What is liquidation preference? | LTSE Equity

Liquidation preference outlines the priority of payment and details the amount of money that investors will receive before other shareholders. Essentially, it is a way for investors to protect their investments and ensure they get paid first if a company goes bankrupt or is sold. 

The liquidation preference can significantly impact the return on investment and the overall value of a startup, making it an essential term to understand for both investors and founders.

Additionally, liquidation preference can impact the decision-making process of both investors and founders. As a result, negotiation of liquidation preferences can often be a key part of investment agreements, with both parties looking to balance the potential benefits and drawbacks.

Liquidation preference for startups

A crucial aspect of any startup or investment is understanding financing terms. One term that is particularly important to understand is liquidation preference. 

Liquidation preference is a provision in investment agreements that outlines how a startup will distribute its sale or liquidation proceeds among its investors. This term is especially significant for early-stage startups that may be seeking funding from venture capitalists or angel investors.

For startups, understanding and negotiating liquidation preferences is critical to ensure the long-term success of the company. While liquidation preferences can offer investors a level of protection, they can also reduce the flexibility and control of founders, potentially limiting the startup's ability to innovate and adapt to changing market conditions. 

Therefore, founders must carefully consider the potential impact of liquidation preferences on the company's valuation and overall financial health. Additionally, founders should seek professional advice to ensure that they negotiate terms that are fair and equitable for all parties involved, while still protecting the interests of the startup. 

Ultimately, understanding and negotiating liquidation preferences is an essential step in securing funding and building a successful startup.

Why liquidation preference matters for investors and founders

Understanding liquidation preference is essential for both investors and founders, as it can significantly impact the return on investment and the overall value of a startup. 

Liquidation preference for investors

• Liquidation preference can provide a level of protection for their investment, as they are guaranteed to receive a certain amount of their investment back before other shareholders. 
• This makes investing in a startup less risky, as it provides a safety net in the event of a liquidation or sale. 
• The type of liquidation preference can impact the potential return on investment, with participating preferred stock offering a potentially higher returns compared to non-participating preferred stock.

Liquidation preference for founders

• Liquidation preference can have both advantages and disadvantages. 
• On one hand, it can make a startup more attractive to investors by offering a level of security for their investment. 
• However, it can also limit the flexibility and control of founders, as they may be required to prioritize the payment of investors over other shareholders. 
• This potentially limits their ability to make decisions in the best interest of the company.

Liquidation preference impact

• The inclusion of a liquidation preference can impact the overall valuation of a startup. 
• Investors may demand a higher return on investment if they’re taking on more risk, potentially lowering the valuation of the startup. 
• This can make negotiating fair and equitable liquidation preferences a critical aspect of investment agreements for both investors and founders.

Types of liquidation preferences

There are different types of liquidation preferences that investors can negotiate with startups. The four main types of liquidation preferences are:

A. Participating preferred stock 

Participating preferred stock is a type of liquidation preference that provides investors with greater protection than non-participating preferred stock. In addition to receiving their initial investment amount, investors with participating preferred stock have the right to receive a percentage of any remaining proceeds after other shareholders have been paid.

For example, let's say an investor has $1 million in participating preferred stock in a startup that is sold for $10 million. The liquidation preference states that the investor is entitled to receive their initial investment amount of $1 million plus 20% of the remaining $9 million, which amounts to $1.8 million. In this scenario, the investor would receive a total of $2.8 million, while other shareholders would receive the remaining $7.2 million.

So, the investor gets their investment amount and a share of the remaining profits.

B. Non-participating preferred stock

Non-participating preferred stock is another type of liquidation preference that provides investors with protection in the event of a startup's liquidation or sale. Unlike participating preferred stock, investors with non-participating preferred stock are entitled to receive either their initial investment amount or a percentage of the proceeds, whichever is higher. If the proceeds are less than the initial investment amount, the investor will receive the full amount.

For example, let's say an investor has $1 million in non-participating preferred stock in a startup that is sold for $10 million. The liquidation preference states that the investor is entitled to receive either their initial investment amount of $1 million or a percentage of the proceeds, whichever is higher. In this scenario, the investor would receive their full investment amount of $1 million, as it is higher than their share of the proceeds.

C. Cumulative preferred stock

Cumulative preferred stock ensures that investors receive their dividends, even if the company hasn’t made a profit in a given year. This means that if the company doesn’t make a profit, the unpaid dividends will accumulate and be paid to investors before any other shareholders receive their share of the proceeds.

D. Convertible preferred stock

Convertible preferred stock is a hybrid form of preferred stock that combines features of both debt and equity. This type of stock can provide investors with the opportunity to convert their shares into common stock at a later, specified time—usually when the company goes public. This can be beneficial if the company is successful and the stock price increases; the investor could receive higher returns. However, the conversion is not always automatic, and the investor may need to meet certain conditions before converting their shares.

For founders, offering convertible preferred stock can be an attractive option for raising capital because it can provide investors with the potential for higher returns, which can help attract more investment. It can also provide some flexibility in structuring the terms of the investment. 

However, it's important for founders to carefully consider the potential dilution of their ownership and control over the company when offering convertible preferred stock.

Understanding the different types of liquidation preferences is essential for both investors and founders. It’s important to carefully consider which type of preference is appropriate for the investment and negotiate the terms accordingly.

Participating vs non-participating liquidation preferences

Participating liquidation preferences are investment agreements that enable investors to both receive their liquidation preference and participate in liquidation events with remaining proceeds. 

The potential for additional returns through participating liquidation preferences can be attractive to investors, as it allows them to benefit from the success of the company beyond their initial investment. However, for founders, this can be a disadvantage as it reduces the amount of proceeds available for distribution to common shareholders.

On the other hand, non-participating liquidation preferences allow investors to receive their liquidation preference only. Any further proceeds from the liquidation event are unattainable.

Non-participating liquidation preferences are often used when investors are only interested in protecting their initial investment and are not looking for additional returns. This type of preference is less favorable for investors, but it may be more favorable for the company's founders, as it allows them to retain a larger percentage of the remaining proceeds.

What is preferred stock liquidation preference?

A preferred stock liquidation preference serves as “downside protection” for investors. If a company is sold or otherwise liquidated for a low price, then having a liquidation preference means that the preferred stock investors have a right to be paid back out of any proceeds that are available, up to the preference amount, before anyone else is entitled to receive any payments. 

However, in a successful exit scenario, the conversion right, another feature of preferred stock, allows preferred stock investors to convert their preferred stock shares into common stock shares if the payment the investors would receive as holders of the common stock exceeds the preference amount of the preferred stock.

What is liquidation preference multiple?

Liquidation preference multiples refer to the multiple (x) that will be applied to a specific investor's investment. This in turn determines how much they are entitled to receive in a liquidation event before common shareholders receive any proceeds. 

How do liquidation preferences work

When a company is sold or liquidated, the distribution of proceeds follows the liquidation preference that has been agreed upon in the investment agreement. Here's how it works:

Liquidation preference example 

Let's say that a startup raises $10 million from investors, with a liquidation preference of 1x participating preferred stock. The company was then sold for $20 million.

A. Liquidation preference calculation

The 1x liquidation preference means that the investors will receive their initial investment amount of $10 million before any other shareholders receive any proceeds. 

Additionally, participating preferred stock means that the investors are entitled to a percentage of the remaining proceeds after their initial investment is paid back. In this case, the remaining proceeds are $10 million. Let's say that the agreed percentage is 20%. This means that the investors will receive an additional $2 million (20% of $10 million) on top of their initial investment of $10 million.

B. Distribution of proceeds

After the liquidation preference is paid out, the remaining proceeds are distributed among the other shareholders based on their ownership percentage. In this scenario, if the company had 1 million outstanding shares and the investors owned 5 million shares, they would receive $12 million ($10 million initial investment + $2 million participation) and the remaining $8 million would be distributed among the other shareholders based on their ownership percentage.

Overall, liquidation preferences protect the investment of early-stage investors and ensure that they receive their investment back before other shareholders. 

Advantages and disadvantages of liquidation preferences

Liquidation preferences have advantages and disadvantages for investors and founders. Here's a breakdown:

A. Advantages for investors:

1. Protection of investment: Liquidation preferences offer investors a level of protection for their investment, ensuring that they receive their money back first in the event of a company sale or liquidation.
2. Potential for higher returns: Depending on the type of liquidation preference, investors have the potential to receive higher returns than they would with common stock.
3. Attractiveness to investors: Offering a liquidation preference can be attractive to investors as it offers a layer of protection for their investment.

B. Disadvantages for investors: 

Reduced potential return on investment: In the case of participating preferred stock, investors may receive a higher return on investment, but this can also impact the valuation of the startup, potentially reducing the overall return. Furthermore, if the liquidation preference is too high, it can limit the flexibility of the startup, potentially hindering its ability to innovate and grow.

1. Difficult for investors to exit their investments: If the liquidation preference is high and the company is struggling, it may be difficult for investors to sell their shares, potentially leading to a loss.
2. Impact the potential for future investments: If investors demand a high liquidation preference, it can make it more difficult for the startup to secure future funding, as new investors may be reluctant to invest in a company where previous investors have priority over the distribution of proceeds.

C. Advantages for founders:

1. Attract more investment: For example, by offering preferred stock with a liquidation preference, founders could attract more investment from risk-averse investors who are looking for some protection in the event of a company's failure. This can be particularly helpful for startups that are still in the early stages of development and may have limited resources or revenue.
2. Maintain more control over the company: For example, founders may be able to negotiate a lower liquidation preference for investors in exchange for greater voting rights or control over key decisions. This can help ensure that the company's vision and mission are maintained, even if investors have a significant stake in the company.

D. Disadvantages for founders:

1. Reduced ownership: Offering liquidation preferences can dilute founders’ ownership percentage and other common shareholders.
2. Limited flexibility: Liquidation preferences can limit founders’ certain business decision-making flexibility as they need to prioritize the interests of investors with liquidation preferences.
3. Increased pressure: Offering liquidation preferences can increase the pressure on founders to meet certain goals and milestones in order to achieve a successful exit.

D. Potential impact on startup valuations:

1. Lower valuations: Offering liquidation preferences can result in a lower valuation for a startup, as investors will demand a higher return on their investment.
2. Attractive to investors: On the other hand, offering liquidation preferences can be attractive to investors and help attract funding.

Overall, liquidation preferences can be a useful tool for both investors and founders in financing a startup. However, it is important to carefully consider the advantages and disadvantages of each type of liquidation preference and negotiate the terms accordingly to ensure a fair distribution of proceeds.

Negotiating liquidation preferences

When negotiating liquidation preferences, both investors and founders should consider several factors to ensure a fair and equitable agreement. Here are some factors to consider:

A. Factors to consider

1. Company stage: Early-stage startups may have a higher risk of failure, which may make investors demand higher liquidation preferences.
2. Market conditions: In a competitive market, investors may have more bargaining power and could negotiate more favorable terms.
3. Valuation: The higher the company's valuation, the less favorable the liquidation preferences may be for investors.
4. Exit strategy: The likelihood and potential returns of a successful exit may influence the negotiation of liquidation preferences.

B. Tactics for negotiation

1. Offer multiple options: Founders can offer multiple liquidation preference options to investors, such as a choice between participating and non-participating preferred stock.
2. Seek expert advice: Founders can seek advice from lawyers, investment bankers, or other professionals to help negotiate favorable terms.
3. Consider other terms: Liquidation preferences are just one part of an overall investment agreement. Founders can negotiate other terms, such as board composition or information rights, to balance the interests of investors and founders.
4. Be willing to walk away: Founders should be willing to walk away from a deal if the liquidation preferences are too onerous or detrimental to the long-term success of the company.

Overall, negotiating liquidation preferences requires careful consideration and a willingness to balance the interests of both investors and founders. Founders can use various tactics to negotiate favorable terms while also protecting the long-term interests of the company.

What is the preference amount?

The specified amount is called the “preference amount,” while the order the stockholder will receive payment is called the “payment priority.” The preference amount is usually expressed as a multiple of the original price per preferred stock share, which means that investors with a higher preference amount will receive a larger portion of the proceeds. 

The preference amount is a critical component of the liquidation preference and can have a significant impact on the distribution of proceeds in the event of a company's liquidation or sale. 

The preference amount can vary depending on the type of liquidation preference and the negotiation between the founders and investors. For example, a participating preferred stock typically has a higher preference amount than non-participating preferred stock, as investors with participating preferred stock are entitled to a percentage of the remaining proceeds after other shareholders have been paid.

When market conditions are good, liquidation preference multiples for preferred stock sold in venture capital financings are typically one-time (1x) the original price per share. When market conditions deteriorate, or if a particular company is facing headwinds or is perceived as a riskier investment, you can expect to see higher liquidation preference multiples.

What is the preference stack?

A preference stack (also referred to as seniority structure or liquidation preference stack) establishes the order in which shareholders receive payouts should a liquidation event occur (e.g., acquisitions, bankruptcy, mergers). 

There are three common structures of preference stacks.

• Standard: Should a liquidation event occur, preferred shareholders are paid before common shareholders. Preferred shareholders will receive proceeds before common shareholders. 
• Tiered: In tiered preference stacks, there are various classes of preferred shareholders; each possessing different liquidation preferences. The top tier is paid first in full, and the next tier will receive the remaining proceeds after that, and so on.
• Pari pasu: All shareholders are treated as equals. No one class of shareholder is given any priority or preference as everyone receives the same percentage of proceeds.

Liquidation preference: Key takeaways

In conclusion, liquidation preferences are an important aspect of investment agreements that impact the distribution of proceeds in a sale or liquidation event. Here are some key points to recap:

• Liquidation preferences provide investors with a level of protection for their investment and can offer the potential for higher returns, depending on the type of preference.
• Founders may experience disadvantages such as reduced ownership, limited flexibility, and increased pressure when offering liquidation preferences.
• Liquidation preferences can impact the valuation of a startup, with some investors demanding a higher return on their investment, potentially lowering the startup's overall valuation.
• Negotiating liquidation preferences requires careful consideration of various factors, such as company stage, market conditions, and exit strategy, and can involve tactics such as offering multiple options and seeking expert advice.
• Seeking professional advice from lawyers, investment bankers, or other professionals can be essential in negotiating fair and equitable liquidation preferences.

Overall, understanding the nature and implications of liquidation preferences is crucial for both investors and founders. By carefully considering the advantages and disadvantages and negotiating terms that balance the interests of both parties, investors and founders can ensure a fair distribution of proceeds and maximize the long-term success of the company.

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Disclaimer: LTSE is neither a law firm nor provides legal advice. Before making decisions on matters covered by this post, readers should consult their legal adviser.