Understanding the types of liquidation preferences is akin to deciphering the secret language of venture capital. Put simply, liquidation preferences are the lifeboats investors and founders use to navigate the turbulent waters of startup exits.
But beneath this seemingly straightforward term lies a labyrinth of complexities and nuances that can significantly impact who gets what when the company’s journey ends.
In this article, we’ll dive deep into the intricacies of liquidation preferences. We’ll explore the fundamental types of preferences—participating and non-participating—and dissect how each choice can sway the distribution of the spoils during an exit event.
What Are Liquidation Preferences in Startup Financing?
Liquidation preferences are a crucial aspect of startup financing, particularly in the context of venture capital investments. They define the order in which investors and founders receive proceeds from a company’s assets in the event of a liquidation, such as an acquisition or the company going public.
Liquidation preferences are designed to protect the interests of investors and founders and determine who gets paid first and how much.
Here’s how liquidation preferences work:
1. Initial Investment Protection
When an investor injects capital into a startup, they typically receive preferred shares of stock. These shares come with a predetermined liquidation preference, which is usually expressed as a multiple of the investor’s initial investment (e.g., 1x, 2x, etc.).
This means that if the startup is sold or goes through a liquidation event, the investor has the right to receive a certain multiple of their initial investment amount before any other distributions are made.
2. Common and Preferred Stock
In a typical liquidation event, the available funds are first used to pay off the liquidation preferences of preferred stockholders (investors). Only after these preferences are satisfied do common stockholders (usually founders and employees) receive any remaining proceeds.
3. Participating vs. Non-Participating
Liquidation preferences can be categorized into two main types: participating and non-participating. Non-participating preferences allow investors to choose between taking their liquidation preference or converting to common stock and participating in the remaining proceeds.
Participating preferences, on the other hand, allow investors to both take their preference and participate in the remaining proceeds, effectively “double-dipping.”
4. Impact on Equity Distribution
The presence and terms of liquidation preferences can significantly impact how the proceeds from a liquidation event are distributed.
For example, if an investor has a 1x participating preference and invests $1 million, they will receive their $1 million back before sharing any additional proceeds with common stockholders.
If the total proceeds are $2 million, the investor would receive $2 million and then share additional proceeds with common stockholders.
Liquidation preferences are a critical consideration during negotiations between investors and founders. The terms of these preferences can have a significant effect on the distribution of proceeds in an exit event and can shape the balance of power and rewards in a startup’s financial structure.
Understanding the various types of liquidation preferences and their implications is essential for anyone involved in startup financing.
Types of Liquidation Preferences and Their Implications
Liquidation preferences in startup financing come in various forms, with the two primary types being participating and non-participating preferences. Each type has its own set of implications for both investors and founders. Let’s delve into these differences:
1. Non-Participating Preferred Stock Liquidation Preference
Non-participating preferred stock provides its holders with a specific liquidation preference but does not allow them to participate further in the distribution of proceeds once the preference is satisfied.
This means that non-participating preferred stockholders have the option to either:
- Take their predetermined liquidation preference, which is typically expressed as a multiple of their initial investment (e.g., 1x, 2x, etc.), or
- Convert their preferred stock into common stock and participate pro-rata with common stockholders in distributing any remaining proceeds.
Here’s how non-participating preferred stock works:
Liquidation Preference: When a startup goes through a liquidation event, such as an acquisition or IPO, the available funds are first used to pay off the liquidation preferences of preferred stockholders.
Non-participating preferred stockholders are entitled to receive their liquidation preference amount before any other distributions occur. This provides them with a degree of protection, ensuring that they at least recoup their initial investment.
No Double-Dipping: The key distinction of non-participating preferred stock is that the preferred stockholders do not share in any additional proceeds once the preference amount has been paid. They do not double-dip by receiving the preference and a share of the remaining funds.
Instead, surplus funds go to common stockholders, who share them according to their ownership percentages.
Non-participating preferred stock is often seen as a more founder-friendly structure, as it limits the investors’ participation in the distribution of proceeds, leaving more value for common stockholders, including founders and employees.
It strikes a balance between protecting the investors’ capital and ensuring that common equity holders also benefit from the company’s successsuccess of the company in an exit event.
Example of a Non-Participating Preferred Stock
Suppose a startup company raises $1 million, representing 10% of the company, from investors in exchange for non-participating preferred stock with a 1x liquidation preference.
This means that the investors will receive their full $1 million investment back before the founders receive anything, but they will not be entitled to share in any remaining proceeds after the founders have received their full investment back.
If the startup is sold for $10 million, the investors would receive their full $1 million investment back, but they would not receive any of the remaining $9 million. The founders would receive the remaining $9 million.
However, if the company is sold for $15 million and the investor prefers stock rather than taking the initial deposit, they will receive stock worth 10% of $15 million, which is $1.5 million.
2. Participating Preferred Stock Liquidation Preference
Participating preferred stock is a type of preferred stock that provides its holders with a liquidation preference, but it also allows them to participate further in the distribution of proceeds after their preference is satisfied.
In other words, participating preferred stockholders can “double-dip” by receiving both their preference and a pro-rata share of the remaining proceeds from common stockholders.
This type of preferred stock is typically more favorable to investors and can potentially reduce the amount of proceeds that common stockholders, including founders, receive in a liquidation event.
Here’s how participating in preferred stock works:
Liquidation Preference: When a startup goes through a liquidation event, such as an acquisition or IPO, the available funds are first used to pay off the liquidation preferences of preferred stockholders.
Participating preferred stockholders are entitled to receive their predetermined liquidation preference amount before any other distributions occur. This provides them with protection, ensuring they at least recover their initial investment.
Participation in Remaining Proceeds: After receiving their liquidation preference, participating preferred stockholders can further participate in the distribution of any remaining proceeds.
They share these proceeds pro-rata with common stockholders based on their ownership percentages. This means that they can potentially receive more than just their preferred amount.
Double-Dipping: The ability to both receive the liquidation preference and participate in the surplus funds is what distinguishes participating preferred stock from non-participating preferred stock, where investors have to choose one or the other.
Example of Participating Preferred Stock
Suppose that a startup company raises $1 million for 20% of the company from investors in exchange for participating preferred stock with a 1x liquidation preference.
This means that the investors will receive their full $1 million investment back before the founders receive anything, but they will also be entitled to share in any remaining proceeds.
For example, if the startup is sold for $10 million, the investors would receive their full $1 million investment back plus 20% of the remaining $9 million, for a total of $1.8 million. The founders would receive the remaining $8.2 million.
How to Negotiate Liquidation Preferences in Startup Financing
Negotiating liquidation preferences in startup financing is a crucial aspect of investment agreements. It can significantly impact the outcomes for both investors and founders. Here are some tips to help you navigate this negotiation process effectively:
1. Understand the Different Types of Liquidation Preferences and Their Implications
As described above, there are two main types of liquidation preferences: non-participating and participating liquidation preferences.
Each type of liquidation preference has its own advantages and disadvantages for founders and investors. It is important to understand the implications of different liquidation preferences before negotiating with investors.
2. Benchmark the liquidity preferences that other startups in your industry have negotiated.
You can do this by talking to other founders or by looking at public data on startup financing agreements. This will give you a sense of what is considered to be fair and reasonable in terms of liquidation preferences.
3. Be Prepared to Negotiate
Investors will expect you to negotiate the terms of the investment agreement, including the liquidation preference. Be prepared to walk away from the deal if you are not comfortable with the terms that the investors are offering.
4. Consider Your Company’s Stage of Development and Risk Profile
If you are raising money for an early-stage startup, investors will expect a higher liquidation preference to protect their downside risk. If you are raising money for a later-stage startup, you may be able to negotiate a lower liquidation preference.
5. Consider Your Bargaining Power
If you have a strong team with a proven track record, you will have more bargaining power when negotiating with investors. If you are a first-time founder with no prior experience, you may have less bargaining power.
6. Ask for a Participating Liquidation Preference Instead of a Multiple Liquidation Preference
Participating in liquidation preferences can be more favorable to founders because itthey allowsallow them to retain a larger ownership stake in the company after a liquidity event.
7. Negotiate for a Cap on the Liquidation Preference
This will limit the amount of money that investors can receive from the proceeds of a liquidity event.
8. Negotiate for a Conversion Liquidation Preference
This will allow investors to convert their preferred stock into common stock before the proceeds of a liquidity event are distributed. This option can benefit investors if they believe the company has the potential to be worth more in the future.
9. Negotiate for a Ratchet Liquidation Preference
This will provide investors with a guaranteed return on their investment, regardless of the outcome of a liquidity event. Ratchet liquidation preferences, however, are extremely uncommon and typically only agreed upon by very successful founders.
Conclusion
Mastering liquidation preferences is your key to success. Whether you are an investor or a founder, finding the right balance in these negotiations is crucial. Remember, knowledge, communication, and creativity are your tools for building a prosperous and harmonious future.