Funding your startup — a founder’s guide to liquidation preferences
Liquidation preferences are a key negotiating point with potential investors during fundraising and can significantly impact your earnings upon a successful exit. To negotiate well, a founder needs to understand why investors request these terms, and how they behave in different exit scenarios.
When a VC invests in a startup they are placing a bet. This bet may earn them nothing or the startup could turn out to be the next Facebook or Google. But what about when the outcome is small? Not a complete failure but not a large success either. Ordinarily the VC would get little or no money back. Any proceeds from the deal would be shared with the common shareholders and dilute the investor’s take. To optimize their outcome in this low-exit scenario, an investor will negotiate for their preferred stock to have liquidation preferences.
Let’s look at an example negotiation and see what’s at stake here…
A seed stage startup, Liquid Dynamics is raising a series A financing which will grant 50% ownership of their company to Star Hill ventures. With no liquidation preferences, both the investors and the existing stockholders will each take a 50:50 share of any future outcome, at any valuation.
However, Star Hill ventures are negotiating for their preferred stock to have a 1x preference with uncapped participation. To make investing in Liquid Dynamics more attractive, particularly in the case of a small exit they want to get their $2M back first, and additionally take their 50% share of the remaining money above $2M.
Illustrated below, these terms mean that a share of preferred stock will always give a better payout than a share of common stock — the venture firm’s initial payout always keeps them $2M ahead of the other stockholders in total proceeds.
Liquid Dynamics meets with their advisors and they develop a counter-offer, requesting non-participating terms.
In the above case, we see that the investors will still get their $2M investment back first, however they do not earn any further proceeds until the exit valuation is high enough at $4M to make converting to common the better option. This counter-offer does not give them the right to participate past their initial $2M preference, hence the term ‘non-participating’.
Exit range 1 stretches between $0 and $2M. In this phase the investors have a 1x liquidation preference and receive every dollar of the proceeds up until $2M — their investment has been returned.
Exit range 2 covers $2M to $4M. Here the investors do not participate and common stockholders receive 100% of any earnings greater than $2M. Note that for any exit valuation in this range between $2M and $4M the outcome for Star Hill is identical — there is no difference to their earnings.
Exit range 3 begins at $4M. At this point it makes economic sense for preferred to convert to common and earn a 50% share of all proceeds. At any value lower than $4M it made economic sense for the investor not to convert and take their still greater than 50% share.
The VCs at Star Hill consider this counter-offer and come back with a compromise deal. For this investment to be attractive, they require more protection across a greater range of low exits. They are asking for participation with a 2x cap.
This adds complexity to the model, as the relative values of the preferred and common stock now change through four distinct phases as exits increase.
Exit range 1 spans $0 to $2M. In this phase the investors have a 1x liquidation preference and receive every dollar of the proceeds up until $2M — they get their money back and nobody else gets a share.
Exit range 2 covers $2M to $6M. Here the investors are also participating alongside Liquid Dynamics and receive 50% of all new earnings. Note that again Star Hill appears to be doing far better than the common stockholders because their earnings include the $2M head start earned in exit range 1.
Exit range 3 begins when the investors hit their $4M (2x) cap and are prohibited from earning any more than 2x their original investment. From $6M upwards the common stockholders are therefore allocated 100% of all new proceeds. NOTE: this phase has been called ‘the dead zone’ as there is effectively no economic difference for Star Hill between an exit of $6M and an exit of $8M where they convert to common.
Exit range 4 is triggered when Star Hill will do better by converting their preferred stock to common and taking a 50% share based on their 50% ownership of Liquid Dynamics. For all values from $8M onwards both the investors and the existing common stockholders will share 50% of all proceeds.
Liquid Dynamics agrees to these terms. They are more attractive than Star Hill’s initial offer of 1x preference, participating, and only affect the outcome if the exit is at $8M or lower. It’s worth noting that the small exit scenario is far more common than the large exit scenario. Despite their hard work and talents many founders end up in situations where liquidation preferences really do matter.
In summary, the 2 most important attributes of the liquidation preference terms are the preference and the participation. The preference controls the proceeds that are paid to the investor before they are required to share, the participation controls how any subsequent sharing happens. We also saw the impact a participation cap can have on limiting the advantage of preferred stock, and how preferredconverts to common stock for exit amounts where common is more valuable.
If you are curious how liquidation preferences apply to your own startup, create an account on LTSE Equity and explore a range of scenarios with our visual, round modeling feature.
The information contained above is provided for informational and educational purposes only, and nothing contained herein should be construed as investment advice, either on behalf of a particular security or an overall investment strategy. Information about the company is provided by the company, or comes from the companies’ public filings and is not independently verified by LTSE. Neither LTSE nor any of its affiliates makes any recommendation to buy or sell any security or any representation about the financial condition of any company. Statements regarding LTSE-listed companies are not guarantees of future performance. Actual results may differ materially from those expressed or implied. Past performance is not indicative of future results. Investors should undertake their own due diligence and carefully evaluate companies before investing. Advice from a securities professional is strongly advised.
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