Paying Attention to Liquidation Preference and Its Implications
Published on March 30, 2020
Written by Adrian Li & Gary Khoeng
One of the most important terms every entrepreneur needs to pay attention to from a term sheet is the liquidation preference. This term is especially used to specify who gets paid and how much they get paid during a liquidation event of the company, such as through a sale or Initial Public Offering (IPO).
What is Liquidation Preference?
Based on Brad Feld’s book, Venture Deals, liquidation preference’s language is typically as the following:
“In the event of any liquidation or winding up of the Company, the holders of the Series A Preferred shall be entitled to receive in preference to the holders of the Common Stock a per share amount equal to [X] times the Original Purchase Price plus any declared but unpaid dividends (the Liquidation Preference).”
That is an example of actual preference. Based on that, a certain multiple of the original investment per share is returned to the investor before the common stock receives any consideration. Typically, investors ask for this as a form of protection given the risk of an early stage investment. Most term sheets will include such a term, however the actual multiple (1X, 1.2X, 2X) could be something that is negotiated by the investor.
Before moving forward to understand deeper about liquidation preference, we need to understand first the definition of a liquidation event. According to Venture Deals, liquidation event is a merger, acquisition, sale of voting control, or sale of substantially all of the assets of the Company in which the substantially all of the assets of the Company in which the shareholders of the Company do not own a majority of the outstanding shares of the surviving corporation shall be deemed to be a liquidation.
Different Types of Participation
The next important component of the liquidation preference is participation. There are typically 3 types of participation; full, capped and no participation.
Full participation indicates that the investors will get their liquidation preference first and then have the opportunity to participate pro rata with the common stock. For example, if an investor invests $10 in a company with 1X Liquidation Preference, during a liquidation event, the investor will receive its 10$ capital invested first then the remaining assets shall be distributed ratably to the holders of the Common Stock and the Preferred on a common equivalent basis.
Another variety is called Capped Participation. This type indicates that the stock will share in the liquidation proceeds on an as-converted basis until a certain multiple return is reached. Sample language is as follows. The “Cap” sets a limit on the multiple of return on investment amount that a series of Preferred Stock can receive before its participation feature is cancelled.
The provision commonly reads as follows:
“After the payment of the Liquidation Preference to the holders of the Series A Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock and the Series A Preferred on a common equivalent basis, provided that the holders of Series A Preferred will stop participating once they have received a total liquidation amount per share equal to [X] times the Original Purchase Price, plus any declared but unpaid dividends. Thereafter, the remaining assets shall be distributed ratably to the holders of the Common Stock”
The last one is No Participation where the investors will receive the gain based on the ownership percentage of the company times the amount of liquidation event itself. This is the most straight forward and least aggressive position for an investor to take.
The founders of a tech startup called ABC Company held 1,000,000 shares of common stock that they paid at $1 per share at incorporation, this means a total of $1 Million. Afterwards, a venture capital firm invested $2 Million to buy 500,000 shares of preferred stock at $4 per share. Now the founders own 66,7% while 33,3%. For simplicity, let’s round it to 67% and 33% and assume the company is sold for $10 million.
- Full Participating
Investors taking participating liquidation preference are seeking the most protection. Preferred stock with a participating liquidation preference will get their liquidation preference first and then have the opportunity to participate pro rata with the common stock. Given the case example above with 1X Participating, the investor will receive its investment amount of $2 Million liquidation preference, then they are allowed to participate in receiving their pro rata share of the remaining $8 million. The remaining $8 million will be divided pro rata between the common stock and the preferred stock as if the preferred stock had converted to common stock. In this example, the investor will receive $2 Million plus 33% of $8 Million ($2,64 Million), or a total of $4,64 Million
- Capped Participation
The second type or variety of a liquidation preference is capped participation. If we use the same example with 2X Cap, then the investors would be entitled to either $4 Million — 2X the initial investment, or 33% of the total proceeds. At a sales price of $10 Million, the investors would choose the first option of $4 Million rather than the $3,3 Million.
- Non Participating
If the preferred shareholders do not convert their preferred shares into common stock, they will receive their liquidation preference of $2 Million. However, they have the right to convert their shares into common stock and participate in the gain out of the liquidation event. By converting all their preferred stocks to common stocks, they are allowed to receive their pro rata share of the $10 million along with all the other common stock. Therefore, the investor will receive 33% of $10 Million, or $3,3 Million.
It is important for entrepreneurs to properly understand the impact of these terms. Typically for early stage investments the standard is to have simple 1X non-participating preference shares. The problem with more protective provisions is that every investor in the future will want to get at least what the previous investor received, and sometimes may even get more protective which ultimately may make the liquidation preferences very onerous for all the founders.
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