Liquidation Preference: The Silent Deal breaker

For first-time founders, navigating the intricacies of venture capital term sheets can be daunting. One of the most crucial, yet often misunderstood, clauses is the Liquidation Preference.

Definition

Liquidation preference dictates the order and amount investors get paid when there’s an “exit event” for your company. An exit event, also known as a “liquidity event,” typically refers to the sale of the company, a merger, an acquisition, or even a winding-up of the company’s operations.

In essence, it’s a protective mechanism for investors, ensuring they receive a certain return on their investment before common shareholders (which usually include founders and employees) receive any proceeds. Investors typically hold “preferred stock,” which comes with these special rights, unlike “common stock” held by founders.

Some Terminology:

Exit Event/Liquidity Event: A major event where the company’s ownership or assets are converted into cash, such as an acquisition or IPO.
Preferred Stock: A class of ownership in a corporation that has a higher claim on assets and earnings than common stock.
Common Stock: A class of ownership that represents a residual claim on assets and earnings, typically held by founders and employees.
Waterfall: The step-by-step order in which the proceeds of a liquidity event are distributed among shareholders.

Why It Matters

The liquidation preference significantly impacts how exit proceeds are distributed, directly affecting how much founders and employees will receive in an event of acquisition or liquidation. For investors, it acts as a safety net, protecting their capital, especially if the company sells for a modest amount or less than its valuation.

For founders, understanding this clause is vital because it can dramatically reduce your payout, particularly in lower-value exits, and can even influence future investor and talent attraction. It also requires a candid discussion about the potential for various exit scenarios between founders and investors.

Common Variations

Liquidation preferences come in several forms, each with different implications for founders:

The Multiple (e.g., 1x, 2x):
- Definition: This is the amount an investor must be paid back, expressed as a multiple of their original investment.
- 1x Liquidation Preference: The most common type. Investors receive an amount equal to their initial investment before common shareholders get anything. If an investor put in $5 million with a 1x preference, they get $5 million back first.
- Greater than 1x (e.g., 2x, 3x): Less common, but sometimes seen in high-risk investments or later stages. An investor with a 2x preference on a $5 million investment would receive $10 million first. This is significantly less favourable for founders as it ties up a larger portion of the exit proceeds for investors.
- Negotiation: Founders should always aim for a 1x liquidation preference, especially in early rounds. Higher multiples can severely diminish founder payouts.
Participation Rights (Participating vs. Non-Participating):
- Non-Participating Liquidation Preference: This is generally the most founder-friendly option. The investor has two choices:
  - Receive their liquidation preference amount (e.g., 1x their investment).
  - Convert their preferred shares into common stock and receive a proportional share of the proceeds based on their equity ownership.
  - The investor can choose the option that yields a higher payout. If the company exits at a high valuation, conversion to common stock often makes more sense for the investor.
- Participating Liquidation Preference (Full Participation): This is often referred to as “double-dipping” and is considered to be investor-favourable.
  - The investor first receives their liquidation preference amount and then also shares in the remaining proceeds on a pro-rata (proportional) basis with common shareholders. This significantly dilutes founder payouts, as investors get both their initial money back and a “slice of what’s left”.
  - The investor can choose the option that yields a higher payout. If the company exits at a high valuation, conversion to common stock often makes more sense for the investor.
- Capped Participation: A compromise between non-participating and fully participating. The investor receives their preference amount and participates in the remaining proceeds with common shareholders, but only up to a certain total return (e.g., 2x or 3x their original investment). Once this cap is reached, they no longer participate in the remaining proceeds, which then go entirely to common shareholders.
- Negotiation: Founders should push for non-participating preferred stock. If participation is unavoidable, negotiate for a cap to limit the investor’s total return and protect more of the founder’s equity.

3. Seniority Structures (Preference Stack):

Standard Seniority: Later-stage investors (e.g., Series B) are paid out before earlier-stage investors (e.g., Series A, Seed). This can be problematic for earlier investors if the exit value is low.
Pari Passu: All preferred shareholders from all funding rounds receive proceeds proportionally to their committed capital, having the same level of seniority. This simplifies distributions and is generally considered fairer across investor groups.
Tiered Structure: A hybrid where investors are grouped into tiers (e.g., Series C-E). Within each tier, investors receive pari passu payouts, and then the next tier is paid.
Negotiation: While often set by market practice, understanding the seniority can help founders anticipate how different investor groups will behave in an exit scenario.

Let us understand it with help of some examples:

Let’s consider a company that raised:

Seed Round: $1 million investment, 20% equity at exit
Series A: $3 million investment, 30% equity at exit

Scenario 1: Company sells for $4 million

1x Non-Participating Preference (most common):
- Series A investor gets $3 million.
- Seed investor gets the remaining $1 million.
- Founders and common shareholders get $0.
- Why this happens: The investors chose their liquidation preference as it was higher than their proportional share of the $4M exit.
1x Participating Preference:
- Series A investor gets $3 million.
- Seed investor gets $1 million.
- Remaining proceeds: $0.
- Total investor payout: $4 million. Founders still get $0. In this example, the participation rights don’t come into play because there are no proceeds left after the initial preferences are paid. If the sale was higher (e.g., $10 million), investors would receive their initial preference and a percentage of the remaining $6 million.

Scenario 2: Company sells for $20 million (a good exit)

1x Non-Participating Preference:
- The Series A investor (30% ownership) would get 30% of $20 million = $6 million. Their 1x preference was $3 million, so they convert to common stock as $6 million is higher.
- The Seed investor (20% ownership) would get 20% of $20 million = $4 million. Their 1x preference was $1 million, so they convert to common stock as $4 million is higher.
- Founders and common shareholders get the remaining $10 million based on their pro-rata ownership.
- Impact: In a successful exit, non-participating preference essentially becomes irrelevant as investors convert to common stock to maximize their returns.
1x Participating Preference:
- Series A investor first receives their $3 million preference. Seed investor receives their $1 million preference.
  Remaining proceeds = $20M – $4M = $16 million.
  Series A gets 30% of $16M = $4.8 million.
  Seed gets 20% of $16M = $3.2 million.
- Total payout:
  - Series A: $3M + $4.8M = $7.8 million
  - Seed: $1M + $3.2M = $4.2 million
  - Founders and common shareholders: Remaining $8 million
- Impact: Participating preference boosts investor returns even in high exits, often at the cost of founder equity. Founders should try to negotiate non-participating rights or at least cap the participation.

Evolv’s Recommendations

Aim for 1x Non-Participating Preferred: This is the market standard for early-stage investments and is the most founder-friendly structure. It provides investors with downside protection without excessively penalizing founders in successful, but not blockbuster, exits.
Model Different Scenarios: Don’t just focus on the valuation. Always model out potential exit scenarios (e.g., low, medium, high acquisition values) to understand how the liquidation preference impacts the actual cash payout for founders, employees, and investors. This helps you grasp the “dead spot”—the range of exit values where the investor’s return remains static despite an increasing company value.
Beware of Multiples > 1x: Higher multiples (2x, 3x) mean investors take out a significantly larger chunk of proceeds before founders see anything. These are rare in early rounds but can appear in later stages or distressed situations.
Avoid Full Participation: Fully participating liquidation preferences can severely dilute founder returns in successful exits. If investors insist on participation, you may negotiate for a cap.
Understand Seniority: Be aware of the “preference stack.” If you raise multiple rounds, understand how each new round’s liquidation preference might affect the payouts of previous investors and, ultimately, your own.
Seek Professional Advice: Always engage experienced legal counsel specializing in venture capital. They can help you understand the nuances of these clauses, negotiate effectively, and ensure the terms are fair and align with your long-term goals.
Maintain Alignment: While investors need protection, overly aggressive liquidation preferences can de-incentivize founders and employees, creating a misalignment of interests. A fair liquidation preference fosters a healthier relationship and ensures everyone benefits from the company’s success.

By understanding and carefully negotiating the liquidation preference, founders can protect their as well the investors’ interests and ensure a more equitable distribution of proceeds in any future liquidity event.