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Whether you’re an entrepreneur, investor, or even an employee with some stock options in a startup, the importance of understanding liquidation preference cannot be overstated.
Consider the purse of prize money at a gaming event: first place receives the lion’s share of the winnings, others on the podium usually get a much smaller slice, and the vast majority of contestants receive nothing. This is a great analogy for thinking about liquidation preference.
In this article, we introduce one of the most important clauses that is included in an angel, venture, private equity, or other investment term sheet.
What is Liquidation Preference?
Liquidation preference is the order and amount in which preferred and common shareholders receive financial distributions after a liquidity event such as the acquisition or bankruptcy of a business.
Although investing in startups can be risky for angel investors and venture capitalists, a liquidation preference can offer a modicum of downside protection. The liquidation preference is an insurance policy that — if there are monies remaining after a liquidation and outstanding debts paid — the investor will receive a certain amount of the proceeds before other shareholders are paid.
Factors of a Liquidation Preference
While it might seem like a straightforward clause within your term sheet, there are a few factors that can impact you and your fellow shareholders in the future.
1. Preference Multiple
In your term sheet you will likely see the preference expressed as a multiple on the investment — 1x, 1.5x, 2x, 3x, etc.
The most common is 1x, which means if and when there is a liquidation in excess of the investment amount, the investor will be repaid the amount of their initial investment. Although this could mean the investor technically broke even, this is still a loss in VC-land because their LPs expect high returns and the fund only has a few opportunities to return the fund and raise another fund.
This is one reason why some investors will negotiate for a 2x liquidation preference or greater. This could mean that the investor must see their investment double, triple, or more before anyone else gets paid.
Liquidation preference of 2x or greater is most common in later-stage term sheets because it can help align incentives for higher exit prices. Since early investors have the benefit of a lower valuation, they would be more inclined to accept an acquisition offer only slightly higher than the recent investor paid.
Some of the highest recorded liquidation preference multiples were in the 10x range before the dot-com bubble burst.
2. Seniority of Liquidation Preference
You typically won’t see the seniority of liquidation preference discussed until later stage funding rounds. In later stage rounds, it becomes more important to discuss upfront which investors will take preference over others.
In some scenarios, the preference terms will be stated as Pari Passu, which means all investors will have equal preference and therefore if a liquidation is for less than the total investment, each investor will take an equal share of the loss.
In other scenarios, investors will push for seniority over other investors in the event of a liquidation. This doesn’t change the amount of liquidation preference, but changes the order in which the money is distributed.
You can think of seniority as last in, first out (LIFO) or first in, first out (FIFO) of liquidation preference.
3. Participating vs. Non-Participating
Another important keyword when analyzing the impact of liquidation preference is participating or non-participating.
Non-participating is most common, and essentially means that the investor has the choice to take their liquidation preference or convert their preferred shares to common shares (rarely advantageous for investors to do).
Participating, on the other hand, gives the investor the right to take their preferred stock liquidation preference and convert their preferred shares into common shares to take advantage of any distributions made to common shareholders. Some term sheets will place a cap on how much investors can participate in the upside after their conversion to common.
For example, it’s not uncommon for a participating 1x liquidation preference with a 2x cap. In this scenario, the investor would receive their initial investment back per the preference, convert to common, and continue earning until they reach the 2x cap.
Liquidation Preference Example
It’s easiest to understand liquidation preference when money is at stake, so let’s assume you invested $1 million in exchange for 10% of the company with a 1x non-participating liquidation preference. Shortly thereafter the company received an acquisition offer of $5 million and the board approved the transaction.
Do you take your liquidation preference or convert to common shares?
The liquidation preference will net you $1 million. If you convert to common shares, you would only receive $500,000 ($5 million * 0.10). You take the liquidation preference and the common shareholders receive less. Since you, the preferred shareholder, didn’t convert to common, the remaining common shareholders receive $4 million ($5 million – $1 million LP).
To showcase the difference between participating and non-participating, let’s assume the same scenario but the 1x liquidation preference this time is participating. The $5 million acquisition nets you the $1 million liquidation preference only this time you also convert to common stock, participating in 10% of the proceeds reserved for common. ($4 million * 0.10 = $400,000). This increases your proceeds from $1 million to $1.4 million and decreases the proceeds for common shareholders from $4 million to $3.6 million.
Why Liquidation Preference Matters
In the best case scenario — liquidation preference won’t matter because investors got big returns, the founding team got rich, and the acquirer got a great deal (acquirer could also mean new shareholder via IPO). In other situations, the liquidation preference helps protect the investors downside and takes some risk off the table.
Below, we showcase a general example of how liquidation preference could impact proceeds at various terms, including non-participating, participating with a cap, conversion threshold, and when common shareholders will start receiving distributions.
The conversion threshold is the point at which the exit returns are enough to make the investor indifferent to their liquidation preference and therefore would simply convert to common shares.
Invest With Your Preferences
As your deal flow increases, you make more investments, investments mature and eventually reach a liquidity event, your earliest decisions and negotiations about liquidation preference, or lack thereof, will come back to save or haunt you — the choice is yours.
Investing in businesses is ultimately about the destination, but the journey must also be streamlined and optimized. EquityNet has been an innovator at the forefront of crowdfunding technology since 2005 making it easier for investors to participate in funding growth and value creation.
