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Decoding Liquidation Preferences: A Founder's Guide to Protecting Equity

 

Startup 101 - How Liquidation Preferences and Share classes can Cause (Major) Missalignement between your investors (and you).


In this article, I will explain what they are and what you as a Founder should think about when Fundraising, if you know anyone currently Fundraising share this Article with them to make sure they have it in Mind.

Liquidation Preferences are something that no one thinks too much about when the market is going well (2021). The only difference between Seed Round and Series C is that we are jealous of the glorious returns of our Seed friend but realize it came with more risk. Things get tricky when things go down and the potential exit is -not- much higher or lower than the total amount of money invested.

When a company is sold, liquidation preferences decide who gets paid first and how much. Typically, investors get their money back before other owners, like founders or employees. The exact details, like how many times of a multiple on their investment they get back, if they can "double-dip" for more money, and their payment order compared to other investors, can vary. Both company founders and investors need to understand and agree on these rules to ensure everyone gets a fair deal when the company makes money from a sale.

Key Features to look for:

1. The Multiple:

- Indicates how much an investor gets paid back before common shareholders.

- Typically ranges from 1x to 2x but can go up to 10x.

- E.g., A 2x preference on a $1M investment guarantees the investor $2M back before any distribution to common shareholders.

2. Participating vs. Non-Participating:

- Non-Participating: Investor chooses between exercising their liquidation preference or converting their preferred shares to common and receiving an equivalent share of the proceeds.

- Participating: After the initial liquidation preference is paid out, the investor also partakes in the remaining proceeds based on their equity ownership.

- Participating is rarer and can lead to double-dipping, which is less favorable for founders.

3. The Cap (For Participating):

  • Introduced to avoid undue advantages to investors via participating preferences.
  • Caps limit the total proceeds an investor can receive. Typically set around 3x the investment amount.
  • Forces conversion to common shares for payouts beyond the cap.

 

4. Seniority Structures:

  • Defines the order in which investors are paid.
  • Standard Seniority: The latest rounds investors get paid first.
  • Pari Passu: All preferred shareholders have the same seniority.
  • Tiered: Hybrid of standard and pari passu; investors are grouped into tiers based on investment rounds.

 

What should we as Founders do with this Information?

Keep in mind this is serious, it can mean you get paid nothing after years of work if the business is sold.

For example: your Company raised 2m in total, Series A investor invested 1m for 20% at a valuation of 5m.

The company was sold for 1.2m. = Series A investor gets 1m back, 200k is distributed amongst other Investors, and Founders get nothing.

If the Investment had a Multiple of 2x the investor would have been entitled to 2m, leaving nothing for other Shareholders.

If the Investor had a 1x participating multiple the investor would receive 1m plus 20% of the rest of the funds that are left over after all the other investors got paid out (likely nothing).

Also keep in mind the Investor can choose the bigger Pot, either a refund or the percentage depending on Equity.

1. Understand Liquidation Preferences: Before entering any negotiations, founders should fully understand the concept of liquidation preferences, how they work, and their potential impact on payouts.

2. Negotiate the Multiple: While it's standard for investors to get back their initial investment (1x multiple), anything higher can significantly reduce the payout to founders and employees. Try to keep the multiple as low as possible.

3. Avoid Participating Preferences: Participating liquidation preferences allow investors to "double-dip." This means they first get their initial investment back and then get a portion of the remaining proceeds. This is disadvantageous for founders, so push for non-participating preferences.

4. Cap the Returns: If you must agree to participating preferences, consider introducing a cap. This limits the total amount investors can make before they have to convert to common shares.

5. Consider Pari Passu: If raising multiple rounds of funding, consider a pari passu structure, where all investors have equal priority in receiving exit proceeds. This can be especially helpful if you've secured funding from prominent investors early on, as it prevents later investors from leapfrogging earlier ones.

Keep in mind this will not help you, but rather your early investors who will appreciate it.

7. Negotiate Seniority Structures: Understand and negotiate the seniority structure. If possible, try to keep things simple, and ensure that any new round of investment doesn't overly dilute the potential returns for earlier investors (or for you).

8. Protect Against Downside Scenarios: While everyone hopes for the best, it's prudent to model out potential downside exit scenarios to understand how much, if anything, would be left for the founders and employees after investors have been paid their liquidation preferences.

9. Stay Informed: As the company progresses, raises additional funds, and potentially modifies terms, always stay informed about the implications of any changes to the cap table and their impact on liquidation preferences.

10. Legal Counsel: Always have experienced legal counsel to guide you through the process. They can provide insights, advise against unfavorable terms, and negotiate on your behalf.

11. Educate and Align Interests: Ensure that other key members of the founding team and early employees understand these terms. Alignment of interests is crucial, especially when considering future rounds of fundraising.

As you can see this is very Mayor, if you do not pay attention to it you could end up working for years and end up with nothing, it is also extremely hard to fix in hindsight and something that especially late-stage VCs use to gain large Leverage against you and your business.

While they have been delivering less returns lately and don't deliver instant Liquidity going for an IPO is sometimes the best approach for a Founder because in an IPO all stock gets automatically converted to common stock.

Even if you screwed up your Liquidation Preferences, there is a way out, build a Unicorn. 👀


Thank you for reading this Article, if you know anyone who is currently Fundraising share it with them to make sure they are equipped to negotiate the best possible outcome.