The Liquidation Preference Dilemma

© Vlad Sargu

After my series on the business model of an early venture firm (see the Risk-Return Profile, Homerun dependency, and the Investment Thesis of an early stage VC), my next articles will focus on individual aspects of the daily work as an investment professional.

Among the hottest topics in contract negotiations, liquidation preferences have a high ranking. In the last two decades, with less money in the (German) market and thus the perception of generally higher risk for investors, it has been common to employ participating liquidation preferences. In line with more liquidity in the market today, risk perception has decreased more widespread approach towards liquidation preferences. Bargaining power obviously always has also a strong influence on the outcome here. I want to contribute to this ongoing discussion by sharing my view on the importance of interest alignment and the perception of fair treatment.

In order to do so, I will employ graphs to showcase my thoughts on the individual models. You will always get a graph on the left showing the return to an investor and on the right a graph representing the return to the founders. Furthermore, you will see a blue line illustrating the return under consideration of the liquidation preference, which will be mapped versus an orange line displaying the hypothetical return under a pure pro rata regime. Finally, I will use grey lines to highlight individual areas that are important to me. The x-axis shows the total volume of exit proceeds, while the y-axis shows the individual returns to investors / founders individually.

To begin with, my belief is that a liquidation preference is employed by early stage investors to protect their downside. Everything going beyond that is optional and will be discussed in turn.

1. Participating liquidation preferences

A participating liquidation preference allows the investor to get the invested funds out first — this is what I call downside protection. However, with his full participation on the subsequent pro rata level, the downside protection is transformed into an upside kicker. Today, this is becoming increasingly less common as founders will never be able to retrieve a full pro rata share in an exit. Thus, there is a continuous area of perceived loss to the founder (“founder loss”). The company and all shareholders thus run the risk of facing more intense discussions prior to an exit. However, it has to be stated that the model still ensures that there is general alignment between founders and investors because each additional Euro of exit volume will increase the exit participation for all parties.

Blue line = result with liquidation preference; orange line = hypothetical return under pure pro rata regime; grey line used to highlight particular areas

2. Non-participating liquidation preferences

Because of the continuous founder loss that I described above it has become more common that liquidation preferences are reduced to downside protection. The most popular application today is the utilization of a non-participating liquidation preference where the investor gets the invested funds back and thereafter does not benefit from a pro rata allocation until his liquidation preference has been fully caught up to (e.g. EUR 2m investment for 25% shareholding means that the investor gets EUR 2m upfront and nothing until the exit volume has reached EUR 2m / 25% = EUR 8m). Thereafter, the investor gets his normal pro rata distribution. This model successfully eliminates the perceived founder loss but comes at a cost that I consider to be even higher. In fact, there will be no alignment between an investor and the founders at any point prior to the completion of the catch-up (in the example prior to EUR 8m). In fact, below EUR 2m the founders will be ambiguous whether there is an exit or an insolvency (to be fair — this is the case with any liquidation preference), however between EUR 2m and EUR 8m, the investor is ambiguous because it does not have an impact for him. This can have an adverse effect on negotiations and willingness to exit at a certain price.

Blue line = result with liquidation preference; orange line = hypothetical return under pure pro rata regime; grey line used to highlight particular areas

In fact, I have seen an even more counter-intuitive variation to the non-participating liquidation preference, that makes the problem more obvious. I have seen contracts that employ phrases like “after an exit of EUR X, the liquidation preference will cease to exist” or “will lapse”. The problem of such wording is that at a certain “point in exit volume”, the liquidation preference will switch from participating to “not existing” with the interesting effect that an investor will have less return if the company is sold at a higher volume, while the founders will see a kicker in their return profile. As a result, the motivation is not only not aligned but even contradictory. I have only included this example to make it clear how important it is to fully understand the metrics of a chosen liquidation preference and also be careful of the wording employed in contracts. Always bear in mind that five years down the road some acting people might be different from today and thus not knowing how things were meant when it was drafted.

Blue line = result with liquidation preference; orange line = hypothetical return under pure pro rata regime; grey line used to highlight particular areas

3. Fade-out liquidation preferences

Given the issues with perceived founder loss and lack of alignment, we have started to employ a fade-out in a variety of cases. What happens is the following: As a downside protection, the investor receives upfront his investment back. Hereafter, he fully participates on the pro rata distribution up to a certain point after which the liquidation preference will start to fade out until a second point, where it has fully faded out. The determination of these two points is fully negotiable. The stronger the founders are or the less risk is perceived by the investor, the more likely it is that the fade out will occur between a multiple of 1 and 2 for the investor. The stronger the investor is, the closer the fade out will get to a multiple of 4 and 6. The calculation is fairly simple:

Lower Point = Liquidation Preference amount +((Investment / Shareholding)*(lower multiple requirement -1))

Higher Point = (Investment / Shareholding) * higher multiple requirement

In fact, this approach solves the problems of the previously discussed models. The investor receives its downside protection and depending on the outcome of negotiations, potentially receives an additional upside kicker. However, if the company is successfully sold at an attractive price, there will be no founder loss because they receive their full pro rata and finally, there is full alignment because all parties benefit from every additional Euro of exit volume.

Blue line = result with liquidation preference; orange line = hypothetical return under pure pro rata regime; grey line used to highlight particular areas

I have learned that alignment and the perception of fair treatment are the most important factors in an exit negotiation, which is also why I am a fan of the fade out, even though it might be a little more difficult to understand and calculate than traditional liquidation preferences regimes.

In any case, it should be clear that this choice even in the earliest financing rounds has a strong signalling effect. If, for instance, I opt to employ a participating liquidation preference scheme in a seed financing round, the probability that an investor in a series A will also use a participating liquidation preference is high.

Thus, no matter how early or late you are in terms of funding I would always be careful in the choice of liquidation preference regimes.