In July 2018, Paddy Power Betfair (now known as Flutter) acquired FanDuel for $465M in cash. On the surface, this looks like a great win for the FanDuel founders and employees. However, because the two lead investors held strong liquidation preference rights, the FanDuel founders and most employees received nothing in this massive deal.
What is Liquidation Preference?
Liquidation preference is one of the most important terms in a term sheet. Liquidation preference determines who gets paid first and how much they get paid when there’s an acquisition.
Because they take on significant risks, investors expect to get “VIP” head-of-line privileges to be paid upon a liquidation event such as an acquisition. Employees wait in line and collect proceeds only after all of the preferred investors take their share.
What Are Liquidation Preference Terms?
There are two components to liquidation preference. The first is the preference multiple, which basically says the investor gets a certain multiple of their investment amount. If the investor invested $5M and got a 2x preference, they would get paid $10M before the common shareholders got paid anything. For founders, obviously a 1x multiple is better than a 3x multiple.
The second component of liquidation preference is participation, which determines whether the investor can take additional proceeds after the preference multiple is paid out. Capped or full participation rights would allow the investor to “double dip” in their payout.
The simplified 3x3 matrix below provides a simplified view of how liquidation preference works. Healthy startups can get terms more in the lower left corner. Marginal startups may find funding, but liquidation preference terms will likely trend towards the upper right corner.
How Liquidation Preference Hurt FanDuel Founders
When the FanDuel founders raised funds, two key investors received a liquidation preference that entitled them to the first $559M in an acquisition. Founders and employees would be paid only if the acquisition exceeded $559M. Because the Paddy Power Betfair was for just $465M, the founders received nothing.
To help founders visualize how liquidation preference could affect their startup, we have a liquidation preference scenario calculator available in our free members area.
Why Founders Couldn’t Stop the Deal
But wait. If this was such a horrible deal for the founders, why did they do the deal? The reality was the founders couldn’t stop the deal because they also granted the same two lead investors drag along rights. This drag along right forced the other shareholders to accept the decisions made by these two investors. Imagine how the founders felt when they received the notice below that the drag along right was being exercised and they could do nothing to stop getting short-changed.
Lessons Learned: Build a Very Fundable Startup
Every founder should learn from this disastrous scenario the importance of building a very healthy, fundable startup. A healthy, vibrant startup draws more investors during fundraising. The competition gives founders the leverage to negotiate for more founder-friendly terms. Healthy startups get better valuations, better terms, and raise funds with much less effort.
Building a healthy startup requires great execution. Great execution involves doing dozens of tasks and processes the right way. Learn how to execute well with our premium startup training. If you are new to our startup training, we recommend starting by watching the 7 Keys to Triple Your Startup Payout, located in our Basic Tier.
For more detail on liquidation preferences, refer to chapter 11 in our book. Good luck building your own healthy, fundable startup!