In my last post, I discussed term sheets and highlighted some of the terms a VC and founder need to focus on when negotiating a deal. One of the terms that focus on economics, liquidation preference, can have vast implications on how much money an investor receives during an exit. In this post, I will walk through liquidation preferences and how they can affect a return.
What is a Liquidation Preference?
A liquidation preference is a clause written into a term sheet that dictates the “payout order” during a liquidation event, such as an IPO, M&A, or winddown of a company. When VCs invest in a startup, they receive Preferred Stock, while founders and the option pool hold Common Stock. This Preferred class of stock comes with certain voting rights and other advantages over Common Stock, such as the liquidation preference. The liquidation preference itself represents an investor’s right to receive a pre-determined amount of money before the holders of Common Stock, thus giving the investor downside protection on their invested capital. In short, with a liquidation preference, an investor will receive their invested capital (or a multiple of that capital) before a founder or option holder during a liquidity event. It’s important to note that at a liquidity event such as an IPO, Preferred Stock will typically convert to Common Stock, and the liquidation preference will cease to exist. There are nuances to this if this Stock is participating, which we will discuss below.
How do Liquidation Preferences work?
There are two primary components of the liquidation preference:
Preference: Term Sheets express liquidation preferences as a multiple of the initial invested capital. For example, a VC investing $5M into a company, with a 1X preference will have the right to receive at least that $5M (or whatever capital is available if it’s a winddown) at the liquidity event before any Common Shareholders receive a return. In today’s world, where there are both a lot of capital and “founder-friendly” terms, a 1X preference is common, particularly in early-stage investing. A 2X preference is seen as overly punitive and discourages founders from creating companies as participating investing parties have misaligned incentives.
Participation: The participation component determines whether or not an investor has the downside protection of their preference and if their shares convert to Common Stock. There are three types of participation that we will walkthrough:
- Non-Participation: In non-participation, at a liquidity event, the investor can choose to take their preference (whatever multiple of their investment negotiated in the term sheet) or convert their shares to Common Stock. In this scenario, the investor will choose whichever option gives them the most return. Assuming the company did well and had a successful exit, the investor will convert their shares to Common Stock. The preference will disappear, and the equity they hold in the company determines their ROI.
- Full Participation: In full participation, the investor will take their preference (a pre-determined multiple of their initial investment) and have their Preferred Shares convert to Common Stock. In this scenario, the investor is “double-dipping,” which can have quite a few implications for the cap table. Often, it is the founders and employees who receive a smaller payout. Because this is such an investor-friendly term, they are rare in today’s investing environment.
- Capped Participation: In a capped participation preference, the investor will have an upper limit on the amount of their preference. Using our earlier example, if a VC invests $5M with a 3X cap (3X is most common), then the VC’s payout preference will be $15M at a liquidation event. In this scenario, the investor can take their capped preference or convert their shares to Common Stock, whichever is greater.
As if liquidation preferences aren’t complicated enough, it’s important to remember that there are typically multiple investors on a cap table, all with different preferences. Due to this, it’s essential to call out that early-stage investors have some responsibility to set a precedent in their Term Sheets. If an investor in a Series A has a liquidation preference, you can bet that the Series B investor will want one too. This dynamic can create a lot of dilution down the line and isn’t ideal for anybody involved. In these situations, there are two ways to determine payouts:
Stacked Preferences: A situation where follow-on investors stack their preferences on top of each other. Series B would get their preference first, then Series A, etc.
Pari Passu/Blended: In the blended situation, all investors’ preferences are equal in status.
Liquidation preferences are a crucial topic during Term Sheet negotiations. Luckily, high multiples and participation are no longer a standard feature. As investors compete for deals, their terms have become less dilutive for founders. Suppose you’re a VC negotiating a term sheet. In that case, it’s essential to consider how your liquidation preferences will align incentives with a founder and also how they will set a precedent for further funding rounds. In many cases, an early-stage investor will also get diluted from later rounds with preferences, so be diligent in considering all exit scenarios!