Everything a first-time founder has to know about liquidation preferences
Us founders should to have a solid understanding of liquidation preferences, since we will run into them sooner or later. Why? Because depending on the exit price, they heavily skew the ownership percentage.
A liquidation preference is the right of an investor to get their invested money back before everyone else does.
As a result, your cap table might actually show a totally wrong picture of who will get how much of an exit. At Ledgy.com we think a lot about liquidation preferences, so in this blog post I will first bring light into the darkness of how liquidation preferences, or colloquially “liq prefs”, work and which variations exist. Then we’ll have a look at common practices and when and which variation makes sense, or not.
Let’s look at the simplest example of a cap table without any liq pref yet, and what happens when a new investor comes in asking for a liq pref. In rough terms the result will look as follows: Even if the company is being sold for such a low amount that her investment has decreased in value, she still gets her full investment sum back, on the expense of the other shareholders. Only after she is compensated for her full investment, the rest is distributed to everyone else. So from an economic point of view, she owns a higher percentage than the other shareholders. And she puts in a much lower risk. You might have noticed that the threshold for which the liq pref starts to have an effect is the valuation at which the investor came in or lower.
Multiple
Now that we understand the basic principle, let’s see which variations exist out there. The simple liq pref I described above had a multiple of 1x. This means, the investor gets 1x of her invested amount back before everybody else participates. It can also be higher, and there were actually times, like after the burst of the dotcom bubble, when startups had such a hard time raising money from investors, that these investors would go up as much as 10x. But that’s bad for us founders, and 1x is at the moment by far the most common multiple.
There is an incentive involved, which is worth understanding: If we go up the exit price, there’s one point where the investor will get their full investment back (valuation during the round she came in). But then, if the exit valuation is increased, she will not get more for a while. She has to wait until the others catch up. Only when the valuation is high enough such that her return equals her actual percentage in the company, she will participate again. From that point onwards, the distribution is pro-rata, meaning everyone gets a share of the proceeds corresponding to their ownership percentage. The result is that she doesn’t have an incentive to increase the exit price within this window where her part stays flat. But the others, especially the founders, do.
Participation
The example above was also non-participating (in German this is confusingly called anrechenbar). After the investor with the liq pref got her full invested amount back, which is more than what she would have got purely from her ownership percentage, the rest of the money is distributed to all the other shareholders without a liquidation preference. If it was participating (nicht-anrechenbar in German), the investor with the liquidation preference would also participate in this distribution of the rest of the money. This would mean that she would always get more than her ownership percentage would grant her. Therefore a participating liq pref is as if the investor had bought more shares at a lower valuation. So you already see the trick here: the investor can settle for a higher valuation, knowing that the liquidation preference results in a lower effective valuation. Because this is quite mean, it is usually not used.
The most common liquidation preference nowadays is non-participating with a 1x multiple, which is also the most founder-friendly.
It is sometimes used in combination with a cap, which brings us to the last parameter. A cap is only used if it’s participating. It is usually given in multiples, like 2x, meaning that the liquidation preference is participating only until the investor is at twice her investment, and then continues as a non-participating liq pref.
Now we already understand how they work and can talk like a pro with our new investor. Which variation and from which financing round on should a founder accept it? The founders always have shares with the least rights (common shares), as they were the first to own shares in their company. New investors coming in might want to protect themselves by asking for liquidation preferences. So the most founder-friendly version is no liq pref at all. But if you agree to one, you should not go for a participating one. You should also refuse one with a multiple higher than 1x. The most common nowadays is non-participating with a 1x multiple, which is also the most founder-friendly among the liquidation preferences.
If there are several rounds with each having a new liquidation preference, the latest one will have the highest priority and then it will cascade down to the common shares. This is called a waterfall.
The later the round, the higher the chance that the new investors demand a liquidation preference. After all there’s more money at stake. Wiser investors in earlier rounds like a seed, however, often don’t ask for one. They know that introducing it so early will for sure nudge the investors in the following rounds to also ask for one. This would increase the risk of these earlier investors to come away empty-handed as well.
As you can see, there’s some strategic thinking involved in liquidation preferences. But for us founders it’s clear that we are always disadvantaged, so we should try to avoid them. A compromise that is not too investor-friendly but still protects them to a certain extent, is a 1x non-participating liq pref, which is therefore often used.
