VCs won’t write checks to a startup company unless they are excited by its prospects. However, just because investors are enthusiastic about the company’s future doesn’t mean that they don’t also consider downside protection. This is where liquidation preferences come in. A liquidation preference is the mechanic for prioritizing distributions to a company’s equity holders in a liquidation, merger or sale (referred to below as a liquidation event) after all obligations owed to the company’s creditors have been satisfied. Liquidation preferences are among the key terms included in most preferred stock venture financings. The basic premise is that if there is a shut down or sale transaction, the VC investors holding preferred stock should be at the front of the line to ensure they receive a return of their invested capital (or a multiple of this amount) before funds are paid to the holders of common stock.
Liquidation preferences are structured in a number of different ways – non-participating, fully participating (also referred to as participating) and, participating with a cap. Also, the liquidation preference would provide that the holders get back their investment amount, referred to as 1x return, or a multiple (i.e. 2x or 3x) on their investment. The particular liquidation preference structure, which will be driven by the company’s circumstances and the lead investor’s approach, will be negotiated during the term sheet phase.
Another common feature of preferred stock purchased by VC investors is that the shares of preferred stock will be convertible into shares of common stock any time at the holder’s election. When faced with a liquidation event, the preferred stockholders will determine whether they will receive a better return through the liquidation preference terms of the preferred stock or whether to convert their shares of preferred stock to common stock and receive their pro rata share of the proceeds. Some preferred stock is drafted to automatically provide for the highest payout without the need to convert.
The most basic (and popular) form is a 1x non-participating liquidation preference. This means that in connection with a liquidation event, the holders of the preferred stock will have the right to receive at least the amount of their investment paid to them before any amounts are paid to the holders of common stock. If the amount of cash or other assets available for distribution is less than the aggregate purchase price paid for the preferred stock, then the holders of preferred stockholders would typically receive their pro rata share of the available proceeds and the common stockholders would not receive any proceeds.
Participating preferred stock provides for the payment of a threshold amount of preferred payments (such as the amount of the initial investment or a multiple of the investment), after which the holders of the preferred stock will also share in the remaining assets/proceeds based on their pro rata ownership of the common stock (on an as-converted basis). Participating with a cap works like straight participating preferred stock, however, if the payout would exceed a specified dollar threshold, then the holders of the preferred stock would simply share in the proceeds based on their pro rata ownership of the common stock (on an as-converted basis).
Although fully participating preferred stock will always generate the highest returns to the investors, the problem here is that their excess payouts reduce the proceeds that would otherwise go to management and the employees had there been a different liquidation preference structure in place. Since the management team and other employees will be critical to achieving a successful exit, it’s important to strike an appropriate balance to ensure incentives are properly aligned between the company and the investors. As a result, many VC investors propose a 1x non-participating liquidation preference to achieve this balance. When negotiating the terms of preferred stock with investors, it’s important for founders to clearly understand the implications of the liquidation preference proposed by investors and the alternatives.
