- By Aaron Kellner
- July 31, 2018
- 6 minute read
Liquidation preferences represent one of the major – and often overlooked – terms that can significantly impact an early-stage investor’s overall returns. In fact, many in the venture capital community consider liquidation preferences to be among the most important of deal terms, second only to the company’s valuation at the time of investment. Therefore, as an early-stage investor it is imperative to understand what they are, why they exist, their key features, and why they matter.
What is a Liquidation Preference?
A liquidation preference represents an investors’ right to get his or her money back before the holders of common stock, which typically includes a company’s founders and employees. Put another way, the liquidation preference dictates the amount of money that must be returned to investors before a company’s founders or employees can receive returns in the case of a liquidation event such as the sale of the company.
Liquidation preferences are expressed as a multiple of the initial investment. They are most commonly set at 1X, meaning that investors would need to be paid back the full amount of their investment before any other equity holders.
Important to note is that only holders of preferred stock receive liquidation preferences. This is one of the reasons early-stage investors should never purchase common stock.
Why Do Liquidation Preferences Exist?
Liquidation preferences serve as a form of protection for investors, especially in situations where a company fails to meet expectations and sells or liquidates at a lower valuation than expected. This is because the liquidation preference essentially guarantees a certain minimum payment due to investors regardless of the company’s valuation at exit, whether that be a sale or the company going out of business.
Important to note is that liquidation preferences are a non-factor if a company exits via an IPO (“Initial Public Offering”) since all preferred shares automatically convert into the publicly-traded common stock.
Are All Liquidation Preferences the Same?
While industry standards do exist, not all liquidation preferences are the same. And the differences that exist between them can have significant effects on an investors’ potential returns. Therefore, when it comes to evaluating liquidation preferences, there are a few key parameters that one should keep in mind:
Liquidation Preference Multiple
As indicated above, the multiple determines the amount that must be returned to investors before a company’s founders or employees receive returns. Holders of preferred stock should expect to receive at minimum the market rate 1X liquidation preference when investing in early-stage companies.
Participating, Non-Participating, and Capped Liquidation Preference
Participating Liquidation Preferences are sometimes referred to as “Double-Dip Preferred” and are most favorable to investors. If an investor’s preferred stock contains participating liquidation preferences, he or she will be paid back his or her liquidation preference and then will share in any additional proceeds in proportion to his or her equity ownership.
Non-Participating Liquidation Preferences are sometimes referred to as “Straight Preferences” and are the most commonly used. If an investors’ preferred stock contains non-participating liquidations preferences, he or she can choose to either (1) receive his or her liquidation preference or (2) share in the proceeds in proportion to his or her equity ownership after converting his or her preferred shares into common stock. Acting rationally, an investor would choose whichever option provides the larger return.
Capped Liquidation Preferences are sometimes referred to as “Partially Participating Preferred” and are considered equally favorable to investors and companies. If an investors’ preferred stock contains a capped liquidation preference, he or she will be paid back his or her liquidation preference and then will share in any additional proceeds in proportion to his or her equity ownership. However, as the name implies with these preferences an investors’ returns would be capped. Because of this, in certain situations it may benefit the investor to convert their preferred shares into common shares, give up his or her liquidation preference, and receive proceeds in proportion to his or her equity ownership instead.
Standard Seniority is the structure followed by most early-stage companies. With standard seniority, liquidation preferences are honored in reverse order from the latest round to the earliest round. In other words, Series B investors would receive their liquidation preference before Series A investors, who would receive their liquidation preference before Series Seed investors, etc.
Pari Passu Seniority gives all preferred investors equal seniority status, meaning that all investors would share in at least some part of the proceeds. If the proceeds from a sale cannot cover every investors’ liquidation preference, the payouts are made in proportion to the amount of money invested (which does not necessarily correlate to ownership).
Tiered Seniority can be thought of as a hybrid between standard and pari passu seniority. With tiered seniority, investors from different funding rounds are grouped into distinct seniority levels that follow the standard seniority format. However, within each tier the payouts follow the pari passu format.
How Can Liquidation Preferences Affect My Returns?
Let’s walk through a hypothetical example to see how liquidation preferences can affect your return. To begin, let’s assume an early-stage company is raising a $250K seed round (the first money that it has raised) at a $1M “pre-money valuation” through the issuance of preferred stock with non-participating liquidation preferences. The pre-money valuation represents how much the company is worth before it started accepting investments. For simplicity’s sake, we will also assume that the company does not have and will not have any outstanding debt or later investors who also receive liquidation preferences. Assuming exactly $250K is raised, the seed investors would own 20% of the company ($250K / $1.25M). The $1.25M figure is known as the post-money valuation and represents how much the company is worth immediately after its fundraise.
Holding all else equal, let’s see what happens in each of the following scenarios if the company either does well and is acquired for $3M, is mediocre and sells for $2M, or performs worse-than-expected and sells for only $1M:
- No liquidation preference (i.e. common stock)
- 1X liquidation preference (most common)
- 1.5X liquidation preference
- 2X liquidation preference
Since these are non-participating liquidation preferences, investors must evaluate what their return would look like if they were to either exercise their liquidation preference or share in the proceeds based on their ownership. Here is how those calculations look:
Since investors will act in their own best interest, they will always select the outcome that provides them with the larger return (highlighted in the above tables).
As noted above though, where liquidation preferences really matter is when a company does poorly. Let’s highlight then the scenario in which the company was acquired for only $1M. Recall the post-money valuation (i.e. what the company was worth immediately after their fundraise) was $1.25M, so in this case the company actually decreased in value.
In this scenario, if seed investors didn’t receive a liquidation preference (which would be the case if they had invested in common stock) they would receive 80 cents on the dollar (i.e. $200K returned vs. their $250K investment). However, if they had invested through preferred stock and received the industry-standard 1.0X liquidation preference they would have gotten every dollar back.
Taking it one step further, if the investors had received 1.5X or 2.0X liquidation preference, they would have actually earned 1.5x and 2.0x return, respectively, despite the startup losing value. The below table highlights the value of the liquidation preference to seed investors in this downside scenario.
Note: This post is not a substitute for professional legal advice nor is it a solicitation to offer legal advice. The foregoing is just a summary of typical terms – legal documents and terms vary widely and the foregoing may not be representative of the terms of any particular convertible note document. Seek the advice of a licensed attorney in the appropriate jurisdiction before taking any action that may affect your rights.
This post was written by aaronkellner on July 31, 2018