Liquidation Preference and Why it Matters
Assume you have been working on your startup for a year now, have raised one round of funding, and an acquisition offer of $20 million comes your way. As a founder and the majority shareholder, you will see most of this $20 million, right? Right?
In truth, maybe you will and maybe you won’t. Here’s where preference comes into play: a preferred shareholder, who owns a smaller percentage of the company, could walk away with a bigger piece of the pie. That’s why it is so important to understand this concept, its variations and when it will apply to you.
What is Preference? preference is the amount of proceeds from a sale or of the company that the preferred shareholders will receive before the common shareholders are entitled to receive anything. Think of it as a pre-nup that provides downside protection to the investor if things go wrong...or right!
What Are the Different Types of Preference? Different types of preferences determine the return that investors get in a transaction both in relation to the founders and in relation to other investors.
Founder Vis-à-Vis Investors
- Standard 1x non-participating preference. This is the most common type. Preferred shareholders have a preference equal to the amount of their investment—a 1x preference. After the preferred shareholders receive their preference, the remaining value of the company is paid to the common stockholders.
- Multiple non-participating preference. Some investors have a multiple—2x or 3x—so they will have a preference equal to the multiple of their investment. Multiples are not typical, but are also not unheard of. This structure provides greater downside protection to the investors and is not as founder friendly.
- Participating preferred shares. This type sweetens the investor economic return. With participating , the preferred shareholders receive their initial preference (whether 1x, 2x or otherwise) and they also share in any remaining proceeds with common shareholders on a proportional ownership , i.e. a double dip.
- Capped participating preference. This is a hybrid between the non-participating and participating preferences in the sense that it limits the investor’s double dip to a cap.
Let’s explain these with some examples: Suppose Investor X invests $5 million at a $25 post-money valuation, i.e., Investor X owns 20% of the company.
Scenario 1: the company is sold for $10 million.
- With the standard 1x non-participating preference, Investor X gets the preference amount, i.e., their $5 million investment amount first, and the common stockholders will receive the remaining $5 million (50% of the exit value), even though they own 80% of the company.
- With a 2x multiple non-participating preference, Investor X gets the entire sale amount of $10 million—two times their $5 million investment amount—and the common stockholders get nothing.
- With a 1x participating preference, Investor X will first get the preference, i.e., their $5 million investment amount—and then participate as a 20% stockholder with respect to the remaining $5 million. So the investor will net a total of $6 million, while the common stockholders will only get $4 million.
Scenario 2: the company is sold for $30 million.
- With the standard 1x non-participating preference, Investor X will want to convert to and participate on a proportional ownership —as a 20% common stockholder. Here, X gets $6 million—representing 20% of the company—and the common stockholders get the remaining $24 million, representing 80% of the company.
- With a 2x multiple non-participating preference, Investor X will still want to get paid out as a preferred shareholder and get $10 million, while the stockholders will only receive $20 million to split.
- With a 1x participating preference, Investor X will again first get $5 million, and then another $5 million as a 20% stockholder participating in the remaining $25 million—for a total return of $10 million.
As you will notice from these examples, non-participating preferred shares always have a tipping point, or conversion threshold, beyond which the preferred shareholders will convert to . For participating preferred, the conversion threshold is never!
Sharing risk? When thinking about the above scenarios, it is important to remember that nearly all acquisitions will have contingent consideration—escrow and/or that get paid out, if at all, at some future date. In Scenario 1, assume that the investor has 1x non-participating preferred, and that the company is acquired for $10 million, but the acquirer wants to leave $3 million, or 30% of the purchase price, in escrow to satisfy any claims or problems that might come up with respect to the company during the year after the acquisition. As a result of this escrow, only $7 million will be paid out at closing, with $3 million “at risk” and contingent. Should Investor X be entitled to take $5 million of the $7 million available at closing as its preference, with the common stockholders receiving $2 million at closing and shouldering all the risk with respect to the $3 million in escrow, or should Investor X only be entitled to $3.5 million of the $7 million available at closing, with $1.5 million “at risk” in the escrow, same as the common stockholders, as they are each entitled to 50% of the $10 million purchase price (assuming the entire escrow amount is eventually paid out). The answer depends on who you —investors want the former, founders and common stockholders the latter. Historically this was simply dealt with and negotiated between the investors and common stockholders at the time of the transaction. However, with the increase of contingent consideration acquisitions, investors and founders have been more and more receptive to negotiating this at the time of the investment. In fact, the National Venture Capital Association model for Series A financings offers two versions of a contingent consideration clause: investor friendly (the should be made with respect to the non-contingent consideration, assuming that there is no escrow or ) or founder friendly (allocate the contingent consideration pro rata between the preferred and the common stockholders, assuming that the entire amount is being distributed at closing).
Investors Vis-à-Vis Other Investors
- Pari-passu preference. With this type of a preference structure, all investors are treated equally irrespective of when or how much they invested. They all share in the same and take pro rata among themselves. This route is generally preferred to make sure that all investor interests are aligned.
- Stacked preference. Here, last money in is the first money out. This type of structure will usually be implemented in late of funding, to account for high valuation and risk trade-offs. If you have a stacked preference structure in an earlier round of funding, it will almost always be used in each subsequent round of funding. As a founder, build a waterfall model that will show you how each series of preferred shareholders will fare in different scenarios to better understand their incentives.
Let’s Take This to the Real World. When Will Preference Come Up? In the ideal exit scenario, a real home-run transaction, the preferred shareholders will convert to and participate in the based on their percentage holding. That said, statistically, most startups do not hit a home-run. You will find yourself in a discussion about using the preference when you have a medium exit, i.e., the transaction is at a value higher than the money invested, but is not a home-run by any means. Still, growing a company to a successful exit that returns the investors’ full investment and provides a return for the common stockholders is a noble outcome for a founder, nothing to scoff at.
However, the most common outcome for startups is the scenario where the company has burned through all or most of its money. If the startup has no viable financing options the result is often pennies on the dollar available for the investors’ preference with the founders getting nothing. In these dire straits, often the best available option to the company is a “fire sale”—an exit in which the acquisition amount is lower than the total money raised. The only other option for the company is to shut down.
A logical assumption is that in a fire sale the investors get the entire sale amount and the founders walk away with nothing. For example, Get Satisfaction’s co-founder Lane Becker was very vocal about the company’s fire sale and the founders being “washed out of the deal.”
But even in the case of a fire sale, there is value for founders to extract. If they are still of management—unlike the situation that Lane Becker found himself in—they can usually negotiate a management carve-out with their investors. A management carve-out is a bonus plan that takes a portion of the preference otherwise payable to the Investors and allocates it to of management and the . A company’s investors don’t oversee the day-to-day operations of the company, and to get any acquisition done successfully (including a fire sale), the investors still need the company’s management to negotiate the exit deal. That gives management . Investors are not blind to the fact that, if get nothing, they have no incentive to work toward completing a successful deal, and will often offer to make a certain percentage of the preference available to management and common stockholders via a management carve-out. Even if a founder doesn’t get a cash payout from the sale via a management carve-out, he or she may be able to their position in the company to get acquirer stock or even jobs for him/herself and the team with the acquirer.
A founder scarred by taking a company through a low-value exit with very little personal economic benefit from such exit transaction may be inclined to their bets and for a management carve-out at the very outset of their next startup. However, it is highly uncommon to see such worst-case scenario planning early on in a company’s history. After all, it signals to investors that the founders don’t believe in themselves for achieving a home-run exit and do not trust the investors to step up and do the right thing in the event of a low-value exit. Both founders and investors want that home-run, so no one talks about management carve-outs or fire sales right at the beginning. Remember, even if all doesn’t go well, a founder doesn’t necessarily have to lose .
For more on how preferences work, check out this video.
Written by former Counsel John Demeter.