May 23, 2024
By Luciana Jhon Urrunaga, Esq. and Anibal Manzano, Esq.
This is post #5 in our Term Sheet series for venture capital equity financings. Find our previous posts here.
Investors typically invest in companies via preferred shares because it gives them the ability to tie certain rights and privileges to their shares; one of these key privileges being the liquidation preference. The liquidation preference dictates the order and amount investors get paid at the time of an exit (if the company is sold, liquidated, dissolved, or wound down) and allows preferred shareholders to recoup their investment before any money is distributed to the common shareholders (typically the founders and company employees). Still, preferred shareholders don’t rank equal to company creditors, who are senior to all shareholders (including preferred shareholders). While liquidation preferences should be about protecting the investor’s downside given the high risk of investing in early-stage companies, founders must be cautious of certain types of liquidation preferences that can leave them with very little upside in the event of an exit.
Liquidation preferences are expressed as multiples of the purchase price (i.e., 1x, 2x, etc.). For example, with a 1x liquidation preference, if an investor invested $1 million Dollars into your company, they must receive at least that amount that in the event of an exit. A 1x liquidation preference is standard—included in over 97% of Series Seed through Series C financings since 2016—but the multiple may increase based on market conditions and the economic situation of the company to 2x, 3x, etc. There are two types of liquidation preferences: participating and non-participating.
When negotiating liquidation preferences, the company and the investor must also determine the seniority structure of the payouts. That is, the payout order in the event of an exit among the preferred shareholders themselves. Typically, liquidation preferences are paid in order from the latest investment round to the earliest, that is, Series B investors would be paid back their full liquidation preference before Series A investors received anything. The parties can also elect a pari passu (equal footing) approach, where the preferred shareholders across all financings are given the same seniority status to share the proceeds of the exit. In cases where the exit amount is less than the amount needed to cover all investors, investors will share proceeds pro rata to capital committed. Alternatively, investors from different financings can be grouped together and placed into tiered seniority levels.
With a non-participating liquidation preference, the investor has the right to recoup their capital before the common shareholders get anything. However, they will have to choose between receiving (a) their original investment amount back OR (b) a proportion of the proceeds of the sale based on their equity ownership of the company assuming the preferred stock is converted into common stock as of immediately prior to the liquidity event (on an “as-converted basis”).
An investor will, of course, choose the option that yields them the highest return. For examepl, if an investor invested $1 million in exchange for 10% of a company with a $9 million pre-money valuation. This would imply a post-money valuation of $10 million. Below is a scenario where the company is sold for $5 million, and the investor has a non-participating liquidation right.
- Investor Return if Liquidation Preference is Elected: $1 million
- Amount left for the Common Shareholders: $4 million
- Investor Return if Participating on As-Converted Basis: $500,000
- Amount left for the Common Shareholders: $4.5 million
In scenario 1, the investor will choose to receive a return on their original investment without converting to common stock, the greater amount due to the sale being at such a low valuation. Now let’s consider a scenario where the company is sold for $20 million.
- Investor Return if Liquidation Preference is elected: $1 million
- Amount left for the Common Shareholders: $19 million
- Investor Return if Participating on As-Converted Basis: $2 million
- Amount left for the Common Shareholders: $18 million
In this case, it will benefit the investor most to participate in the upside and choose to be paid out on an as-converted to common stock basis.
With a participating liquidation preference, investors will receive both (a) their original investment amount AND (b) a proportion of the proceeds of the sale based on their equity ownership of the company on an as-converted basis. This is often referred to as “double dipping” because you dip in to recoup your investment and then again to receive your ownership share of the remaining proceeds. Let’s revisit our previous scenarios applying a participating liquidation preference to them.
- Investor Return on Original Investment: $1 million
- Investor Return on As-Converted Basis: $400,000
- Total Investor Return: $1.4 million
- Amount left for the Common Shareholders: $3.6 million
- Investor Return on Original Investment: $1 million
- Investor Return on As-Converted Basis: $1.9 million
- Total Investor Return: $2.9 million
- Amount left for the Common Shareholders: $17.1 million
As you can see, a participating liquidation preference can allow an investor to profit even if the company is sold at a loss. Although the difference may not seem too drastic when projecting a sale in the tens of millions, it can have a huge impact on common shareholders if the company is sold for a smaller amount of money as investors can walk away with the majority of the exit value. If an investor insists on a participating liquidation preference, a founder should propose a cap on participation that limits the amount received by the preferred shareholders to a fixed amount, often a multiple of the original investment amount. Once the cap is reached, the remaining proceeds are distributed solely among the common shareholders.
While liquidation preferences are viewed as fair to investors and companies by many practitioners because they give protection in priority (relative to founders and other service providers) to the company’s cash investors, it is important to understand the implications that certain types of liquidation preferences can have on your company and its common shareholders. Each time a company fundraises through the issuance of preferred shares, the common shareholders ownership interests are diluted. This — coupled with the additional dilution afforded by a participating liquidation preference (especially one with no cap) — can leave common shareholders with little to no proceeds in an exit. Additionally, because each subsequent financing round requires the negotiation of a liquidation preference, if a company affords a liquidation preference that is extremely investor friendly during an early financing, it is important to consider the impact on the company’s future negotiating power in subsequent financings, as new investors will likely demand similar or better terms than previous investors. Overall, although some terms may seem unfair in certain circumstances, they can be appropriate and balanced in many others, which is why it is important to rely on experienced counsel.
Anibal Manzano is a corporate lawyer who specializes in venture capital and startup law, mergers and acquisitions, and cross-border transactions connected to the United States and Latin America. He is based in Boca Raton, Florida and regularly represents startups and investors in connection with venture capital financing transactions and related corporate and securities matters.
anibal@manzano.law
Mobile: (561) 440-8242
