Startup Valuation School

Liquidation Preference in Startup Deals

Liquidation Preference entitles its holder to a preferential payout in a winding-up or sale of a company. It is commonly used as a right to protect investors’ investments in unfavorable payout scenarios. Depending on the terms however, liquidation preference can be extremely beneficial to investors, potentially increasing their payouts by multiples in comparison to actual share ownership.

How Liquidation Preference Works


The Liquidation Preference clause determines how much an investor gets in a liquidation event – meaning when the company gets sold or is wound up. The arguments for it are straight forward. Imagine a young startup having its first Angel round of US$500k at a post-money valuation of US$2.5m. That means the Investor owns 20% of the company and the founders 80%. Now imagine things don’t progress so well, but in two year’s time someone is willing to buy the remains of the business for US$1m. Then the founders get US$800k (still life changing money for most entrepreneurs) and the investor only gets US$200k. Quite a misaligned situation: The investor looses most of her money, while the founders make a significant profit despite a fire-sale exit.

The Liquidation Preference protects the investors by guaranteeing a minimum payout of usually at least the original investment amount. That means in the above example, the investor would first get US$500k back and only then would the rest be distributed. You might think, well isn’t that part of the investor’s risk? But then again why should one party profit so substantially, while another party looses half of their money. Plus: Investors tend to have a strong negotiation power and they usually won’t give this downside protection up.

Where it gets more tricky is when the Liquidation Preference turns from a risk protection tool to a major return driver. Think of doubling the liquidation preference amount or guaranteed dividends etc. These terms can be so powerful that investors might take all the payout in certain scenarios, while making a significant return on investment.

Liquidation Preference in the Shareholder Agreements


Let’s dive into the actual contractual arrangements in a little more detail. How can you actually structure a Liquidation Preference in your legal agreements? You somehow need to set a price for shares to execute this, but how to create the flexibility to profit beyond the preference amount?

Usually, the standard share holders return is dealt with by conversion into ordinary shares. The Liquidation Preference amount is only what you get, if you don’t convert. So for a regular non-participating Liquidation Preference, the preference amount really is just a price per share that is equal to how much the investor paid. And to be able to participate in the upside, the investor needs to convert her preference shares into ordinary shares. Usually the agreements are structured in a way that on a liquidation event you get a payout as-if converted. That helps to avoid all the unnecessary admin around redeeming and issuing shares when you just want to execute and exit.

Going by individual share price as opposed to going by total investment amount also helps with the administrative side of things. Investors of one round can have varying investment amounts and convertible note holders might convert into preference shares of a specific round. So your agreement will specify the preference amount per share class and per share in dollar terms.

What is a Liquidation Event?


A liquidation event is commonly defined as a liquidation of the company or complete sale of the company. The former will likely not even pay back the investor’s original investment, but at least make sure whatever is available helps to recoup some of that cash investment. And the latter is of course the exit scenario that every founder dreams about.

One caveat here is what counts as a sale of the company. Does it have to be 100%? What about a majority sale? The easiest case is if this refers to a complete sale of all equity. If a majority sale of shares is meant, you really need to be also clear in regards to who gets to sell their shares first or if everybody sells pro-rata. Otherwise one needs to clarify, whether shareholders sell partial shares or if the shares with liquidation preference shares get that full investment out, but are forced to sell all their shares etc.

Also important in this case is to remember your tag along and drag along rights. They are the corner stone legal tools that allow you to sell the entire company in the first place and govern how investors participate in a majority sale. More on voting dynamics in our section on this below.

Order of Preference among Investment Rounds (Seniority)


Who gets paid first, if multiple rounds of preferred shares have been raised? Imagine a US$5m Series A was raised at a US$15m post-money valuation after that initial US$500k Angel round at US$2.5m. What if the same fire sale was the fate of the company after Series A? How would the US$2m be shared and among whom? There are essentially two ways to go about this. Either you give seniority or treat every body pari passu.

a) Seniority:

Under seniority, the last investor gets his investment back first and then the other rounds. In the case above, Series A would get paid first, then Angel A and Ordinary would come last if something is left over. Since the payout doesn’t even cover Series A’s investment amount, all goes to Series A.

b) Pari Passu:

Pari passu stands for “on equal footing” and means that the shareholders with liquidation preference get their payout together. So in the case above, the US$2m would be divided up between Angel A and Series A investors. The split could go by number of shares, but by dollar amounts would make most sense. The different share prices of the two rounds would benefit the round with the cheaper share price (Angel A). In contrast, going by investment amounts arguably reflects the risk taken by each party more directly.

So the US$2m would be divided by the total investment of US$5.5m (=US$0.5m+US$5m) to create a ratio. Angel investors would get US$500k / US$5.5m x US$2m = US$0.18m and Series A would receive US$5m / US$5.5m x US$2m = US$1.82m.

Types of Liquidation Preference


As mentioned before, Liquidation Preference in its pure form is a risk protection mechanism. But there are several ways how it can be incredibly attractive and boost an investors payout. The problem is the payout is governed by multiple adjustments to the payout and the exact payout percentage depends on the amount of payout.

Typically one thinks “I own 10% of the company’s shares so if it gets sold for US$10m, I get US$1m”. That is not always true! For example if the payout is just about enough to service the Liquidation Preference, than those investors get 100% of the payout! Now think of scenarios where there is more payout than liquidation preference, but not that much more. Here an investor might get 20% of the total payout. Or 30%, or 40%… depending on the total amount available for payout. You get the point.

This is why it is so important to not only truly understand deal terms, but actually calculate a basic payout model to fully understand how much each party gets at what scenario.

a) Non-Participation vs. Participating

As a base case, Liquidation Preference simply means that its holder just gets his investment back, nothing less but also nothing more. If that investor wants to enjoy a higher upside in an exit, he needs to convert into ordinary. He then gets a return based on his percentage shareholding. That means this right is only valuable in negative exits.

In contrast, if the liquidation preference is structured as “participating” then the investor first gets his investment back AND then participates on a pro-rata basis on everything else that is left over.

While dreaming of your US$100m exit you might think who cares about that US$5m liquidation preference!? In reality that is however a substantial benefit to investors. In fact to get to a US$100m exit you will likely need multiple VC rounds meaning your liquidation preference might have accumulated to US$30m instead of US$5m.

b) Single Return vs. Multiple Return

Another way to increase the investor portion of a payout is by multiplying the actual liquidation preference with a multiple. So instead of paying only the investment back, pay back 1.5x! Or 2.0x. The sky is the limit in negotiations and again this gets out of control very fast.

The good news is that such a multiple isn’t as bad as participating preferred, as it only impacts negative exits. The bad news is that its still expensive and really can skew incentives in all kinds of votings. Imagine discussing drag-alongs with a 2x liquidation preference in a Series B or C where tens of millions of liquidation preference might be in negotiation. Your new investor might want to negotiate for a low drag-along threshold so she can just find a buyer at a cheap price and double her money in a year. Nice deal!…for her.

c) Guaranteed Return: Preferred Dividends

If 2x participating preferred stock doesn’t sound insidious enough, let’s add some preferred, guaranteed dividends. Imagine the argument: “Liquidation Preference is just a protection, but as investor I should get some guaranteed return for all my investment. After all I could just buy real estate and you as a Founder already are taking a (small) salary!” The founders say: “How can we guarantee a dividend, we don’t even have revenues, let alone profits yet.” Hence founders and investors suddenly meet in the “middle” and agree on an 15% guaranteed dividend that only gets paid if there is cash for it. If there are no profits, unpaid dividends accumulate into the liquidation preference amount.

In that case it innocently accumulates over time. Of course you won’t have profits the first few years, so you’ll end up with a liquidation preference that grows every year by 15%. Peanuts in comparison to your US$100m exit!? Not quite. After just a few years, that base Liquidation Preference increase by another 30-50%, times a 2x multiple, and the investor might get 3x their investment before pro-rata distribution kicks in.

So overall, Founders really need to be very careful with Liquidation Preference. Fair and common is regular non-participating as a protection mechanism. If you are a Unicorn on Series Z, some guaranteed return for mega-rounds could help protect from too great asymmetry among incentives. But either way, be clear about terms and MODEL SOME SCENARIOS. Hence, let’s look at a few examples next.

Examples of Liquidation Preferences


Below we are discussing the implication of Liquidation Preference and its many variations on the simple Angel round introduced above. Liquidation Preference does impact payout on LIQUIDATION, not the actual valuation of a round. So to analyse the impact of it we need to look at payout distributions for various payout scenarios. While terms of Liquidation Preference can differ wildly, the biggest impact is usually on the low payout scenarios – essentially when a company didn’t perform as well as everybody hoped.

In out example we look at a US$500k Angel A round that was raised at a US$2.5m post-money valuation. That means Angel A holds 20% of shares after this round. We then tested the impact of various liquidation preference scenarios.

a) No Liquidation Preference

As a starting point, lets look at a graph that shows payout distribution WITHOUT any Liquidation Preference. Here the payout for each scenario is solely dependent on the shares owned by each group of shareholders. As ordinary holds 80% of shares, it of course gets 80% of the payout at any given payout scenario.

b) 1x Non-Participating

Now let’s look at a standard 1x Non Participating Liquidation Preference. Note, the dotted lines represent the payout on a pure share basis to give you a reference point.

As discussed this type of Liquidation Preference only protects the downside in unfavorable payout scenarios. It focuses on ensuring to pay back the original US$500k investment to the Angel A holders. At a US$250k payout, even that cannot be ensured, but between US$500k and the indifference point, the Angel investors get their US$500k back in full. Depending on the payout scenario this is a huge benefit as can be seen by comparing the payout to the dotted line.

Of course this benefit comes out of the pocket of the Ordinary shareholder. Before Angel A gets their US$500k, Ordinary doesn’t see anything. Their payout gradually increases back to the per-share payout (dotted line) which is reached at the indifference point.

The indifference point is the point where a preferred shareholder doesn’t benefit from her liquidation preference anymore. That means, right when she earns the most by holding ordinary shares (or under as-if-converted terms). As the Liquidation Preference in this example is set at the original investment, the indifference point is when the exit payout is equal to the oringnal investment valuation. The post-money valuation of Angel A was US$2.5m, hence the indifference point is at US$2.5m payout.

c) 1x Participating

1x Participating stands for a Liquidation Preference, where the investor first gets its investment paid back, and participates pro-rata on any remaining payout. This can be confusing as even with the non-participating variant, higher payouts are relative to shareholdings. The difference is however that under the participating Liquidation Preference, Angel A will always earn more than on a simple per-share distribution. The US$500k acts like a bonus.

You can easily see this by looking at the graph above. The payout for Angel A is shifted parallely up by US$500k, while Ordinary’s payout is shifted down by the same amount.

Looking at it in this way, it should become obvious, how this protective right, suddenly turns into a significant boost in returns. Only at very large payouts does its impact get diminished. But to get to very high payouts you will likely have to raise multiple rounds of investment, which likely will negotiate for “similar terms as what the founders agreed to in prior rounds“.

d) 1x Participating with Dividends

Adding dividends is simply another bonus you are giving to investors. While every shareholder should be entitled to regular dividends out of profits, requesting guaranteed dividends that accumulate into equity payouts should be considered greedy.

If founders agree to it, they will simply shift payouts across all payout scenarios in favor of the investors. You can see that in the extra “bump” between US$500k and US$750k in the graph above. Such dividends are usually structured as a percentage on original investment and may or may not be cumulative. Either way, the more time has passed between funding round and exit, the higher this benefit will be. This example assumes only 2 years and 15% interest p.a. non-cumulative (= 30% extra), but of course this could be much higher.

e) 1.5x Non-Participating

Another way to improve investors’ returns is to increase the initial payback amount by a multiple. So instead of the original US$500k, Angel A gets 1.5x of that amount. Since its still non-participating, the preference amount simply shifts up until the indifference point. And thanks to the 1.5x multiple, the indifference point has increased to a US$3.75m payout (= 1.5 x US$2.5m).

Of course you can combine a multiple with participation. 1.5x Participating, 2x Participating, 100x Participating with 50% Dividends…anything is possible if the founders fall for it.

Advantages of Liquidation Preferences (to Investors)


The Liquidation Preference clause provides for a meaningful way to protect an investor’s investment in less favorable exit scenarios. You might think “Sweat equity is also equity, why should a negative liquidation event favor investors so substantially?” But especially when you think of the down-round exits, Liquidation Preference is actually quite reasonable.

A down-round exit being an exit at a share price less than what the investor invested in. In a scenario like that the investor would loose by definition while founders would win at least “something”.

Disadvantages of Liquidation Preferences (to Founders)


There are two main aspects to disadvantages of Liquidation Preferences. Firstly, while it fixes some incentive asymmetries it can create a host of new ones. Secondly, the more aggressive variants of Liquidation Preference are just way too investor friendly and can be downright unacceptable.

a) Incentive Asymmetries

Regarding asymmetries, well think of what Liquidation Preference means for any future fund raise or exit. You now have created an artificial bar of a valuation to reach before which founders make little to no return. And beyond that lies the “indifference point” – the point where all shareholders benefit on their actual percentage ownership. Furthermore, every future investment round will have new Liquidation Preference amounts, creating ever new asymmetries and indifference points. The conclusion being, that investors and founders might now think very differently about certain exit valuations.

b) Too Investor Friendly

Secondly, as discussed above, the Liquidation Preference should really be used as a protective measure. Any extra gains from guaranteed dividends, participation or multiples on initial investment should be avoided as much as you can. They add up so quickly, you might as well take a significant hit on your valuation and still be better off.

What’s reasonable


It should probably be clear by now, that we highly recommend founders to negotiate for a simple 1x non-participating Liquidation Preference. That protects the investor, but if the company does well everybody benefits based on their share holdings.

The only exception to this is, if you have a complex cap table and raised a lot of prior rounds. Think of Series C, D, E,… Basically a company where there is a huge valuation gap between the early VC investors and the guys who are now supposed to bring-in really big money (Maybe high tens or even hundreds of millions of dollars). Here the potential for making multiples on your investment is just so dependent on market sentiment, the economy and other factors.

To somewhat de-risk such a substantial investment, it might be reasonable to discuss additional guaranteed return components such as multiples on investment amounts. That way a late stage investor can be assured of a decent return even if increasing valuations get more and more difficult ahead of what likely has to be an IPO. The other VCs and the founders will still make a handsome return as long as the company doesn’t have to sell at a huge loss or goes bankrupt.

Shareholder Voting Dynamics and Impact on Future Fund-raises.


Liquidation Preference fixes but also creates some of the main shareholder incentive asymmetries. As such every scenario analysis in regards to this topic should have voting rights in mind. And that of course does not only relate to actual shareholding percentages, but also tag-along, drag-along and veto rights.

As more investors join the table, keep in mind who profits under what scenario and who might be in favor of what kind of exit drag along scenario. You don’t want to create a situation where investors get multiples on their investment with a low valuation and get to drag you at a low valuation threshold. The cheaper the price, a buyer might even be willing to clash with founders.

Conclusion


The infamous Liquidation Preference clause is a reasonable tool to align share holder interests and protect investors from loosing in less than favorable exits. That is however only true for the classic 1x non-participating Liquidation Preference. With a few minor adjustments, Liquidation Preferences can become so aggressive your investors are basically stealing your company under your feet. Modeling-out scenarios rarely is as important as in the case of trying to understand Liquidation Preference terms and should always have voting powers in mind.

Disclaimer
This guide is not intended to and does not constitute legal or tax advice, recommendations, mediation or counseling under any circumstance. This guide and your use thereof does not create an attorney-client relationship with Startupvaluationschool.com or Ed.Pres Limited. The guide solely represents the thoughts of the author and is neither endorsed by nor does it necessarily reflect Ed.Pres Limited’s belief. Ed.Pres Limited does not warrant or guarantee the accurateness, completeness, adequacy or currency of the information in the guide. You should seek the advice of a competent attorney or accountant licensed to practice in your jurisdiction for advice on your particular problem.