Don’t Get Left Empty-Handed: The Importance of Liquidation Preference

In the world of venture capital financing, one of the most important terms, behind price/valuation, is liquidation preference. As a startup company founder, having a solid understanding of liquidation preference is incredibly important, as it could mean the difference between whether or not you collect any proceeds from a sale of your company.

Liquidation preference is the essence of “preferred stock.” The fundamental difference between common stock (the class of stock typically owned by founders and employees) and preferred stock (the class of stock typically owned by investors) is liquidation preference. The liquidation preference is the mechanism by which holders of preferred stock receive a priority return of their investment upon a “liquidation event.”

A “liquidation event” is usually broadly defined and includes both the actual winding-up of the company and a sale of the company (either via merger, asset sale, change of control, etc.). The liquidation preference states the order in which the company’s funds will be paid out to holders of its various classes of shares upon a “liquidation event.” This concept is also commonly referred to as a liquidation “waterfall.”

Liquidation Preference

Liquidation preference is usually expressed as a multiple of the original purchase price of the applicable shares of preferred stock. A 1x liquidation preference would mean that the holders of the applicable series of preferred stock will receive a return of their investment before any holders of junior preferred stock or common stock receive a penny. A 2x liquidation preference would mean the holders of the applicable series of preferred stock will receive a return of two-times their investment before anyone below them on the liquidation “waterfall” gets paid. In a company-friendly fundraising environment, liquidation preferences are usually only 1x. In down markets, when startup company investments become inherently riskier and the leverage is with investors, you’ll see liquidation preferences at 2x and sometimes even as high as 3x or more.

Example 1:

Startup Inc. has 3 classes of stock outstanding: Series B Preferred Stock (1x liquidation preference), Series A Preferred Stock (2x liquidation preference) and Common Stock. Startup Inc. raised $5 million in its Series B financing and $2 million in its Series A financing. Startup Inc. is being acquired for $10 million. Startup Inc. has no debt, and for simplicity’s sake, we will not factor in any transaction costs, which would likely be paid from the liquidation proceeds.

Assuming none of the preferred stock has “participation rights” (discussed below), in this case, the liquidation preferences would work as follows:

• First, the Series B holders would receive $5,000,000 (1x the $5 million raised in the Series B financing);
• Second, the Series A holders would receive $4,000,000 (2x the $2 million raised in the Series A financing); and
• Last, the Common Stock holders would receive $1,000,000 (the amount left over after the Series A and Series B liquidation preferences are paid).

Participating vs. Non-Participating

A liquidation preference can come in two distinct flavors – “participating” and “non-participating.” A participating liquidation preference means that the holders of the applicable series of preferred stock receive their liquidation preference, and then, if there is still money to distribute to the holders of common stock after paying all of the liquidation preferences to the preferred stock, the preferred stockholders will actually participate on an as-converted to common stock basis in the distribution of the leftover funds with the common stockholders.

A non-participating liquidation preference means that the holders of the applicable shares of preferred stock must choose between (a) receiving their liquidation preference or (b) forgoing their liquidation preference and participating with the common on an as-converted basis. Whether a preferred stockholder chooses option (a) or (b) involves an analysis of how much money is available to distribute, and whether the preferred stockholder will receive more money via its liquidation preference or via converting into common.

Example 2 (Participating Preferred):

Same facts as Example 1, but assume the Series B and Series A both have participation rights, the Series B Preferred Stock comprises 20% of Startup Inc.’s outstanding shares on an as-converted to common stock basis, the Series A comprises 30% of Startup Inc.’s outstanding shares on an as-converted basis, and the Common Stock comprises 50% of Startup Inc.’s outstanding shares.

The distribution of the proceeds upon liquidation would go as follows:

• First, the Series B holders would receive $5 million (1x the $5 million raised in the Series B financing);
• Second, the Series A holders would receive $4 million (2x the $2 million raised in the Series A financing);
• Then, after the liquidation preferences to the Series B and Series A, the Series B and the Series A would also participate with the Common Stock in the remaining $1 million, with $200,000 going to the Series B, $300,000 going to the Series A, and $500,000 going to the Common Stock.

Example 3 (Non-Participating Preferred):

Same facts as Example 2, except none of the preferred stock has participation rights, and Startup Inc. is being acquired for $100 million.

If the Series B and Series A preferred holders chose not to be treated as if they converted into Common Stock, they would receive their same liquidation preferences as in Example 1, and the holders of Common Stock would share in the $91 million left over after paying the liquidation preferences to the Series A and the Series B. However, in this case, because they would receive much more of the liquidation proceeds by being treated as if they converted to Common Stock, that is exactly what the Series B and Series A holders will do, and rather than following a waterfall as in the previous examples, everyone would be treated as if they converted into Common Stock and the $100 million would be distributed as follows:

• $20 million to the Series B holders (20% of the proceeds);
• $30 million to the Series A holders (30% of the proceeds); and
• $50 million to the Common Stock holders (50% of the proceeds).

In this same home run scenario, if the Series B and Series A had participation rights, they would not need to do any analysis about whether they would be better off being treated as if they converted into Common Stock, and would instead collect their collective $9 million in liquidation preferences as in Example 1, and then would share in the remaining $91 million with the holders of Common Stock in the same 20%, 30% and 50% proportions as above.

As you can see, non-participating liquidation preferences are much more company friendly. Non-participation gives the investors some downside protection in case the investment is not a home run, but it doesn’t allow them to double dip in the way that participating preferred stock does.

Participation with a Cap

Because participation rights allow holders of preferred stock to double dip by receiving their liquidation preference and then sharing in the remaining proceeds with the holders of Common Stock, it is very common to add a cap to a participating liquidation preference. A participating liquidation preference with a cap might state that the holders of preferred stock will receive a 1x participating liquidation preference, but that their participation is capped at 3x their investment. In the scenario in Example 3, if the Series B and Series A were each capped at 3x on their participation, the liquidation proceeds would be distributed as follows:

• First, the Series B holders would receive $5 million (1x the $5 million raised in the Series B financing);
• Second, the Series A holders would receive $4 million (2x the $2 million raised in the Series A financing);
• Then, after the liquidation preferences to the Series B and Series A, the Series B and the Series A would also participate with the Common Stock in the remaining $91 million, with $15 million going to the Series B (3x their $5 million investment), $6 million going to the Series A (3x their $2 million investment), and $70 million going to the Common Stock.

Note that in the real world, in the scenario above, the holders of Series A would convert to Common Stock and share in the proceeds remaining after the Series B liquidation preference (if the Series B didn’t convert to Common Stock too), because doing so would allow them to collect much more of the liquidation proceeds than they would by remaining as preferred stock and collecting their liquidation preference plus participation up to their cap (by converting to common stock, the liquidation waterfall would look much more like Example 3). As for the Series B, it appears that they would receive the same amount whether they convert to Common Stock or not.

Last In, First Out

One final concept to note with respect to liquidation preferences is the “last in, first out” principal. This means that the last money in is the first money out in a liquidation scenario.  Startup companies typically do their financing rounds in an alphabetical order (with the first round being the Series A, the second round the Series B, etc.).  Generally, with each round of financing, one of the terms within the liquidation preference concept is that the newest series of preferred stock will be senior to all prior series of preferred stock – that is, they will get their money out first in a liquidation scenario.  Example 4 below shows an example of the downside protection of liquidation preferences and the last in, first out principal in a scenario where the company is sold in a fire sale, and the proceeds are not enough to cover the liquidation preferences:

Example 4:

Same facts as Example 1, except Startup, Inc. is acquired for $7 million.

In this case, the liquidation proceeds are not enough to cover the liquidation preferences. The Series B will receive its liquidation preference, the Series A will receive all that is left after the Series B liquidation preference, and the holders of Common Stock will receive nothing:

• First, the Series B holders receive $5,000,000 (their entire 1x liquidation preference);
• Second, the Series A holders receive $2,000,000 (everything that is left over after the Series B liquidation preference); and
• Common Stock holders receive $0.

You’ll note that the Series A holders did not receive their 2x liquidation preference in this example. That is because the Series B was the last money in, and they get to receive their entire liquidation preference prior and in preference to any distributions to the Series A or the Common Stock. In this situation, the Series B gets its full liquidation preference, but the Series A takes a haircut on their 2x liquidation preference. Unfortunately, in this case, the founders will receive nothing for all of their hard work, but hopefully they were able to negotiate employment contracts with their acquirer, or at least a management carve-out with their investors (a topic we’ll discuss in a future post), in order to get a little bit of the liquidation proceeds upon the sale.

Conclusion

As you can see from the examples above, liquidation preferences can be hugely important to both founders and investors, because it impacts who gets paid, and when, in a liquidation scenario. For these reasons, you should negotiate liquidation preferences with your investors with great care, and pay special attention to the market in this regard. In company friendly fundraising environments, 1x non-participating liquidation preferences are generally the norm, but in down economies or tight fundraising environments, participation and liquidation multiples become more common. If you receive a term sheet from an investor with a 2x or 3x multiple on their liquidation preference, when the market data is showing that 1x is the norm, you should pin your investor down on why they feel such a liquidation preference is appropriate. The same goes for an investor who delivers a term sheet with a participation right, when the market norm is for non-participating preferred. Liquidation preference is one of the most important terms you’ll negotiate in your financing term sheets. Don’t take the concept for granted.