Liquidation Preferences

During equity funding rounds, preferred stock investors receive additional rights not granted to common shareholders. Many of these rights can significantly change the economics of a proposed investment and alter the return founders will receive during an exit opportunity. As you consider the impact of these shareholder rights, you should pay close attention to the liquidation preferences offered in the deal. Many people in the startup community¹ consider liquidation preferences to be the second most important aspect of a financing arrangement, preceded only by the valuation. This article explores the mechanics of liquidation preference calculations and the most commonly used variations.

Description

Liquidation preferences represent a right to receive proceeds from a liquidation event before other shareholders. As mandated by corporate law, creditors receive any capital resulting from the liquidation event until 1) they have recovered their entire investment or 2) they have exhausted the proceeds from the liquidation event. Once creditors have been paid in full, liquidation preferences determine how much of the remaining amount goes to preferred stockholders and how much goes to common stockholders (held by founders and employees).

Investors include liquidation preference clauses within term sheets as downside protection in case the startup’s exit (commonly referred to as a liquidation event) is below expectations. In most business settings, the phrase liquidation event refers to bankruptcy proceedings. In the venture capital (VC) industry, however, investors use a broader definition of liquidation event that encompasses not only bankruptcy, but also acquisitions and changes of control². Thus, liquidation preferences can play a critical role not only in downside scenarios like bankruptcy, but also in upside exits like a lucrative acquisition. Liquidation preferences can influence investor returns for any type of exit other than an IPO³.

In addition to receiving a right to liquidation preferences, preferred stockholders also hold a voluntary conversion right that allows them to convert their preferred shares into common shares at any time. Before a liquidation event, investors analyze whether they will receive a higher return by receiving their liquidation preferences or by converting their shares to common stock.

Although liquidation preferences may decrease the amount that founders receive during an exit, founders still agree to funding arrangements that include liquidation preferences because VCs often insist on these types of protections in return for their capital investment. Some founders grant favorable liquidation preference provisions to investors in order to receive a higher valuation. The higher the valuation, the larger ownership stake founders can retain while raising the same amount of funding.

Consider a hypothetical startup which recently accepted a Series A investment from a VC fund. The fund invested $5 million (m) to acquire 50% of the company, leading to a $10 m post-money valuation. For simplicity, assume that the founder owns the other 50% of the shares and that the company does not have debt (i.e., they have no creditors).

‍Scenario 1: Over the next year, the startup performs very well and accepts a $20 m acquisition offer from a strategic competitor. The VC firm can either retain its preferred stock and receive its liquidation preference (the $5 m initial investment) or convert its shares to common stock and receive 50% of the sale proceeds ($20 m). The founder receives $15 m ($20 m - $5 m) if the VC receives the liquidation preference and $10 m if the VC converts to common stock, as shown in the following table.

As illustrated above, the VC firm would prefer to convert its shares to common stock ($10 m) instead of retaining the liquidation preference ($5 m). Investors generally require liquidation preferences as protection in case the company valuation declines. Since the company’s valuation has increased from the time of the initial investment, the VC firm does not need to use its liquidation preference.

‍Scenario 2: Consider the same situation as Scenario 1, except that the startup has performed poorly since the Series A round. The startup accepts the best available exit opportunity: a $7 m acquisition offer from a strategic competitor. The VC firm can either receive its liquidation preference (the $5 m initial investment) or convert its shares to common stock and collect 50% of the sale proceeds ($3.5 m). If the VC firm exercises its right to the liquidation preference, the founder receives only $2 m (the amount of proceeds left over after the VC’s liquidation preference: $7 m - $5 m). If the VC firm converts to common stock, the founder receives $3.5 m ($7 m x 50%), splitting the proceeds with the VC firm based on their 50-50 ownership percentage. The table below shows the possible outcomes.

In this situation, the VC would rather receive the liquidation preference ($5 m) than convert to common stock ($3.5 m). The liquidation preference provides the VC with the ability to recoup its original investment, even though the company has lost value during that period. This downside scenario illustrates why investors insist on including liquidation preferences in their agreements.

Notice that the liquidation preference effectively diluted the founder’s returns by artificially increasing preferred stockholder’s returns. When investors convert to common stock (Scenario 1), shareholders receive a return proportional to their ownership in the startup (50-50 split). When investors exercise their right to liquidation preferences (Scenario 2), shareholders no longer split the proceeds proportional to ownership percentage. Even though the VC only owns 50% of the shares, it receives over 71% of the sale proceeds due to the liquidation preference. (For more information about dilution, see our Dilution and Stock Option Pools article.)

Liquidation Preference Multiples

Term sheets indicate how many multiples of their initial investment preferred shareholders receive before common shareholders receive any liquidation proceeds. The previous examples illustrate liquidation preferences with a 1x multiple, meaning that preferred stockholders have the right to recoup exactly 100% of their initial investment before other stockholders receive anything. Using similar logic, a 2x multiple guarantees that preferred shareholders will at least double their investment before other shareholders receive any of the transaction proceeds. The higher the multiple, the more favorable the terms are to investors (and harmful to founders). Many VCs structure deals with a 1x multiple, but some deals include multiples of up to 3x. Watch out for deals with high liquidation preference multiples, since they can significantly decrease the value of your equity!

Most reputable investors strive to negotiate a deal that is fair to both founders and investors. In fact, investors have incentives not to set extraordinarily high multiples. First, high multiples lower the value of the common stock, which may affect the startup’s ability to attract talented employees through employee option programs. Second, VC firms that develop a reputation for negotiating draconian terms with founders will lose out on investment opportunities as entrepreneurs wisely refuse their proposals.

‍Scenario 3: To illustrate the concept of liquidation preference multiples, consider again the facts from Scenario 2. Suppose that instead of a 1x liquidation preference, the VC receives a 2x liquidation preference. The new outcome is illustrated in the table below.

Notice that the VC’s liquidation preference does not reach the 2x limit of $10 m (2 x $5 m initial investment). The total value of the liquidation proceeds ($7 m) is below the 2x liquidation preference multiple ($10 m). Liquidation preferences do not guarantee that the investor will achieve the stated multiple, but rather that the investors will receive the stated multiple before common shareholders receive any portion of the proceeds.

Higher liquidation preference multiples lead to greater discrepancies between returns and ownership percentage. With a 2x multiple, the VC receives 100% of the proceeds despite owning only 50% of the company. (By contrast, the VC received 71% of the proceeds with a 1x multiple in Scenario 2.)

Participation

In addition to recapturing a multiple of their initial investment before other shareholders, investors sometimes receive a percentage of any proceeds remaining after the liquidation preferences have been paid. In these situations, preferred shareholders participate in the residual value of the firm, as if they had converted their shares to common stock. We will now address each of the three main variations of shareholder participation: full participation, capped participation, and no participation.

Full Participation

Full participation is not only the most investor-favorable variation, but also the most harmful to founders. Full participation provides preferred shareholders with the right to a liquidation preference and a percentage of all residual proceeds. This structure provides investors with downside protection (liquidation preference) and upside potential (participation rights) $2 m of proceeds, with the other 80% going to common stockholders, as shown below.

In this scenario, the preferred stockholders increased their return by receiving both a liquidation preference and participating in the allocation of residual proceeds. Without the full participation clause, the preferred shareholders would only have received $5 m instead of $5.4 m. Meanwhile, the founder lost $0.4 m due to the full participation clause.

Capped Participation

Capped participation is a compromise between the full participation and non-participating variations. Just like full participation, capped participation provides investors with the right to a liquidation preference and a percentage of all residual proceeds. However, the deal structure limits the overall payout to preferred stockholders.

For example, a liquidation preference capped at 2x would prevent investors from receiving more than 200% of their original investment. Assuming a liquidation preference multiple of 1x, investors would receive a return of their initial investment followed by participation of up to 1x the original investment. Once an investor receives the maximum value allowed by the cap, the other shareholders share any remaining proceeds.

‍Scenario 5: To evaluate the effect of capped participation rights, review the facts from Scenario 1, but with a 1x liquidation preference multiple, 35% full participation rights, and a 2x cap. The first $5 m of proceeds would be allocated to the VC’s liquidation preference, which is displayed below.

After receiving the initial $5 m in liquidation preference, the VC is entitled to 35% of the remaining proceeds with a cap at $5 m. Under full participation rights, the VC would have received $5.25 m from its participation, however, due to the 2x cap, the VC’s return is limited to $10 m including the liquidation preference. As a result, the founder receives an additional $0.25 m that would have gone to the VC without the cap. By chance, the analysis indicates that the VC is indifferent between receiving the liquidation preference (and associated participation) and converting to common stock.

No Participation/Non-Participating

Non-participating liquidation preferences do not give preferred stockholders the right to any proceeds beyond their liquidation multiple. Common stockholders keep any proceeds remaining after the payment of preferred stockholder liquidation preferences. Preferred stockholders can either keep their liquidation preferences or participate in the residual liquidation proceeds by converting their shares to common stock, but not both. (Scenarios 1-3 illustrate non-participating liquidation preferences.)

Effect of Multiple Funding Rounds

In subsequent equity rounds, investors and startup management must negotiate the relationship between the liquidation preferences of different funding rounds. Follow-on investors either stack their liquidation preferences or receive equivalent treatment. If investors stack their liquidation preferences, the investors in the upcoming round of funding negotiate to receive their liquidation preferences before the investors of earlier funding rounds. For example, investors in a Series B round can determine that they receive their liquidation preferences before the Series A investors. If the new investors receive equivalent status, also known as pari passu, then all preferred stockholders share common liquidation preference terms and distributions are made pro rata to each stockholder.

Helpful Hints

1. Build Financial Forecasts – Before accepting a proposed financing arrangement, forecast the potential impact of liquidation preferences on the return structure. As you model different possible exit scenarios, pay close attention to how investor’s liquidation preferences can change the size of your return.
2. Know what you can negotiate – Nearly all startup investors require at least a 1x liquidation preference. Although the existence of a liquidation preference is virtually non-negotiable, you may be able to negotiate a lower multiple or participation level.
3. Setting Precedents – If you provide generous liquidation preferences to early-stage investors, subsequent investors may demand equally generous terms. If each round of financing receives full participation rights, founders may recover little or no value during a downturn. Be judicious about providing participation rights to early-stage investors.

Conclusion

Liquidation preferences play an integral part in any equity financing arrangement and should be a central focus of your negotiation efforts. Ignoring the effects of liquidation preferences can significantly reduce your return in future exit opportunities. As you carefully analyze the favorability of liquidation preferences, you will be better prepared to structure a deal that is fair to you and your investors.

Resources Consulted

• Brad Feld Blog: Liquidation Preferences
• Brad Feld Blog: Term Sheets – Liquidation Preferences
• Brad Feld Blog: Participating Preferences
• Cooley: Negotiating Term Sheets
• VentureBeat: Beware the Trappings of Liquidation Preference
• Term Sheets and Valuations by Alex Wilmerding