Liquidation Preference - Explained
How does a startup exit for $20-$50m and the founders and employees still get a $0 payout? When the exit value is less than the liquidation preference stack. This article is an expansion of a LinkedIn post that I had posted about previously.
TLDR
In an exit, Liquidation Preference on non-participating preferred shares allows investors to choose between receiving a multiple of their investment and an amount based on ownership percentage, whichever is higher.
Under normal fundraising circumstances, 1x liq pref is the norm especially in early rounds.
Every fundraising round adds to the liquidation stack, later rounds are senior to earlier rounds. Common shareholders (founders and employees) are at the bottom of the liquidation stack.
Participating preferred shares entitle investors, in an exit, to both a multiple on investment amount AND proportional amount based on ownership percentage after the liquidation stack has been paid out.
Preferred shares prevent downside for the investor but also allowing them to share in the upside in the case of a big exit.
Founders can and should fight for a carveout if exit amount is lower than liquidation stack to ensure they get some sort of payout.
What is a Liquidation Preference?
A liquidation preference is a relatively common term in a fundraising term sheet that gives investors the right to, in the event of an exit, receive a set multiple of their initial investment if it is higher than what they would receive based on ownership percentage. Liquidation preferences are expressed as a multiple of the initial investment and are usually 1x under normal fundraising circumstances. It’s a feature of non-participating preferred shares, which is the type of equity that investors receive.
For example, let’s look at a startup that raised $1 million in Seed funding for 10% ownership and has a 2x liquidation preference. The seed investors will choose to execute their liquidation preference only if the startup exits for under $20m as $2m will be a bigger payout for the investor than 10% of the exit value.
In an exit, liquidation preference gives investors the right to be paid back the specified multiple of their investment before subordinate shareholders get their share: including founders, employees, & earlier investors.
How does a Liquidation Preference stack work?
When an a VC firm invests in a startup, they are usually purchasing preferred shares, which have a higher priority to common shares that founders and employees receive and earlier investors. Let’s take a look at post Series A startup exit where the exit value is smaller than the liquidation stack; The proceeds are then distributed to shareholders in the following order:
Preferred shareholders from the Series A are paid up to their liquidation preference.
Preferred shareholders from Seed round are paid up to their liquidation preference.
The remaining proceeds are split proportionally among founders, employees, and any other common stock holders.
In this situation, there is a chance that Seed investors or common shareholders receive no payout if the exit value is lower than the liquidation preference of the Series A investors.
In this example, this startup would have to exit for more than $14m before common shareholders get a single penny. The stack is liquidated from top to bottom.
Further examples for non-participating preferred shares:
Investor invests $5m into a startup A for a 20% equity stake at 1x liquidation preference.
- $5m exit = $5m to investor, $0m to others
- $10m exit = $5m to investor, $5m to others
- $25m exit = $5m to investor, $20m to others
- $30m exit = $6m to investor, $24m to others
Investor invests $5m into a startup B for a 20% equity stake at 5x liquidation preference
- $5m exit = $5m to investor, $0 to others
- $25m exit = $25m to investor, $0 to others
- $30m exit = $25m to investor, $5m to others
In startup B's case, unless the exit price is over $125m, the investor will always execute their liquidation preference as it will result in a higher outcome for the investor: 20% of exit vs $25m .
So far, we’ve only been discussing non-participating preferred shares. However, there’s another class of shares that even more advantageous for investors called participating preferred shares.
Participating Preferred Shares
In the event of an exit, these shares give investors the right to receive a multiple on their initial investment back AND a share of any remaining proceeds. Essentially, this allows investors to have their cake and eat it too. They participate in both the liquidation stack and the remaining proceeds after the stack has been paid out.
Example: A startup raises a $1m seed round selling 10% ownership at $10m valuation with 1x liquidation preference.
In a few years, the founders decide to sell the company for $8m.
If the investor holds non-participating preferred shares the investors would receive:
$1m because the 1x liq pref > 10% of $8m
If the investor holds participating preferred shares the investor would receive
$1m from the 1x liq pref
$700k from participating in the proceeds. This is calculated as ($8m-$1m) x 10% ownership
For a total of $1.7m payout for investors
Why do Preferred Shares exist?
Preferred shares are a common way for venture capitalists to protect their downside in investment in startups. By giving preferred shareholders a preference over common shareholders, venture capitalists can increase the probability that they will receive a return (even if its just 1x) on their investment even if the company fails to produce a big outcome.
It also aligns incentives between investors and founders to produce a meaningful exit.
Take for example a startup that raised $4m for 50% ownership without a 1x liquidation preference. The next day, the founders receive an acquisition offer for $4m. Without the liquidation preference, the founders could see this opportunity as an easy way to exit for a $2m payout. The investor would receive a payout of $2m and would have lost money on this investment.
With the 1x liquidation preference, the founders are incentivized to produce a meaningful exit: at least a value that’s higher than the liquidation stack so the founders, who are common stock holders, can receive a payout.
Why would founders sign a term sheet with anything more than 1x liquidation preference?
Under normal fundraising circumstances, a 1x liq pref is the norm in early rounds. But sometimes, founders might find themselves with limited options and be forced to take a term sheet with 2x or even 3x liq pref to keep the startup alive. There are a few scenarios when they would be forced to do so.
First, the startup might be in desperate need of cash to extend their runway. In this case, they may be willing to accept a term sheet with a higher liquidation preference to live to fight another day. Perhaps the startup’s traction was not attractive enough to investors or that capital is expensive in the macro-environment.
Second, founders might believe that their company is worth more than the valuation at which it is being raised. In this case, they may be willing to accept a higher liquidation preference for lower dillution because they believe that the liquidation preference will not matter when they IPO the company for billions of dollars.
Third, founders might be willing to accept a higher liquidation preference in order to get more favorable terms on other parts of the deal. For example, they might not be willing to give up a board seat or super pro-rata rights to a new investor.
Ultimately, the decision of whether or not to accept a term sheet with anything more than 1x liquidation preference is a complex one that should be made on a case-by-case basis. Founders should carefully consider the terms of the deal and their own financial situation before making a decision.
What to do if a potential exit value is lower than the startup’s liquidation stack?
Unfortunately this situation happens way more often than a big exit. It’s a tough conversation to have around the board with both founders and investors. The founders are technically entitled to $0.
However.
In any exit, investors know they still need the founders to carry through with their duties until it the exit is realized. So in some sense, the founders still have a bit of leverage. It’s not uncommon for founders to receive a small carveout from the exit. The exact amount is negotiated between the founders and the board.
Conclusion
Liquidation Preference is an extremely powerful tool for investors to protect their downside and align incentives for founders. The difference between non-participating vs participating, 1x liq pref vs 3x liq pref can have immense implications for the potential payout for founders. Founders should read every term sheet carefully and understand how every fundraising round changes the liquidation stack of their startup to ensure that the incentives are fair to them as they strive to build a successful company.
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