Understanding Liquidation Preferences
A high Liquidation Preference can mean you walk away empty handed, even if your company makes 2x or 3x the initial investment. Liquidation preferences are used as tools by VC firms and other investors to help ensure higher returns in an otherwise risky market, and may come back to a larger degree in the coming years as interest rates increase and VC money becomes more scarce. We will be looking at 4 different concepts you need to understand as you look for investment.
1. Initial preference
This is the money you are guaranteeing to your investor in the event of a buyout, acquisition, etc. Typically the initial preference is a multiple of the initial investment, but can under less common circumstances also grow by a defined percent annually. This helps protect investors from smaller exit events. For example if a company raises $10,000 for a 10% stake with a 1x initial preference and the company later exits for 10,000 dollars, the entire amount will be given to the investor. Initial preference is given EVEN if the founder and employees receive nothing, or the investor receives a greater percent than the initial stake. However if the company is sold for more than $100,000 the following rules may apply.
2. Non-participating preferred
Non-participating preferred means that the investor either receives their initial preference OR the common stock stake in the company. let’s look back to our original example, but assume the company is sold at 200,0000. In this case, the 1x liquidation preference is worth less than converting the stake to common stock. As such, the investor will convert their stock to common stock and receive 10% of the sale price and get 20,000. The chart below shows how the initial preference with non-participating stock fares across various exit scenarios, at the inflection point of 100,000 it becomes advantageous to convert the non-participating preferred to the common stock
3. participating preferred (with cap)
Participating preferred with a cap means the investor receives the initial preference and then their percent of the remaining money as it gets allocated up till a specific point known as the cap, also traditionally a multiple of the original investment. For example, if their initial preference is worth 10,000, and they have a 25% stake in the company that gets sold for 110,00 they would get their 10,000 and 25% of the remaining 100,000 up to their cap of 3x, for a total of 30,000. The chart below examines a 10% stake in a company with a 1x initial preference worth 10,000, and a 3x cap for their participating preferred stock. At the inflection point of 300,000 it becomes advantageous to convert the non-participating preferred to the common stock
4. participating preferred without cap
participating preferred without cap means that the investor always receives their initial preference and their stake of all remaining money. For example, if their initial preference is worth 10,000, and they have a 25% stake in the company that gets sold for 110,00 they would get their 10,000 and 25% of the remaining 100,000, for a total of 35,000.
While liquidation preferences can hurt a founder in the case of a smaller exit, they shouldn’t be looked at in a wholly negative way. Instead they should be looked at as tools. They allow founders to get the requisite amount of funding, when they might otherwise be prevented by adverse business conditions. To ensure you get a great investor, check out www.frontiernode.com where we help founders anonymously share their experiences and advice regarding investors.
