Liquidation Rights and Incentive Misalignment in Start-up Financing

Details

Author(s):
Publish Date:
September 30, 2013
Publication Title:
Cornell Law Review
Format:
Journal Article
Citation(s):
  • Michael Klausner & Stephen Vanuto, Liquidation Rights and Incentive Misalignment in Start-up Financing, 98 Cornell Law Review 1399 (2013).
Related Organization(s):

Abstract

Introduction (footnotes omitted):

This Article analyzes how the accumulation of liquidation rights in a start-up can result in a suboptimal contract among the company’s investors and its management team. 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.

As a start-up grows and negotiates multiple rounds of financing, liquidation rights accumulate. In the aggregate, these rights can create a misalignment of interests and a suboptimal outcome for investors, the management team, and employees. The source of this problem is the sequential nature of the contracts involved; each round of investment involves a new negotiation of liquidation rights. As new investors negotiate their rights, however, 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.