Liquidation Preference: What It Is and How It Works

A liquidation preference determines the order in which investors are paid out in the event of a liquidity event, such as the sale of a company or its assets. The preference dictates how much preferred shareholders are paid before common shareholders, such as founders and employees. This ensures that investors make money or at least break even.

The impact of this term can be huge for founders during an exit. It can mean the difference between a modest payout and complete lifetime financial independence for you and your family. Therefore, it’s important to pay attention to this term. This article will explain the key terms that every founder should know about liquidation preferences.

Liquidation Preference Multiplier and Participation

There are two major components in a liquidation preference:

  • Multiplier—This is the percent of the original investment that is returned to the investor. It is typically expressed as a multiple of the original investment. For example, 1x means 100% of the original investment, 2x means 200%, 3x means 300% and so on.
  • Participation—This refers to whether and how the investor will receive money that is distributed to stockholders after the preferred shareholders have been paid their multiple.

Types of Liquidation Preference Participation

There are three main types of liquidation preference participation:

  • Non-Participating Preferred: The investor receives their investment back first before any other payouts are made according to their multiple. After that amount has been paid, they do not participate in any additional proceeds beyond their initial investment.
  • Full Participation: The investor receives their preference (the multiple of the original investment) first, then receives their pro rata percentage of the remaining proceeds from the sale. Full participation means the investor is allowed to fully participate with other shareholders on the remaining balance as common shareholders. Sometimes referred to as “double-dipping,” participating liquidation preference gives shareholders the right to receive their multiple payout and then to “participate” in the remaining proceeds in proportion to their ownership.
  • Capped Participating Preferred: Capped participation is a variation of full participation, where the investors get to take their liquidation preference as well as the proceeds from the sale price based on their ownership percentage—just like full participation. But the twist is that the total payout is capped at a certain amount. Capped participation allows shareholders with participating liquidation preferences to only participate with common shareholders until the preferred shareholders receive an aggregate amount of x-times the original investment (this limit being the “cap”).

Founders should understand these different types of liquidation preferences and work with experienced legal counsel to negotiate terms that are fair for both investors and founders. If you are looking for legal counsel, we would be happy to chat. Connect with us here.

The Impact of Liquidation Preferences on Startup Valuations

Liquidation preferences can significantly impact startup valuations. Investors often use them to protect their investment and ensure they receive some return in the event of a liquidity event. However, if the liquidation preference is too high or heavily favors investors, it can lower the company’s valuation.

For example, if an investor negotiates a multiple liquidation preference of 3x for their investment, it means they will receive three times their initial investment amount before any other payouts are made. This can result in a lower valuation for the company, as it reduces the amount of money available to be distributed among other shareholders.

High-liquidation preferences can also make it more difficult for startups to raise additional funding rounds. Potential investors may be hesitant to invest in a company with high-liquidation preferences, as it means they are less likely to see returns on their investment.

On the other hand, having no or low liquidation preferences can also affect startup valuations. Investors may be more hesitant to invest if they feel their investment is not adequately protected in case of a liquidity event.

It’s important for founders and investors to strike a balance when negotiating liquidation preferences. Founders should aim to negotiate terms that protect investor interests while also ensuring fair treatment for all shareholders involved in a liquidity event. By doing so, startups can maintain healthy valuations and attract future investments.

The Impact of Liquidation Preferences on Founders and Employees

Liquidation preferences are designed to protect investors, not founders and employees. They can have a significant negative impact on common shareholders, such as founders and employees.

If investors negotiate a liquidation preference that is too high or structured in a way that heavily favors them, it can leave little to no payout for common shareholders in the event of a liquidity event. This can be particularly problematic if the company is sold for an amount that is less than the total amount invested in the company.

For example, let’s consider a startup that raises $10 million in funding from investors and negotiates a 2x multiple liquidation preference. If the company is sold for $25 million, the investors will receive their initial investment of $10 million plus an additional $10 million (2x their investment), leaving only $5 million for common shareholders to split among themselves.

In this scenario, common shareholders may receive little to no payout, depending on how much equity they hold in the company. This can create tension between investors and common shareholders, and make it difficult for startups to attract future investments.

It’s important for founders to carefully consider the impact of liquidation preferences on common shareholders when negotiating with investors. They should aim to strike a balance between protecting investor interests and ensuring fair treatment for all stakeholders involved in a liquidity event. By doing so, they can maintain healthy relationships with both investors and common shareholders while also positioning their startup for long-term success.

Liquidation Preference Scenarios

Ok, now that we understand the concept, let’s run some scenarios to help you understand how the various liquidation preferences affect the proceeds for investors and founders.

  • 1x Non-Participating. If an investor with a 1x non-participating liquidation preference invests $1 million and the company is sold for $10 million, the investor will receive 100% of their initial investment—$1 million first, and the remaining $9 million will be split among the common shareholders. In this case, the investor’s return on investment is limited to the initial investment amount. Investors do not participate in any additional proceeds.
  • 2x Non-Participating. If an investor with a 2x non-participating liquidation preference invests $1 million and the company is sold for $10 million, the investor will receive 200% of their initial investment—$2 million first, and the remaining $8 million will be split among the common shareholders. In this case, the investor’s return on investment is limited to twice the initial investment amount. Investors do not participate in any additional proceeds.
  • 3x Non-Participating. If an investor with a 3x non-participating liquidation preference invests $1 million and the company is sold for $10 million, the investor will receive 300% of their initial investment—$3 million first, and the remaining $7 million will be split among the common shareholders. In this case, the investor’s return on investment is limited to three times the initial investment amount. Investors do not participate in any additional proceeds.
  • 1x Participating. If an investor with a 1x participating liquidation preference invests $1 million and the company is sold for $10 million, the investor will receive 100% of their initial investment—$1 million first, and then will participate with the common shareholders in the remaining $9 million on a pro-rata basis based on the ownership percentage. In this case, the investor’s return on investment is the initial investment plus additional proceeds based on the ownership percentage.
  • 2x Participating. If an investor with a 2x participating liquidation preference invests $1 million and the company is sold for $10 million, the investor will receive 200% of their initial investment—$2 million first, and then will participate with the common shareholders in the remaining $8 million on a pro-rata basis based on the ownership percentage. In this case, the investor’s return on investment is twice the initial investment plus additional proceeds based on the ownership percentage.
  • 3x Participating. If an investor with a 3x participating liquidation preference invests $1 million and the company is sold for $10 million, the investor will receive 300% of their initial investment—$3 million first, and then will participate with the common shareholders in the remaining $7 million on a pro-rata basis based on their ownership percentage. In this case, the investor’s return on investment is three times the initial investment plus additional proceeds based on the ownership percentage.

What Are the Standard Liquidation Preferences for Startups?

According to a study of over 200,000 venture deals by the National Venture Capital Association and Alumni, below is the data on liquidation preferences broken out by deal stage.

Percentage of startup funding deals that have a 1x liquidation preference multiplier by stage:

  • Seed—99.6%
  • Series A—99.1%
  • Series B—98.8%
  • Series C—97.9%
  • Series D—97.2%

Percentage of startup funding deals have a non-participating liquidation preference by stage:

  • Seed—98.4%
  • Series A—96.7%
  • Series B—95.7%
  • Series C—97.2%
  • Series D—97.2%

The data clearly shows that 1x non-participating is the most common liquidation preference. While every deal has its own nuances, if either party proposes a liquidation preference that is not 1x participating, they should have a compelling reason for doing so.

If you’re interested in diving deeper into the effects of liquidation preferences on founders, check out our Founder’s Guide to Seed Funding and Founder’s Guide to Series A.

 

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