Liquidation preferences in startup financing

Startups usually depend on financially strong partners to grow. During financing rounds, investment agreements are concluded, and liquidation preferences are often one of the major deal terms to be negotiated. They are THE main feature of preferred shares (versus common shares allocated to founders and employees) investors can (and in most cases should) negotiate for.

A liquidation preference is the formula that defines who is paid first and who gets how much money when the startup gets acquired or liquidated, or when the startup's substantial assets are sold.

From the investors' point of view, a liquidation preference makes sure they get paid before and in preference to the founders and employees. The primary purpose is to protect them from losing (too much) money if the startup they invested in does less well than anticipated.

From the founders' point of view, it comes down to how much money is left once the investors received their payment. If the liquidation preference is too investor-friendly, they may receive little or no money even if the startup is doing great. This can make them lose interest in their venture. After all, without any reward and recognition for the blood and sweat they put in, why should they care?

So what is the "right" approach when negotiating a liquidation preference? Let's talk about that.

Negotiating liquidation preferences: What interests are involved?

Negotiating liquidation preferences is about balancing the following interests:

• Downside protection: The primary goal of a liquidation preference is to protect the investors against losing money.
• Return rate: Liquidation preferences define who gets how much in case of an exit. A little change in how the preference is structured can have a huge impact on the possible returns of the different shareholders.
• Founder motivation: A startup's wellbeing usually depends on the motivation of its founders. For this reason, it will very likely backfire if investors demotivate the founders with a liquidation preference that leaves them nothing to look forward to.
• Setting precedents for future rounds: Every round sets a precedent for the next round. Early stage investors in particular should factor in that they might face the same consequences as a founder (getting paid zero), if the investor-friendly liquidation preference they negotiated for is duplicated in future rounds.
• Keeping things simple: If things get too complex, people become wary.

The different features of liquidation preferences

There are five primary features of a liquidation preference:

• single (1x) or multiple (2x, 3x, etc.)
• non-participating vs. participating
• participation caps (for participating preferences)
• seniority structures
• dividend preferences

1X non-participating liquidation preferences

The 1x non-participating liquidation preference is downside protection (and that's about it). With it, investors can choose to get paid before common shareholders up to the amount of their initial investment.

Whatever is left after the investors got paid, will be distributed among the shareholders holding common shares (typically the founders and employees) based on their ownership percentage in the startup.

Instead of exercising the liquidation preference, investors can also choose to be treated as common shareholders. This means they ultimately get paid the higher of the amount of their investment and the return based on their ownership percentage in the startup.

Example: In exchange for a 20% ownership stake in a startup, an investor puts in 2M with a 1x non-participating liquidation preference. If the company is sold for 3M, the investor has the option to:

1. exercise the 1x liquidation preference and get the 2M back, OR
2. be treated as a common shareholder and receive 600k (20% of 3M = 600k).

The investor should only go with the second option if the startup is sold for more than 10M, meaning the 20% ownership stake in the company is worth more than the initial investment of 2M.

Multiples (2X, 3X etc.)

A 1x liquidation preference means the investors get back the invested capital before the founders get their share. With a multiple liquidation preference (2x, 3x etc.), the investors get a multiple of their investment before the founders get paid.

Example: An investor invested 2M in a startup with a 2x non-participating liquidation preference in exchange for a 20% ownership stake. The company is sold for 5M. The investor has the option to:

1. exercise the 2x liquidation preference & get 4M (2x 2M), OR
2. be treated as a common shareholder & receive 1M (20% of 5M = 1M).

The investor should only go with the second option if the startup is sold for more than 20M, meaning the 20% ownership stake in the company is worth more than the 2x liquidation preference of 4M.

A multiple's impact is especially significant in later, larger financing rounds and can leave the founders, employees and even early stage investors empty-handed if the startup does not perform extremely well.

Fully participating liquidation preferences

With a fully participating liquidation preference, the investors "double-dip" in the liquidation proceeds: First they receive their investment back, then they ALSO participate in the remaining proceeds in proportion to their ownership stake in the company (while with a non-participating preference, it's either or instead of both).

Example: In exchange for a 20% ownership stake in a company, an investor invests 1M with a fully participating liquidation preference. The startup is sold for 9M. In this case, the investor receives:

1. 1M (his investment), AND
2. 1.6M (20% of the 8M remaining proceeds).

In total, the investor receives 2.6M.

Participation caps

Participation caps are used with participating liquidation preferences. They limit the maximum amount the investors receive. They are often fixed at a multiple of the original investment, i.e. 2x or 3x.

In other words: First the investors receive their investment back, then they also participate in the remaining proceeds in proportion to their ownership stake in the company UNTIL the cap (e.g. 2x or 3x of the original investment) is reached.

As with non-participating preferences, if the capped preference amount is lower than what the investors would receive if they converted to common shares, there is no point in exercising the liquidation preference.

Example: In exchange for 20% of the company, an investor invests 1M with a participating liquidation preference subject to a 2x cap. The company is sold for 9M. The investor receives:

1. 1M (his investment), AND
2. 1M (20% of the 8M remaining proceeds capped at 1M when the 2x of the original investment is reached).

In total, the investor receives 2M (2x the original investment).

If the company was sold for more than 10M, the investor would choose to be treated as a common shareholder, because the ownership stake exceeds the 2M of the liquidation preference.

Seniority structures

When there is more than one financing round, it is also important to determine payment priorities between investors from different rounds. This is also called the "exit waterfall". Here are some options:

• Last in first out: With this structure, the payouts are done in order from the latest to the earliest round. If the exit proceeds are lower than the liquidation preference of all investors, the investors from the latest rounds may get paid while the earlier investors and common shareholders may miss out.
• Pari passu: With this structure, all investors have equal priority and get a piece of the exit proceeds regardless of which round they invest in. If the exit proceeds do not cover the liquidation preference amount of all investors, the investors share the proceeds in proportion to their investment amounts (or, more accurately, the amounts of their liquidation preferences) instead of their ownership.
• Tiered: This structure is a hybrid between the first two options. Investors from different rounds are grouped into seniority levels ("tiers"). The higher tiers (i.e. the more senior ones) are paid before the lower tiers. Within each tier, the investors have the same priority and share pari passu.

Dividend preferences

There's one more thing you need to factor in when you negotiate preferred shares:

Typically, a liquidation preference entitles investors to get their investment back PLUS ANY DECLARED BUT UNPAID DIVIDENDS before the common shares receive exit proceeds. So if the board has declared any dividends during the startup's journey that haven't been paid already, these will get added to the initial investment.

If the dividends are "accruing" (or "cumulative"), investors receive their investment back PLUS ANY ACCRUED BUT UNPAID DIVIDENDS whether or not they were declared by the board. Accruing dividends (usually ranging from 5% to 10%) are primarily used as a protective device to secure a minimum annual rate of return on the investment.

Dividend preferences are mostly relevant in downside scenarios. In an upside scenario, either the liquidation preference is not exercised, or the dividends only amount to a tiny fraction of the return.

A note to founders: if your investors ask you for a COMPOUNDING DIVIDEND (i.e. interest on interest, which means the interest is added to the principal, based on which the future interest is calculated, which is again added to the principal, etc.), it is probably better to thank them for taking the time and walk away from the deal. Compounding dividends are just not worth the squeeze.

Other types of liquidation preferences

If you do not feel like sticking with the standard types of liquidation preferences, you can also add additional features. Here are some options:

• There are fully participating liquidation preferences where the common shareholders receive the purchase price of their shares before the remaining proceeds are distributed among all shareholders in proportion to their ownership stake in the company. However, this catch up for the common shareholders is hardly ever significant since they typically paid a much lower price for their shares than the investors.
• A fully participating liquidation preference can also be combined with multiples entitling the investors to receive their investment back times the agreed multiple before the remaining proceeds are distributed.
• Founder friendly investors allow founders to get a piece of their investment back if the exit proceeds do not or barely cover the liquidation preference amounts of the investors, so founders are not left empty-handed.

There are many more variations – the limit is set by your imagination.

What is the "Best" liquidation preference?

From an investor's point of view, a participating preference is tempting. After all, getting the investment back AND at the same time benefiting from an unlimited upside potential sounds like an amazing plan.

However, previous rounds set precedents for later rounds. When an early stage investor imposes a participating preference on the founders, the next investors will likely do the same. This can backfire. Look at the example below. The seed investor's return is considerably higher with a non-participating than with a participating preference.

Example: An investor invested 2M in the seed round of a startup in exchange for a 20% ownership stake. The company has two more financing rounds and is then sold for 100M. Here's how much everybody gets with a participating compared to a non-participating preference:

The same goes for a 2x, 3x or 4x preferences, where investors get a multiple of their investment back. Again, in early rounds, negotiating for as high a multiplier as possible might not be a good idea. When an early stage investor imposes a high multiplier on the founders and the next investors do the same, the early stage investors are likely taking the hit alongside the founders. In the example below, the seed investor's return is considerably higher with a 1x than with a 2x liquidation preference (assuming a standard seniority structure).

Example: An investor invested 2M in the seed round of a startup in exchange for a 20% ownership stake. The company has two more financing rounds and is then sold for 100M. Here's how much everybody gets with a 1x non-participating compared to a 2x non-participating preference:

Even without taking future rounds into consideration, overly investor-friendly liquidation preferences can create negative incentives for the founders and employees, when most of the additional value they generate goes to the investors and only a rare, high valuation exit would provide them with any kind of significant return.

In early rounds, we usually recommend aligning the investors' and founders' interests, which typically results in a 1x non-participating liquidation preference. For later stage investors, other options can absolutely make sense, but it remains critical to consider the effect this has on the earlier investors, founders and employees.

Summary

In financing rounds, investors provide startups with the funding they need to grow. Liquidation preferences can protect the investors if the startup is sold at a rather low valuation and can ensure a higher return rate in an upside scenario. It is, however, a challenge to strike the right balance between the different interests at play, particularly when the startup has had multiple financing rounds.

There are many ways to structure a liquidation preference: single (1x) or multiple (2x, 3x, etc.), non-participating or participating, etc. Each option has a different impact on the parties in the deal and their interests.

Our general recommendation, especially for early rounds, is a 1x non-participating liquidation preference with no accruing dividends. The most important goal is to align the interests of all parties in the deal as best as possible. If you succeed in that, it is more likely that everybody will be working hard toward the same common goal: the startup's success.

This blog post is for discussion and general information purposes only and should not be considered as legal advice.