Liquidation preferences: love them or hate them, but just make sure you understand them

Recently I have found myself in a few conversations with founders asking about what terms they should look out for when fundraising, and I want to pick up on one particularly troublesome clause that has started creeping into some Australian investments that is not well understood and ought to be — participating liquidation preferences. As I have gone through the explanation about how this clause works a few times now with different founders, I thought that others might benefit from a brief crash course. So, read on for the startup investment lesson you may never have known you wanted…participating liquidation prefs.

Quick note: I am not a lawyer and this is not legal advice. It’s also worth noting these terms can work a million different ways so I am just going to work through how they commonly operate — but always make sure you read exactly how the terms work in your circumstance.

First, I want to start with “Non-participating liquidation preferences” (NPLP) as these are often confused with participating liquidation preferences but are much more common and not normally troublesome for founders. This clause means investors get their money back first, but so long as they get at least their money back, then they participate like any ordinary share holder. The main implication is that when the company is sold for less than the post money valuation it raised at previously, investors will get what they invested back, then the ordinary shareholders (typically founders and employees) can share the remaining amount (split up between them according to how much each ordinary shareholder owns). Therefore in the downside case, ordinary shareholders will get less as a % than what their ownership suggests.

Illustration: Company X raised $2m at a pre-money of $8m (i.e. post money of $10m). To keep things simple for this scenario, there’s no ESOP or other share types and there are two founders with an equal shareholding. In this scenario, post raise, the cap table is:

Ordinary shareholders

  • Founder 1: 40% equity
  • Founder 2: 40% equity

Preference holders

  • Investors: 20% equity

Then things go bad and the company sells for $5m. If there was not a NPLP in place then the proceeds would be split “pro-rata” (i.e. according to ownership %) and with a NPLP in place, they are split as described above with investors getting their money back. This means the parties each get:

However, say the company goes well and is sold at $20m:

As you can see, in this case the NPLP does not make a difference. Investors will only get back more than % entitlements in a downside case.

Why do investors often insist on this term? There can be many reasons but, in my experience, the most well thought through reason is that it is a type of risk levelling. It ensures that if the founders do look to have a quick exit at a lower valuation, which might still be a good outcome for the founders who will get a few million each, then the investor is at least not losing money and will be able to get their money back.

Now for the one that founders should watch out for: “Participating liquidation preferences” (PLP)

These are a totally different beast and, thankfully, are not common in early stage Aussie deals (though are in approx. 20% of Seed — Series B deals in the US according to data I have seen).

In a PLP scenario, investors get what they invested back (and sometimes even more than 1x that amount) PLUS the remaining amounts are split up according to how much each holder owns (inc. the investor even though they already got x times their cash back). So in this case, the investors gets more as a % than the ordinary holders even when the company sells for a higher valuation. This is where founders can get tripped up as they end up giving away more of their potential returns than they thought they were.

Illustration: using the above Company X example, let’s say investors have a 1x PLP (i.e. they get 1x their cash back first), the resulting amounts for the downside case are the same as above, but now for a $20m exit:

So here the investor gets an outsized amount of the proceeds, more than the 20% the founders may have thought that they were giving away. This effect does decrease with exit price. Below I have set out the outcome at various exit prices and at a $500m exit this effect is tiny:

As I mentioned above, sometime investors ask for 2x or 3x preference (NB: I have never seen this in Aus but I have heard of it in the US). At a 2x pref the above outcomes become:

So why do some investors ask for them? If I was being cynical, I would say it is because they can, but a more well thought through investor might argue that it is a low growth protection mechanism and if founders are looking to build billion dollar companies then they shouldn’t worry about the term as the effect is minuscule at large exit values. These sort of terms might make sense in later stage deals with lofty valuations but, IMHO, at the early stages (seed to series A) I don’t really buy this reasoning as it just complicates cap tables unnecessarily and if an investor is that concerned about a low growth situation early on, then they should just try to negotiate a lower valuation or not invest…

One thing to note is that, as you can see above, these preferences will mean that investor’s preference shares are worth more than ordinary shares in a lot of outcomes so the prices of each type will likely be different to reflect this. This shouldn’t make a difference in a trade sales or IPO (where shares are normally all converted to ordinary shares) but can come into effect if founders are looking to take some cash of the table prior to an exit.

One final thing to note, these clauses are not always given the above names nor are they always set out really clearly. So, read the Shareholders Agreement and Subscription Agreement carefully. Often I will do an exercise like the one above and play out a few different valuations and work out what the resulting amounts paid out would be to make sure I understand how it is all working, especially when there are also convertible notes and other share types involved.

Hope this has been helpful. If anyone has any comments or would like a crash course in any other term — please let me know!