Liquidation Preferences

What is a Liquidation Preference?

Preferred stockholders get a liquidation preference, which determines the priority for distributing funds during a liquidity event. This ensures they receive their investment returns first in mergers or IPOs. It sets an order for distributing funds, giving precedence to preferred stockholders over those holding common shares.

Many venture capital firms invest and support startups by using preferred stock, which provides a safety net through the liquidation preference over other stockholders. Without this safeguard, the common shareholder and preferred stockholders would share the proceeds equally. However, with a liquidation preference, preferred stockholders are prioritized to receive returns on their investment up to a fixed multiple before any distribution is made to common stockholders.

Liquidation Preference Structure

Liquidation preferences come in different multiples, the most common being 1x, 2x, and 3x preferences. This determines the amount that investors will receive in relation to their original investment in a liquidity event.

For example, an investor with a 2x liquidation preference who invested $1 million would get $2 million before common shareholders receive any proceeds in an acquisition or asset sale. With a 3x liquidation preference multiple however, that same investor would receive $3 million before common shareholders get paid.

Investors in investment agreements have different levels of priority in liquidation preferences based on their involvement in funding rounds. For example, initial investors may have a 1x preference, followed by Series A investors with a 2x preference, and Series B investors with a 3x preference. This creates a ranking system for payments, compensating investors based on seniority. Liquidation preferences can be participating or non-participating. Non-participating preferences give investors the choice between receiving their predetermined preference amount or a share of profits. Participating preferences allow investors to receive their full preference amount first and then share the remaining proceeds with common shareholders.

Participating preferences provide more downside protection and often result in higher payouts for investors in a liquidity event. Non-participating preferences favor founders and employees holding common stock in the company.

Types of Liquidation Preferences

There are a few types of liquidation preferences that investors may require, and founders should understand:

Participating Liquidation Preferences

In a liquidation, according to the preference agreement, preferred shareholders receive their investment back as a priority. After that, the remaining shareholders split the remaining.

For example, if the liquidation preference is 2X and the company exits for $10 million, the participating preferred holders would get back their initial $5 million investment. Then, they would split the remaining $5 million with common shareholders based on ownership percentage. Participating in liquidation preferences means preferred shareholders get the best of both worlds—downside protection plus upside participation. This is an aggressive term for investors.

Non-Participating Liquidation Preferences

When a non-participating liquidation preference is in place, preferred shareholders will receive their full liquidation preference amount. However, they do not have the opportunity to share in the remaining proceeds proportionately with shareholders.

Using the example above, the preferred holders would receive their $5 million preference, and all the remaining $5 million would go to the common shareholders. There is no upside participation for the preferred shareholders beyond the liquidation preference.

Capped Participation

A capped participation liquidation preference is a hybrid between participating and non-participating preferences. Investors receive their liquidation preference first, then participate pro-rata with common shareholders up to a set cap or ceiling.

Once the cap is reached, all additional proceeds go solely to common shareholders. The cap provides some upside participation for preferred shareholders while limiting the dilution of common shareholders in a very large exit. This balanced structure is a reasonable compromise in many cases.

Calculating the Liquidation Preference

When investors are ready to receive their payout during a liquidity event, it is important to know how the calculation for liquidation preference is determined. Let's explore a couple of scenarios:

1x Non-Participating Liquidation Preference

• Company raises $1 million from VC firm for 1 million shares of preferred stock
  • Liquidation preference = 1 x original investment = 1 x $1 million = $1 million
• Company sells for $2 million
  • VC firm invests $1 million, gets first $1 million back; $2 million - $1 million = $1 million left for common shareholders

2x Participating Liquidation Preference

• Company raises $1 million from VC firm for 1 million shares of preferred stock
  • Liquidation preference = 2 x original investment = 2 x $1 million = $2 million
• Company sells for $5 million
  • VC firm invests $1 million, gets 2 x $1 million = $2 million back first. Remaining $5 million - $2 million = $3 million
  • VC converts preferred to common stock
• Total proceeds = $2 million liquidation preference + common payout of $3 million
  • So VC firm gets $2 million + $3 million = $5 million total

3x Non-Participating Liquidation Preference

• Company raises $1 million from VC firm for 1 million shares of preferred stock
  • Liquidation preference = 3 x original investment = 3 x $1 million = $3 million
• Company sells for $1.5 million
  • VC firm invested $1 million
• Company sold for less than the 3x preference, so VC firm gets the full $1.5 million
  • $0 left for common shareholders

Capped Participation

• Company raises $1 million from VC firm for 1 million shares of preferred stock
  • Liquidation preference = 2x, capped at 2x return on investment
• Company sells for $5 million
  • VC firm invested $1 million with 2x return = $2 million
  • Cap means VC firm gets either 2x return or common payout, whichever is lower
• Common payout = ($5 million - $1 million) / Common shares = $4 million
  • So VC firm gets the lower number = $2 million
• $3 million left for common shareholders

Implications of Liquidation Preferences

Liquidation preferences have consequences for founders and other shareholders who have fundraising endeavors. For founders and staff holding stock, a liquidation preference indicates that they will receive payment only if there is remaining value following the preference payout. This reduces the potential upside for common shareholders in a moderate exit.

Liquidation preferences can also negatively impact future fundraising efforts and valuations. Investors in later financing rounds also may not want to invest at the same valuation since the liquidation preference must be paid out first. This results in a down round with a lower valuation. The liquidation preference influences the viability of potential exits as well. With a high liquidation preference, the acquisition offer has to clear a higher bar for common shareholders to see meaningful returns. Otherwise, founders and employees may push to hold out for a higher valuation and risk not getting an exit.

Overall, while liquidation preferences protect investors' downside, they can significantly limit the upside for founders and common stockholders. Startups should be cautious about accepting high liquidation preference multiples, which could constrain them during later fundraising and acquisitions.

Negotiating Liquidation Preferences

During the fundraising stages of a startup, founders hold bargaining power when discussing advantageous terms related to liquidation preferences. Nevertheless, the venture capital firm and companies that provide funding in the early phases also play a role in determining these preferences because of their knowledge and the inherent risks associated with such investments. Here are some tips for founders to negotiate liquidation preferences:

• Explain why the proposed liquidation preference may hurt future fundraising and limit exit options. Investors want their portfolio companies to thrive, so pointing out how a high preference could backfire can persuade them to lower it.
• Compare the proposed terms to industry norms and standards. If the liquidation preference requested is higher than typical seed or Series A deals, emphasize this discrepancy.
• Offer caps, collars, or other compromises to limit multiples. Proposing a 1X cap on non-participating preferences or a 2-3X cap on participating preferences shows a willingness to find the middle ground.
• You can trade other terms in the deal, like voting rights or protective provisions, in exchange for reducing liquidation preferences.
• Connect high preferences to lower startup valuations to highlight the inverse relationship. Investors want to maximize ownership per dollar invested.
• Leverage competing term sheets by demonstrating you have multiple financing options. However, use this tactic carefully to avoid alienating investors. For later-stage rounds, investor leverage increases, but savvy negotiators can still improve liquidation preferences by highlighting the increased company value and lower risks.

Despite initially resisting it, Bigcommerce accepted a participating preferred series B round with a 3X liquidation preference from General Catalyst. This demonstrated flexibility to close the deal. In other cases, founders may successfully hold firm if they maintain strong negotiating leverage. For example, due to high investor demand, Airbnb reportedly kept their Series B liquidation terms identical to its Series A.

Liquidation Preferences in Term Sheets

The liquidation preference is a crucial component of the term sheet in a VC financing round. It specifies and multiples the total payout order if the company is sold or dissolved. The key terms to look for related to liquidation preference in the term sheet are:

• Liquidation Preference - This specifies the dollar amount of the liquidation preference, typically 1X or 2X the original investment amount.
• Participation - Indicates if the preferred shares are participating or non-participating. Participating shares get their liquidation preference first and share proceeds pro-rata with common shareholders.
• Capped Participation - Limits the payout to investors if the company successfully exits. Prevents excessive dilution of common shareholders.
• Multiple - A multiple, such as 2X or 3X, dictates the multiple of the original investment the investors get before common shareholders are paid out.
• Seniority - Where the particular series ranks in order of payout. Typical terms are senior, pari passu, or junior.
• Structure - Specifies whether the preferences have a stacking structure or are pooled. This impacts the order of payouts. Carefully reviewing the liquidation preference details in the term sheet ensures founders understand the implications of an exit scenario.

The liquidation preference privileges investors get can significantly reduce or eliminate payouts to common stockholders if the exit value is low relative to the liquidation preference stack. As such, founders should negotiate capped participation, lower multiples, and conditional conversion mechanisms that reduce preference overhang.

Alternatives to Liquidation Preferences

Here are some alternatives founders may want to consider:

Other Mechanisms for Downside Protection

Convertible Debt

Some investors will provide financing via convertible debt rather than issuing preferred shares into common stock with a liquidation preference. This allows them to get their money back before equity holders in a liquidation event. The company doesn't give up equity initially but owes the money back with interest.

Revenue-Based Financing

Here, investors get a share of the revenue until the company earns a fixed return instead of paying a lump sum. This helps lower the risk of liquidation for the investor without decreasing the founders' ownership stake.

Repayment Guarantees

Personal loan guarantees from founders can provide extra security to investors, ensuring they will get their capital back. This avoids favoring one shareholder class over another.

Milestone-Based Vesting

Tying founder equity vesting to specific milestones helps ensure investor goals align with execution. This can reduce the need for outsized liquidation preferences.

When Liquidation Preferences Aren't Needed

Bootstrapped Startups

Many bootstrapped companies avoid VC deals and can grow organically without liquidation preferences if they retain earnings for funding.

IPO Exit

In a successful IPO exit, liquidation preferences don't apply since the company stays intact. So they provide less value to public market investors.

High-Growth Startups

For startups with huge growth potential, investors are less concerned about downside protection than the upside. Liquidation preferences may be minimal or not needed.

Later Stage Deals

In later rounds like Series B/C with high valuations, liquidation preferences are less important to investors confident of equity gains.

Key Takeaways

Understanding liquidation preferences is crucial for founders navigating venture capital term sheets and startup funding. Here's a breakdown of the points:

• Liquidation preference decides the priority and extent of payouts investors receive during events like acquisitions or IPOs. It grants investors priority over common shareholders in these scenarios.
• The main types are participating and non-participating liquidation preferences. Participating preferences allow investors to get their initial investment back and share pro-rata in the remaining proceeds.
• Liquidation preference multiples like 2X or 3X mean investors get that multiple of their initial investment returned before common shareholders get any payout.
• Higher liquidation preference multiples favor investors but can hurt founders and employees who hold common stock and reduce future fundraising potential.
• Alternatives like capped participation and other negotiated structures allow for balancing investor and founder interests.
• Liquidation preferences should be evaluated in the context of valuation and the overall term sheet. They provide downside risk protection to investors.
• Founders should understand how liquidation preferences work, how to negotiate them, and the implications on their ownership stake.

Transparency on high multiple liquidation preferences avoids surprises in an eventual exit. Understanding liquidation preferences and how they impact common equity shareholders is vital for founders in venture capital fundraising. This guide provides a comprehensive foundation on how liquidation preferences offer preference structures, calculations, negotiation tactics, and key considerations for founders.

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