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Liquidation preference and what it means when investing in startups

Angel investing in startups represents an opportunity to diversify your investment portfolio and create the potential for high returns. However, in startup funding, it is critical to manage your risk and protect your capital – this is an area where liquidation preference is vitally important. Many venture capital investors consider liquidation preference second in importance only to the valuation of a startup.

So, what is a liquidation preference?

Let us start with a simple definition of liquidation preference – precisely as the name suggests,  it is when an investor is assigned preferential treatment in a liquidation event, compared to other parties who also have a stake in the startup. It means an investor who holds preferred stock with a liquidation preference has the right to receive funds before common stockholders, which often includes the founders and employees of the startup. If the startup does not succeed and a liquidation event occurs that achieves a lower-than-expected return, those with a liquidation preference are first in line to receive a payment. The detailed explanation is complex, and the specific application depends on several factors, as outlined below.

Why is a liquidation preference significant?

It can potentially limit the downside risk for investors who hold the preferred stock if the startup is not successful. It can give the investor some peace of mind knowing their place in the repayment queue. It is certainly no guarantee of getting all or even some of your investment back. Still, it does give you a preference or priority when the company’s assets are being distributed in a liquidation event.

It is essential to know that liquidation preferences are given to holders of preferred stock. Common stockholders do not receive liquidation preferences, making them last in the queue for repayment in a liquidation event. However, there are other creditors that must be paid before preferred stockholders in the event of a liquidation.

Types of liquidation events 

The term liquidation is often associated with bankruptcy, however, the term liquidation means bringing the operation of a corporate entity to an end and distributing the corporate assets to those with a legitimate claim against the business in order of claim priority. A company merger, acquisition, or outright sale are all examples of liquidation events. 

Multiples in liquidation preference 

Liquidation preferences are usually assigned as a multiple of the original investment. 

A 1X liquidation preference is most common and is generally considered an appropriate balance between managing investor downside risk without imposing overly onerous financing conditions on the startup. 

A multiple greater than 1X, such as 2X or 3X liquidation preference, may be used in some financing rounds but is less common than 1X. Depending on specific circumstances, extreme liquidation preferences as high as 10X can be offered on occasion, for example, perhaps with a convertible note. 

Investors and founders need to keep in mind that high multiple liquidation preferences can be a barrier to subsequent funding rounds because later investors are likely to seek similar terms, or they may recognize the potential impact it could have on their returns. High liquidation preferences can also negatively affect the potential for common stockholders to achieve a fair return in a liquidation event.

We will work through some examples later of how these multiples work in liquidation preference.

Non-participating liquidation preference vs. Participating liquidation preference

A “Non-participating liquidation preference” means that in a liquidation event, the investor can usually choose one of the following options at the time of liquidation:

  • If the investor’s share of the company valuation is less than the value of their liquidation preference, they can choose to receive their liquidation preference. 
  • Suppose the investor’s share of the company valuation is greater than the value of their liquidation preference. In that case, they can choose to convert their preferred stock to common stock and receive their share of the total company valuation.

With a “Participating liquidation preference,” the investor has the same options as shown above, but they can also participate in potentials upside. Also known as double-dipping, this means that the investor first receives their liquidation preference and then also receives their share of the remaining company value on a pro-rata basis with other stockholders.

Again, examples of non-participating and participating liquidation preferences are provided below.

Capped liquidation preference

A capped liquidation preference limits the amount s an investor can be paid on preferred stock, which benefits the company by increasing the potential return for common stockholders if the start-up performs well. 

Seniority

Seniority is an essential consideration in any investment – it refers to the order in which investors in different capital rounds are paid, as follows:

  • Pari Passu (from the Latin for “equal footing”) means that investors in all capital rounds have equal seniority, where all investors are paid in proportion to how much they have invested.
  • Standard seniority means that liquidation preferences are paid in preferential order of last money in – first money out, i.e., a Series B round investor would be paid before a Series A round investor, who would be paid before a Series Seed investor.

You should understand your order in the payment queue relative to investors in other funding rounds.

How liquidation preferences work 

The importance of the above points is best illustrated by a worked example showing potential returns for different liquidation preference scenarios.

Say a startup was seeking funding by raising capital, and before the raise (“pre-money”), it had $1.5m. And let us assume that they set out to raise $500k, all taken up by a single investor. This means the valuation after the raise (“post-money”) would be $2m, and the new investor would own 25% of the company in preferred stock. For this example, let us assume that there is no debt and no other preferred stockholders, so the remaining 75% of the company would be owned by common stockholders. 

The tables below show examples of potential returns for the investor holding preferred stock with various multiples’ liquidation preferences for both Non-participating and Participating liquidation preferences. Also shown are the potential returns for holders of common stock, i.e., what remains for them after the preferred stockholders are paid. The examples consider scenarios for the company valuation at the liquidation event being below, at, and above the post-money valuation. These samples are for illustrative purposes only and should not be used to gauge future returns.

It is important to note that in Non-Participating Preferred Stock, the preferred shareholders will choose to convert to common when their 25% ownership is worth more than their liquidation preference. This is indicated in the below example in cells colored green.

Reasons to consider not using liquidation preferences

Liquidation preferences are an important way for founders to attract investment because it can help investors protect their capital in case of an unfavorable exit. However, it can be a powerful tool that, if misused, can favor investors too heavily when multiples and participation are offered. This can adversely affect future funding rounds by raising concern among prospective investors and can disincentivize the founders by not leaving enough money on the table for them in a good exit. 

In short, liquidation preferences are helpful to potentially limit investor downside risk but can be problematic when used to create potential upside benefit for some investors at the expense of common stockholders. For this reason, a simple 1x non-participating liquidation preference can often be the most appropriate choice because it protects the investor’s capital but also rewards holders of common stock if the company succeeds.

Reasons to consider using liquidation preferences

Many angel investors consider it to be one of the most important factors when evaluating startups. As a founder seeking capital, it is important to provide what investors are looking for, which means offering liquidation preference could make the difference between a successful capital raise and an empty bank account.

Liquidation preference is popular with investors because it potentially protects their capital and defines their place in the payment queue in a liquidation event.

Summary

The sample investment returns shown above vary greatly depending on the type and multiple of the liquidation preferences, as well as many other factors, demonstrating how important it is for investors to have a good understanding of liquidation preferences and the impact they can have on their investment. Investors should also keep in mind the many other factors that can affect their returns, such as the current market conditions, how well the startup is run, can they bring their product or service to market and is there even a market for the product. Liquidation preference is just one of the many factors that an investor should consider before making a decision. 

If you would like to learn more about Angel Investing, you can check out this helpful article, and you can also check out the Propel(x) blog if you’d like to learn more about investing in startups.

 

READ MORE:  Preferred Stock vs. Common Stock in Startups

Private Placements are a high-risk investment, and an investor could experience an entire loss of principal.  Private investments are highly illiquid and risky and are not suitable for all investors. Investments in early-stage private companies should only be part of your overall investment portfolio.

Past Performance is not a guarantee of future performance. There is no guarantee that any exit strategy will come to pass and there is no guarantee that an investment will be profitable.

 

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