Liquidation Preference

As a startup founder raising funds from venture capital investors, you’ll encounter a variety of terms and concepts that can significantly impact your company’s future. One crucial term is “liquidation preference.” In this blog, we’ll discuss what liquidation preference is, the types of liquidation preferences, why investors want them, their prevalence in venture capital deals, implications for startup founders, and a numerical example to illustrate how they work.

What is Liquidation Preference?

In short, liquidation preferences dictate the order and amount investors get paid when there’s an exit. Investors love them and founders do not.

Liquidation preference is a term used in venture capital financing agreements that grants preferred shareholders the right to receive their investment back before any proceeds are distributed to other shareholders, typically the founders and employees holding common shares. This preference is triggered when a company experiences a liquidity event such as a merger, acquisition, IPO, or liquidation.

Types of Liquidation Preferences

There are several kinds of liquidation preferences that may be negotiated, each with its unique characteristics and implications for both investors and founders. Here are the types:

1. Non-Participating Liquidation Preference: With a non-participating liquidation preference, preferred shareholders (usually investors) receive their invested capital back, plus any accrued dividends, before any proceeds are distributed to common shareholders (typically founders and employees). Once the preferred shareholders have been paid, the remaining proceeds are shared among the common shareholders.
2. Participating Liquidation Preference: In this scenario, preferred shareholders not only receive their initial investment back (plus any accrued dividends) but also participate in the distribution of remaining proceeds along with common shareholders. This arrangement allows investors to potentially “double-dip,” receiving a more significant share of the proceeds.
3. Capped Participating Liquidation Preference: This type of preference is similar to a participating liquidation preference, but it has a cap on the total return that preferred shareholders can receive. Once the cap is reached, the remaining proceeds are distributed solely among the common shareholders. This cap helps balance the interests of both investors and founders, ensuring that the latter group still benefits from a successful exit.
4. Multiple Liquidation Preferences: In some cases, investors may negotiate a multiple liquidation preference, which means they receive a multiple of their original investment before any proceeds are distributed to common shareholders. For example, a 2x liquidation preference would entitle preferred shareholders to receive twice their initial investment before any distribution to common shareholders.
5. Senior and Junior Liquidation Preferences: If a startup has multiple rounds of investment, different classes of preferred shares may be created, each with its own liquidation preference. Senior liquidation preferences have priority over junior preferences, which means that investors holding senior preferred shares get paid before those with junior preferences during a liquidity event.

As a startup founder, it’s crucial to understand the implications of different liquidation preferences when negotiating a venture capital fundraise. Striking a fair balance between investor protection and founder incentives can help ensure a successful partnership and outcome for all parties involved.

Key elements of liquidation preferences

Here is a summary of the four primary features of liquidation preferences:

1. The Multiple: This determines the amount an investor must be paid back before common shareholders receive any proceeds. A 1x liquidation preference guarantees the investor gets their initial investment back, while a 2x multiple guarantees they get twice their investment. Generally, multiples range from 1x to 2x, but can be higher in certain market conditions.
2. Participating vs. Non-Participating:
   • Non-Participating Liquidation Preference: The investor can either exercise their liquidation preference or convert their preferred shares into common shares, receiving a proportion of the proceeds based on their equity ownership.
   • Participating Liquidation Preference: The investor receives their liquidation preference and then participates in the remaining proceeds based on their ownership, effectively “double-dipping” in the proceeds pool. Participating preferences are less common and less favourable for founders.
3. The Cap: This feature limits the total proceeds an investor with participating liquidation preferences can receive. Caps are typically around 3x the investment amount and are meant to protect entrepreneurs from unfair payout scenarios.
4. Seniority Structures: These determine the payout order in the event of a liquidity event.
   • Standard Seniority: Liquidation preferences are paid in order from the latest investment round to the earliest. Most startups follow this structure.
   • Pari Passu: Preferred shareholders across all stages have equal seniority, sharing proceeds pro rata to capital committed. This structure is more common in well-funded, high-profile startups.
   • Tiered: Investors from different rounds are grouped into tiered seniority levels, forming a hybrid between standard seniority and pari passu structures.

Why Investors Want Liquidation Preferences

Venture capital investors seek liquidation preferences when investing in startup companies for several reasons, primarily to protect their investments and increase their chances of obtaining a favourable return. Here are some key reasons why investors want liquidation preferences:

1. Downside Protection: Investing in startups can be risky, as a significant percentage of startups may fail or not generate the expected returns. Liquidation preferences offer downside protection for investors by ensuring they receive a pre-determined return on their investment before other shareholders in the event of a liquidity event such as an acquisition, IPO, or the company’s liquidation.
2. Priority in Exit Proceeds: Liquidation preferences give preferred shareholders (usually investors) priority over common shareholders (founders and employees) during the distribution of exit proceeds. This priority ensures that investors recoup their invested capital before the proceeds are distributed to others, reducing the risk of loss.
3. Negotiating Leverage: Liquidation preferences can serve as a negotiating tool for investors when discussing valuations and other deal terms. By securing a liquidation preference, investors can potentially receive a higher return on investment, even if the overall valuation of the company is lower than initially anticipated.
4. Aligning Interests: Liquidation preferences can help align the interests of investors and founders. By offering downside protection to investors, founders can incentivize them to make larger investments, contribute additional resources, and remain committed to the company’s growth and success. This alignment of interests can help build a strong partnership between founders and investors.
5. Differentiating Among Rounds: Startups often raise multiple rounds of funding, each with different terms and valuations. Liquidation preferences can help differentiate the rights and preferences of investors from different funding rounds, providing greater returns and priority to those who invested earlier or at higher valuations.

While liquidation preferences can offer significant benefits to investors, it’s essential for startup founders to carefully consider the implications of granting these preferences during fundraising negotiations. Striking a fair balance between investor protection and founder incentives is critical for a successful and long-lasting partnership.

How Common Are Liquidation Preferences?

Liquidation preferences are quite common in venture capital financing deals, particularly in preferred stock investments in startups. They are a standard feature of term sheets and investment agreements as they offer investors downside protection and a preferred return on their investments in the event of a liquidity event, such as an acquisition, IPO, or the company’s liquidation.

The prevalence of liquidation preferences can vary depending on the stage of the company, the type of investor, and the overall market conditions. In the early stages of a startup, it is more common for investors to seek liquidation preferences due to the higher level of risk associated with investing in unproven companies. As the company matures and the risk profile decreases, the terms surrounding liquidation preferences might become less stringent.

In some cases, particularly in competitive funding environments or when a startup has significant traction, founders may have more leverage to negotiate the terms of liquidation preferences. However, even in these scenarios, it is still common for investors to seek some form of liquidation preference as a means of protecting their investment.

Overall, liquidation preferences are a standard aspect of venture capital deals, and both founders and investors should be familiar with their implications and potential impact on the distribution of proceeds during a liquidity event.

Implications for Startup Founders

Liquidation preferences can significantly impact the distribution of proceeds during a liquidity event. As a founder, you need to understand and carefully negotiate liquidation preference terms. Participating liquidation preferences may lead to a smaller share of the proceeds for common shareholders, potentially reducing your payout in an exit scenario.

Here are some key implications to consider:

1. Diluted ownership: When a startup raises capital by issuing preferred shares with liquidation preferences, the founders’ ownership stake in the company is diluted. This means that their share of the proceeds in a liquidity event will be smaller, as investors with preferred shares have priority in receiving distributions.
2. Lower proceeds for common shareholders: Since liquidation preferences provide preferred shareholders with a priority claim on the proceeds from a liquidity event, common shareholders (including founders) may receive less or even nothing if the proceeds are not sufficient to cover the liquidation preferences and the remaining distribution.
3. Incentive misalignment: Liquidation preferences can create a misalignment of incentives between founders and investors. In some cases, investors may push for a quick exit to secure their returns, while founders might prefer to grow the company for a more substantial exit down the road. This misalignment can lead to conflicts and disagreements over the company’s strategic direction.
4. Negotiating power: The specific terms of liquidation preferences can impact the negotiating power of founders in future financing rounds or potential exits. More favourable liquidation preferences for investors may make it difficult for founders to negotiate better terms in subsequent rounds, as new investors will likely demand similar or better terms than previous investors.
5. Increased pressure to deliver returns: When investors hold preferred shares with liquidation preferences, there is increased pressure on founders to deliver high returns in a liquidity event to ensure that both the investors and the common shareholders (including themselves) benefit from the exit.

Take a look Eventbrite’s pre-IPO liquidation preference stack.

Numerical Example with a 1x multiple

Let’s consider a simple numerical example of liquidation preferences in a startup investment:

Startup ABC has two types of shareholders: Common (founders) and Series A Preferred (venture capital investor).

Total Investment:

• Series A Preferred (VC): $5 million, representing 25% ownership
• Common (founders): $15 million, representing 75% ownership

Liquidation Preference: The Series A Preferred investor has a 1x non-participating liquidation preference.

Now, let’s consider three different exit scenarios for Startup ABC:

1. Exit value: $6 million The VC investor will exercise their 1x liquidation preference, receiving $5 million. The remaining $1 million goes to the common shareholders (founders).
2. Exit value: $20 million The VC investor can either exercise the 1x liquidation preference and get $5 million or convert to common shares, representing 25% ownership. In this case, the investor chooses to convert and gets $5 million (25% of $20 million), which is equal to the liquidation preference. The founders receive the remaining $15 million.
3. Exit value: $30 million The VC investor will choose to convert their preferred shares to common shares, receiving $7.5 million (25% of $30 million). The founders receive the remaining $22.5 million.

In this example, the liquidation preference ensures that the VC investor gets their initial investment back ($5 million) before any distribution to common shareholders in the case of a lower exit value scenario.

Numerical Example with a 2x multiple

Let’s consider the same example of Startup ABC with a 2x liquidation preference for the Series A Preferred investor:

Startup ABC has two types of shareholders: Common (founders) and Series A Preferred (venture capital investor).

Total Investment:

• Series A Preferred (VC): $5 million, representing 25% ownership
• Common (founders): $15 million, representing 75% ownership

Liquidation Preference: The Series A Preferred investor has a 2x non-participating liquidation preference.

Now, let’s consider three different exit scenarios for Startup ABC:

1. Exit value: $6 million The VC investor will exercise their 2x liquidation preference, receiving the entire exit amount of $6 million, as it is less than their liquidation preference of $10 million (2 x $5 million). The common shareholders (founders) receive nothing.
2. Exit value: $20 million The VC investor can either exercise the 2x liquidation preference and get $10 million (2 x $5 million) or convert to common shares, representing 25% ownership. In this case, the investor chooses to exercise the liquidation preference, receiving $10 million. The founders receive the remaining $10 million.
3. Exit value: $30 million The VC investor will choose to convert their preferred shares to common shares, receiving $7.5 million (25% of $30 million), as it is more than their liquidation preference of $10 million. The founders receive the remaining $22.5 million.

In this example, the 2x liquidation preference ensures that the VC investor gets twice their initial investment back ($10 million) before any distribution to common shareholders in the case of a lower exit value scenario.

Numerical Example with a 1x multiple and participation

Legal wordings of Liquidation Preferences

Here are a few examples.

Example 1

Liquidation Preference. (a) In the event of any liquidation, dissolution or winding up of the Partnership, whether voluntary or involuntary, before any payment or distribution of the assets of the Partnership (whether capital or surplus) shall be made to or set apart for the holders of Junior Units, the holders of the Series B Preferred Units shall be entitled to receive two thousand five hundred dollars ($2,500.00) per Series B Preferred Unit plus an amount equal to all distributions (whether or not earned or declared) accrued and unpaid thereon to the date of final distribution to such holders, but such holders shall not be entitled to any further payment. If, upon any liquidation, dissolution or winding up of the Partnership, the assets of the Partnership, or proceeds thereof, distributable among the holders of the Series B Preferred Units shall be insufficient to pay in full the preferential amount aforesaid and liquidating payments on any other class or series of Parity Units, then such assets, or the proceeds thereof, shall be distributed among the holders of the Series B Preferred Units and any such other Parity Units ratably in accordance with the respective amounts that would be payable on such Series B Preferred Units and any such other Parity Units if all amounts payable thereon were paid in full. For the purposes of this Section 3.3, (i) a consolidation or merger of the Partnership with one or more Persons, (ii) a sale or transfer of all or substantially all of the assets of the Partnership, or (iii) a statutory exchange of units shall not be deemed to be a liquidation, dissolution or winding up, voluntary or involuntary, of the Partnership.

Example 2

Liquidation Preference. In the event of any voluntary or involuntary liquidation, dissolution or winding-up of the Company, each Holder shall be entitled to receive out of the assets of the Company available for distribution to stockholders of the Company, before any distribution of assets is made on the Common Stock or any other Junior Stock, an amount equal to the greater of (i) the aggregate Liquidation Preference attributable to shares of Series A Preferred Stock held by such Holder, subject to adjustment as provided in Section 15(a), plus an amount equal to the sum of all accrued and unpaid cumulative dividends, and (ii) the product of (x) the amount per share that would have been payable upon such liquidation, dissolution or winding-up to the holders of shares of Common Stock or such other class or series of securities into which the Series A Preferred Stock is then convertible (assuming the conversion of each share of Series A Preferred Stock), multiplied by (y) the number of shares of Common Stock or such other securities into which the shares of Series A Preferred Stock held by such Holder are then convertible. None of (i) the sale of all or substantially all of the property or business of the Company (other than in connection with the voluntary or involuntary liquidation, dissolution or winding-up of the Company), (ii) the merger, conversion or consolidation of the Company into or with any other Person or (iii) the merger, conversion or consolidation of any other Person into or with the Company, shall constitute a voluntary or involuntary liquidation, dissolution or winding-up of the Company for the purposes of the immediately preceding paragraph. In the event the assets of the Company available for distribution to Holders upon any liquidation, winding-up or dissolution of the Company, whether voluntary or involuntary, shall be insufficient to pay in full all amounts to which such Holders are entitled pursuant to this Section 4, no such distribution shall be made on account of any shares of Parity Stock upon such liquidation, dissolution or winding-up unless proportionate distributable amounts shall be paid on account of the shares of Series A Preferred Stock, ratably, in proportion to the full distributable amounts for which Holders and holders of any Parity Stock are entitled upon such liquidation, winding-up or dissolution, with the amount allocable to each series of such stock determined on a pro rata basis of the aggregate liquidation preference of the outstanding …

Conclusion

Understanding liquidation preferences is essential for startup founders seeking venture capital investment. Being aware of the types, implications, and the rationale behind these preferences will help you negotiate better deals and protect your interests during a liquidity event.