Liquidation Rights and Incentive Misalignment in Start-Up Financing
39 Pages Posted: 23 Oct 2013 Last revised: 12 Mar 2014
Date Written: August 1, 2013
Abstract
This Article analyzes how the accumulation of liquidation rights over multiple rounds of investment in a start-up can result in an aggregate contractual arrangement among the company’s investors and its management team that is suboptimal. Liquidation rights determine the allocation of the proceeds when a start-up is sold. Because a sale is the most common form of exit for investors, these rights are a key factor in determining the return to investors, the return to the company’s management team and employees, and the incentives of all parties involved. The source of this problem is the sequential nature of the contracts involved. As new investors negotiate their rights, earlier investors’ rights are rarely renegotiated. In order to protect themselves from the impact of later investors’ liquidation rights, earlier investors often seek rights that turn out to be counterproductive. This Article analyzes this phenomenon and suggests a contractual mechanism to coordinate liquidation rights over time so that the sequential negotiation of liquidation rights is less likely to result in a reduction in firm value.
Keywords: Venture Capital, Liquidation Rights, Entrepreneurship, Start-up
JEL Classification: G24, G32, G34, K22
Suggested Citation: Suggested Citation