part on the weaker legal system of the country. However, while the market has matured and trust grown over the last few years, prevailing investment terms haven’t changed that much.
Rules of the Road is here to help you understand venture capital or VC terms, including current market standard practice, so that after you outdrive the competition to the finish line, you don’t get run over by your own investors. There are many articles and blogs out there about VC terms, but most of those resources focus on the U.S. market rather than Asia in general or China in specific. With Rules of the Road, we hope to give a sense of what is “normal” on this side of the Pacific.
Liquidation preference is a common term that VCs use to ensure they receive a certain amount of money before other shareholders when there is a liquidation event such as a sale of the company. This term helps to motivate a founder to push for a sale of the company that will give the investor back its capital plus a profit. Without a liquidation preference, a founder who owns a large percentage of the company could have a life changing exit by selling at a valuation that would result in a loss to the VC.
In the U.S., it’s common to see a “straight preferred” or “non-participating preferred” liquidation preference of 1.0x, where at time of exit the VC would at minimum receive 1.0x their invested money back before common shareholders receive anything. If, however, the exit is at a valuation that exceeds the post money valuation the VC invested at, then the VC would just receive a percentage of the exit amount equal to its percentage ownership of the company. For example, say the VC purchased 20% of the company for a US$1m investment, and the company is sold for US$10m: the investor would receive 20% of the US$10m, or US$2m. The VC owns 20% of the company and they receive 20% of the return. This “non-participating preferred” is therefore downside protection for the VC, but it does not give them a better investment return if there is a big exit.
In China and Asia, it is fairly standard to see a 1.5x liquidation preference that is“participating preferred”, which means the VC would first receive 1.5x their invested money back at exit, and the remaining cash would be split based on each holder’s percentage ownership of the company. For example, say the VC owns 20% of the company for a US$1m investment and the company is sold for US$10m: the investor would receive US$1.5m first and then receive another 20% of the remaining US$8.5m (i.e. US$1.7m) for a total of US$3.2m of the US$10m exit proceeds. The VC owned 20% of the company, but they receive 32% of the exit proceeds. The investor is double dipping—meaning that the “participating preferred” term is not only downside protection for the VC, but it also gives them a higher investment return than the founders, and a bigger cut than their percentage ownership would warrant. In China, it’s rare to see a 1.0x participating preferred liquidation preference and quite common to see a 2.0x.
Bonus Topic: Most Favored Nation
Recently we have seen early stage investors make a big deal about how they are receiving common stock, but then they slip in a “most favored nation” clause. This clause generally says that their rights as shareholders will be upgraded to be at least as favorable as the rights given to the investors in the next financing round.
For VCs investing Series A and beyond, you sometimes see the “most favored nation” clause, but it’s not standard as it makes it hard to raise the next round. If early stage investors don’t have a lot of investor protection terms such as liquidation preference in their documents and then add a “most favored nation” clause, they’re just pretending to be entrepreneur-friendly. They are not putting in investor protections such as liquidation preference, because they know that as soon as the company raises another round of funding, their rights will be upgraded to the same rights as the new VC coming in, as this VC is sure to ask for standard Series A investor protections. Watch out for this, as it’s bull$hit, and you should call them out.
What Do We Do?
At SOSV, Chinaccelerator and MOX, we receive common stock for participation in our program—and when we join a follow on investment round, we ask for a 1.0x participating preferred liquidation preference. We do not ask for “most favored nation” clause in our program investments or follow on equity investments. We do have a “most favored nation” clause in our convertible loan note, but it only covers additional convertible loan notes that a company may issue, and it does not apply to the equity received when the note is converted.
William Bao Bean is a Partner at SOSV and Managing Director of Chinaccelerator and MOX. Rules Of The Road is written in partnership with Greg Pilarowski at Pillar Legal. Always hire a good lawyer!