What is a Liquidation Preference and Why Should You Care?

Even though it could significantly impact how much cash is left in their pockets post-exit, liquidation preference is a term that’s often overlooked by founders, discounted by beginner and early investors, and could be a complete unknown to startup employees.

We’re here to fix that.

liquidation preference

What Is A Liquidation Preference?

When angel investors and venture capital funds invest in startups, they essentially acquire preferred shares. A liquidation preference, among other, is one of the terms or characteristics that makes a preferred shared preferred. In one sentence, it ensures that investors get their investment (or a multiple of it) back before any of the common shareholders (the founders and employees) get a dollar.

Liquidation preferences are expressed as a multiple of the investment amount invested in the company. A 1x preference means that investors get their investment amount first before any shareholders get paid. A 1.5 preference means that investors get 150% of their investment back first. A 2x pref…. ok, you get the idea.

What’s The Purpose Of A Liquidation Preference?

A liquidation preference protects investors in cases where the company doesn’t hit a home run and in cases where the interest of the founders and the investors when it comes to a sale may not be aligned.

An example will explain this best:

Let’s say I just started a company with my bff (we’re 50-50) and we raised 1 million dollars. To get that one mil, we sold 20% of the company to investors. Fast-forward two years and we get an offer to sell the company for $2m. We own 80% of the company (let’s assume no employees for simplicity). That means we’re going to bank $1.6m. Our investors, however, are going to get only $400k for their 20%, which means that while we’re almost millionaires without having invested a dollar, they lost money[1].

That doesn’t seem fair, right?

That’s the purpose of a liquidation preference. The same example with a 1x liquidation preference means that our investors get their $1m before we get to enjoy any proceeds. That’s the protection they deserve for putting their money into our company.

Other liquidation preference key parameters other than the multiple (e.g. 1x) are participation and the cap.

Participating Or Not? The Double-Dip Question.

A non-participating liquidation preference means that investors can choose to either use their liquidation preference and get their preference multiple back OR participate in the proceeds according to their ownership stake in the company[2].

A participating preference means that they can do both. In this case investors both get their preference multiple back AND participate in the remainder of the proceeds according to their ownership percentage. This is often referred to as double-dipping.

Going back to our example:

  • Non-participating 1x preference: our investors have the choice to get $1m using their 1x preference OR get $400k based on their 20% ownership. They choose the higher $1m option of course and the co-founders split the other $1m and get $500k each.
  • Participating preference: our investors get their $1m back AND 20% of the remaining $1m for a total of $1.2m. As co-founders, we split the remaining $800k and get $400k each.

The Cap.

Non-participating preferences can feel unfair to investors (in our example, our investors made no profit and the founders got paid handsomely) and participating ones can feel unfair to founders and employees due to the double-dipping problem. A potential solution for that comes in a form of a compromise: participating preference with a cap. In such case, investors are capped on how much money they can make by using their liquidation preference. That cap is also expressed by as a multiple of the original investment amount.

Let’s go back to our example and assume the company sold for $8m instead of $2m and that the liquidation preference is 1x and participating. In this case, investors get their $1m and then another 20% of the remaining $7m ($1.4m) for a total of $2.4m. If there was also a cap of 2x in place, investors would only be able to get $2m (2 times their investment of $1m) using the preference.

It’s important to note that any kind of participation is considered non-favorable for founders and that in the last few years, which have brought an abundance of capital waiting to be deployed, a plain-vanilla founder-favorable non-participating 1x liquidation preference has become the norm.

Preference Among The Preferred.

The final concept we’ll introduce is seniority, which determines proceeds distribution priority among the company investors. As such, it only matters to investors and not so much to the common shareholders of the company (its employees and founders).

Briefly, there are three common seniority options:

  • Standard: latest rounds get priority over early rounds. In this case, sale proceeds will satisfy Series C investors’ liquidation preference before they will satisfy B investors’ preference and so on.
  • Pari Passu: all investors are treated the same. In cases where sale proceeds cannot satisfy all liquidation preferences, investors will get paid proportionally.
  • Tiers: this is the hybrid approach. It puts multiple rounds of investment into one seniority group that has priority over another seniority group.

Why Should You Care?

Liquidation preference can make or break your return on investment whether you’re an investor who actually invested money or a founder or employee who invested their money, time, energy, and life.

For investors, liquidation preferences can significantly impact your returns, especially in cases when things don’t go according to plans and the company you invested in doesn’t hit a home-run (so most times). Even if the company you invested in did hit a home run, favorable liquidation preferences (i.e. participating with no/high caps) can boost your returns dramatically, so negotiating them is key.

Founders must take liquidation preferences seriously when negotiating a term sheet with investors. This can be hard to do for optimistic founders that don’t see anything but success in their future, since these liquidation preferences often become effective only when the company does not do as well as planned[3].

While employees have no seat in the negotiation table, it’s useful for them to understand the concept of a liquidation preference. Why? Let’s say you’re about to join a company and the CEO tells you she believes the company can sell for $500m in two years Let’s also assume you believe her. Is $500m good? A quick online search may help you figure that out. If the company raised $400m and may need to raise more, a simple non-aggressive non- participating 1x liquidation preference will leave its employees with very little to nothing out of the $500m. If the company raised $40m, you can be much more optimistic about the future.

The Bottom Line.

The bottom line is that while investors, founders, and employees many times focus on valuation and their share of the company and think about the product of these two as the “value” in their pocket, that’s not always the case. Valuation preferences can change that value dramatically. The lower you are in the capital food chain (or in its technical term – the waterfall), the more that value can shrink. Early investors (see a recap from our previous posts startup investing basics), founders, and employees should be aware of that.

Just ask Uber.

 

P.S. Liquidation Preferences go away when a company IPOs. So the above is really just relevant to scenarios in which the company is acquired.

 

 

[1] In real life, our investors probably make sure that our shares vest over time, but even in that case, with us founders owning 67% of the company after two years vs. their 33%, we still become rich and they lose money.

[2] Investors who choose the latter basically choose to convert their preferred shares into common shares and give up their preference. This happens at a point where the valuation of the company is high enough so they make more money by taking their share based on their ownership percentage than using their liquidation preference (with or without participation). That point is often referred to as the Equilibrium. We’ll go into preferred to common conversion in another post.

[3] If the company’s valuation is high enough, investors will convert their shares into common shares since they will be past the equilibrium point.

3 thoughts on “What is a Liquidation Preference and Why Should You Care?

  1. Pingback: Everything you need to know about Preferred Shares in Startups. – EquityBee Blog

  2. Pingback: How to Evaluate and Negotiate Your Stock Option Package | EquityBee Blog

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