The Importance of Liquidation Preference for a Startup Founder

As a startup founder, you’ve dedicated countless hours and immense effort to build your company from the ground up and into the hands of customers. When it’s time to raise capital, it’s crucial to secure the best deal possible to safeguard your hard work. Understanding liquidation preference and its potential impact on your stake in the company is essential to achieving this goal.

So What is Liquidation Preference?

At its most basic level, Liquidation preference refers to the order in which shareholders are paid when a company experiences a liquidity event, such as an acquisition or a recapitalization. Investors with preferred shares are paid before common shareholders (e.g., founders and employees with common stock). This means that if your startup is sold or goes public for an amount relatively small compared to previous funding rounds, preferred shareholders might receive all the proceeds, leaving common shareholders with nothing.

There are three typical liquidation preference structures:

Non participating preference: This is the simplest form – when there is a corporate event, preferred shareholders receive a multiple of their initial investment before common shareholders.

Participating preference: In this case, investors not only receive their fixed return but also participate in the distribution of the remaining proceeds from the sale of the company.

Participating capped preference: A hybrid of the first two structures where investors receive a multiple of their initial investment and also participate in the distribution of the remaining proceeds up to a certain cap or limit. Once this cap is reached, investors no longer participate in the distribution of remaining assets.

Now let’s run through a quick and simple example of how liquidation preference impacts founders’ ownership.

Let’s say that the startup raised $10 million in a funding round at a pre-money valuation of $40 million from an investor for a 20% ownership. It seems like a great deal, right? But there’s a catch – the investor also wants a 2x liquidation preference. This means the investor would receive twice their initial investment ($20 million) before other shareholders, including you (the founders), receive any pay out.

Now consider three possible exit scenarios:

1– Exit at $80 million: In this case, the investor has two pay-out options – they can either convert their preferred shares for receive 16 million (which is 20% of $80 million), or they can excise their liquidation preference and receive $20 million (2x liquidation preference). The rational choice for the investor is to exercise liquidation preference and receive $20 million, and the remaining $60 million would be distributed among all shareholders, including the founders and other investors. As a founder, you’d be still very content with the outcome as you’d receive a substantial portion of the exit value.

2– Exit at $30 million: The investor takes the amount equivalent to the 2x liquidation preference, which is $20 million. Additionally, if it’s a participating preference, they take 20% of the remaining $10 million, which makes it $22 million for investors and $8million for founders and remaining investors even though they own 80% of the shares

3– Exit at $15 million: In this scenario, the investor will take the entire amount because their 2x liquidation preference equals $20 million – which is less than $15 million. Unfortunately, this leaves nothing for the founders and other shareholders, which can be disheartening, especially if you worked tirelessly to build your startup.

The problem with liquidation preference is that it can create a misalignment of incentives between investors and founders. If investors have a liquidation preference that guarantees them a return on their investment before anyone else, they have less incentive to work with founders to build a successful company. Instead, they may focus on pushing for a quick exit or a sale, even if it’s not in the best interest of the company or its founders.

Furthermore, liquidation preference can be a major hurdle for founders who are looking to raise additional capital or sell their company. If a company has a liquidation preference that’s too high, it can make it difficult for new investors to come in or for the company to be sold for a price that benefits everyone involved.

So What’s The Solution?

As a founder, it’s important to negotiate for a fair liquidation preference that aligns the interests of all parties involved – for investors, it’s a kind of a downside protection for the risk they are taking to protect their investment, while for founders, it’s the need for an incentive to work and build a successful company.

As such, there are two levers – Non-participating liquidation preference should be something that you, as a founder, should negotiate for, so that investors only get their money back before other investors and founders, but don’t get to share in the remaining proceeds.

The second lever is the multiple itself – the lower the liquidation preference, say 1x-1.5x, more incentive it is for founders to have a better chance of success, both now and in the future.

Key Takeaway:

It is important for founders to carefully evaluate the terms of any investment deal and weigh the potential implications of liquidation preferences on your startup’s future exit scenarios.

Always remember that negotiation is an integral part of fundraising. It’s crucial to have open and transparent discussions with potential investors to ensure that you strike a balance between securing necessary funding and preserving your ownership rights. In some cases, selecting an investor who offers a lower valuation could be a wise decision if their term sheet is more favourable towards the founder.