What You Need to Know About Liquidation Preferences
If your business has an investor, or if you’re considering working with venture capitalists (VC), then one term that you need to familiarize yourself with is “liquidation preferences,” which indicates who gets paid when your company enters liquidation and the payment order when dissolving assets. It is meant to protect investors in the event that a company exits at a lower value than initially expected.
A liquidation preference acts as a guide for the distribution of a company’s assets in the event of a liquidation. It is a common occurrence in investment agreements involving venture capitalists to indicate the order of priority when paying investors, and the amount they should be paid after the sale of the company or some other liquidation event. Investors typically demand liquidation preference over the founders and other common shareholders in order to protect their investment and ensure that they don’t lose money.
With liquidation preferences, investors (preferred shareholders) are assured of getting back at least 100% of what they put in before other shareholders (founders and employees) get any payments from the sale of assets. So, if the liquidation doesn’t cover 100% of the VC investment, the founders won’t get paid anything from the liquidation. Liquidation preferences are only attached to shareholders with preferred shares, which are generally issued to investors during financing rounds, whether early-stage investments or subsequent rounds of investment. As such, a liquidation preference only comes into play when the company exits through a merger and acquisition or decides to sell off its assets following recapitalization or bankruptcy.
What constitutes a liquidation event?
A liquidation preference is considered irrelevant during public exits because an initial public offering (IPO) typically automatically turns all preferred shareholders into ordinary shareholders.
That said, a liquidation event does not always have to be brought about by a problem such as bankruptcy or company closure. For companies that are based on venture capital, a liquidity event may also constitute:
- A merger
- Company shares acquisition
- Acquisition of a substantial amount of the company’s assets
- Transfer or change of company control
Other similar events that are indicated in the company’s official documents, such as investment agreements or the Articles of Association, can also lead to a liquidation event. This refers to any event whereby the company shareholders hold a small fraction of the remaining shares of what’s left of the company.
In a good number of VC investment agreements, selling a business is considered a liquidation event. If the sale is profitable, then the liquidation preference can help the VCs receive the first share of the returns. On the other hand, if the sale is at a loss, then the same liquidation preference will allow for the VC investors to be awarded a larger proportion of the revenue, regardless of loss made.
Key Features of a Liquidation Preference
Here are the main features of a liquidation preference:
This indicates the amount that preferred investors must be reimbursed before other shareholders can start receiving any proceeds of their own. For instance, a 1x liquidation preference implies that an investor who has put in $1 million in the company must be repaid the $1 million in full before any common shareholders can receive anything from the liquidation. So, if a company sells for $2 million, then you’re assured of receiving at least $1 million irrespective of your equity ownership. Conversely, if the business sells for $0.9 million, then you get all the proceeds because the liquidation preference guaranteed you $1 million. Multiples are usually in the range of 1-2x to have the least value of returns obligated to an investor.
Participating versus non-participating
For non-participating liquidation preferences, the investor can choose to either exercise his or her liquidation preference or take the preferred shares and convert them into common equivalent shares (the percentage of equity ownership is derived) and use this measure to obtain a share of the returns.
For a $1 million investment with a 1x non-participating type liquidation preference in exchange for 15% equity ownership, and the business is sold for $1.5 million, the investor will have two options for payment:
- Apply the liquidation preference to get back the guaranteed $1 million, or
- Convert your preferred shares for $225,000 (15% of $1.5M).
The first option is obviously the more rational choice for a much higher payout. For the investor to be indifferent about the choice of investment, the exit value must be at nearly $7 million, where the payout will be equal with either option. This is the “conversion threshold.”
A participating liquidation preference is different in that the investor will receive additional “participation”—even after being paid back their liquidation preference—in the extra proceeds depending on their ownership.
So, for a $1 million investment with a 1x participating type liquidation preference in exchange for 15% equity ownership, and the business sells for $1.5 million, the investor will get back the guaranteed $1 million, plus 15% of $0.5M (remaining proceeds), which is $70,000, or a total payment of $1.075 million.
Obviously, participating in liquidation preferences generates a higher exit amount for investors, which puts the founder at a disadvantage.
For companies with two or more investors, a seniority structure should be provided, so they know their rank during payouts. The ranks include:
- Standard seniority: Liquidation preference payments are made in order, starting with the most recent one to the first round. As such, Series B VCs must receive their full payout before seed investors. This is the most common structure because the initial investors rely on new investors to keep the business going.
- Pari Passu: Liquidation preference payouts are made equally across all stages of investment, as investors have the same seniority level. If the proceeds are not equal to pay all investors, then they are shared pro-rata to capital invested.
- Tiered: With this arrangement, investors are split into tiered seniority levels depending on the round of investment, such that Series G to E investors share the highest seniority level while Series A to C are in the lowest tier. The middle tier comprises Series D investors.
If liquidation preferences are meant to protect the investors, then caps are used to protect founders who find themselves in participating in liquidation preferences. Caps limit the amount of payout to a typical maximum of 3x their investment. As such, an investor providing $1M capital with 1x partaking liquidation preference on a 3x cap should receive a maximum of $3M in total proceeds (this is the $1M liquidation preference + participation of $2M) if they don’t want to convert.
For investors who provide companies with capital—-whether as startups or running businesses—-a liquidation preference can allow investors to claim their investment in the event of a liquidation. Keep in mind that experienced investors usually don’t want to be part of a business that has multiple liquidation preferences because it means the common shareholders’ equity might be too little to motivate them.
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