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Demystifying Liquidation Preference

Posted by  Rajesh Gopi   on February 19 2022

 

 

Liquidation Preference is probably one of the most confusing concepts of a term sheet. Most founders I've spoken with don't quite understand the different aspects of liquidation preference and struggle to comprehend the payout order in the event of a liquidation.

 

 

What is liquidation preference?

Simply put, liquidation preference is the rights investors get to decide between pulling their investment out or converting to common shares in the event of an acquisition.

 

 

Why investors ask for liquidation preference?

Let's consider the example of an investor Jenni, who invests $1M for a 10% equity stake in your startup.

Let's assume that your startup gets acquired the very next day for $5M.

If Jennie did not have a liquidation preference, her ownership would immediately get converted to 10% of $5M. Jennie walks away with $500K from a $1M investment. That sucks for Jenni.

With liquidation preference built into the investment contract, in this scenario, it makes the best sense for Jenni to pull out her $1M, leaving $4M available for the rest of the shareholders on the cap table.

However, if your startup were to get acquired for $100M, it's in the best interest for Jenni to convert her preferred shares to common shares and capture 10% of the $100M. In this scenario, Jenni invested $1M and walked away with $10M.

 

 

What is a liquidation multiplier?

Things get interesting now. Investors can ask for a multiple on their investment.

Let's say Jenni requires 3x multiple for her $1M investment.

When your startup gets acquired for $5M, Jenni will skim $3M from the top, leaving $2M for the rest of the shareholders.

 

 

What is a participating preferred stock?

A final lever available to investors to their liquidation preference is whether they get to participate after pulling their money out. The three variants are:

 

  • Non-Participating
  • Capped Participation
  • Uncapped Participation

 

Let's assume that you agreed to a 3x multiplier and uncapped participation for your startup's $1M investment for 10% equity.

 

When your startup gets acquired for $50M, Jenni first skims $3M from the top and participates the entire 10% of the remaining $47M, netting her $7.7M.

 

However, suppose Jenni had a 3x multiplier capped at $5M. In that case, the most Jenni can take out in a $50M exit is $5M, leaving a more significant allocation available to the rest of the shareholders.

 

 

What is the typical liquidation preference?

The most common term we have seen is a 1x non-participating liquidation preference.

A 1x non-participating liquidation preference gives the investor the right to either pull their money out or convert to common shares and participate in the upside - whichever works out to the investor's benefit.

 

 

Does liquidation preference ever disappear?

Yes, only when the company goes public. At IPO, all preferred shares convert to common. However, considering the tiny fraction of companies going public, as founders, you should be very careful about agreeing to atypical liquidation preference terms. The biggest challenge could be that future investors require similar or better terms.

All payout absorbed by investors comes at the cost of other common shareholders. And guess who typically has the most significant ownership? You - the founder.

 

 

How can TWO12 support founder's journey?

Cap tables are complex. Equity is a high stake asset, and being cavalier can be disastrous to founders. 

 

Understanding exit waterfall, calculating investor's return-on-investment, determining impact to equity by non-standard liquidation preference, building models across various exit scenarios, etc., can take multiple weeks to build on a spreadsheet or cost lots of money going to other products or services. 

 

With TWO12, founders can build all models with complex scenarios in a few seconds. Head over to https://two12.co.

 

Topics: cap table, liquidation preference