How to read an Investment Termsheet: the Liquidation Preference and Waterfall
By David Willbe for Startup Grind
This is the second entry in my series trying to demystify the termsheet: to explain the jargon to watch out for, and give you practical examples and resources to understand what each term might mean for your business.
In the first article, on Valuation, we unpacked one of the two key financial terms founders need to understand. This time we’ll look at the other, more complicated, one — the preferred return or liquidation preference, which is sometimes referred to as the “waterfall”. Once you can fit the two together, you can get a proper idea of the post-investment stake in the company that your termsheet offers.
I’ve tried to step through a number of different scenarios below, as the best way to explain a purely economic term is to show its effect on the economics. Use in this article doesn’t imply that they’re standard or “market” terms, I chose them to help demonstrate my points. What’s “market” varies so widely between stages, geographies, and types of investor that there’s no way to reflect it for Startup Grind’s audience.
Jargon
- “Liquidity event” — a sale or winding-up of the company, sale of all the assets, or a significant corporate reorganization. Any of these triggers the liquidation preference.
- “Prefs” — preferred or preference shares, i.e. the ones your investors take (the founders will have “common,” “ordinaries,” or “ords”).
- “Waterfall” — the step-by-step order in which the proceeds of a liquidity event get shared out. Sometimes used as a shorthand for the preference itself.
- “Participating” — the last step of the waterfall shares out whatever proceeds are left among certain shares. The shares that get part of this, which will always include the ords, are participating.
- “Times” or “X” (pronounced like the letter) — in this context, the size of the liquidation preference by reference to the amount invested.
If your investor puts in $5 million and asks for a “2x liquidation preference,” they want a liquidation preference worth $10 million.
In the valuation article, we said that if the investor put in $5,000,000 on a pre-money valuation of $20 million (with no other shares rolled into the pre-money valuation), then the investor would end up with 20% of the company and the founder group with 80%. If the company is sold the next day for $30 million, how much will the founders take home?
If you said $24 million…well, you might be right. But the investor probably has a liquidation preference, which is a right to get paid a certain amount of the proceeds before anyone else gets anything. That right will be triggered on the sale, so we need to deal with that before we can know how much everyone gets.
The Waterfall
There are various types of liquidation preference, including an annual rate like the interest on a loan, but the most common is either the amount invested or a multiple of that amount. If the investor in our example had a liquidation preference that would pay out twice the amount invested (a “2x preference”) then the waterfall on the $30 million sale would be:
- Step 1: Pay the prefs $10,000,000; and
- Step 2: Share out the remaining proceeds among the ords.
So the founder team gets $20 million, rather than the $24 million that we would have expected from the valuation and the cap table. Because the liquidation amount is a fixed number (not a percentage), the lower the value of the liquidity event the greater the proportion of the proceeds that will go to the investor — even up to 100 percent, if the proceeds are less than the amount needed to pay the preference.
The investor will also have the option to convert the prefs into ords, abandoning the liquidation preference and just taking their percentage of the proceeds. In our example, the investor would convert for any liquidity event with proceeds above $50 million, but at or below $50 million they would retain their prefs and be paid out the fixed $10 million amount.
Note that the investor will receive the same payment on a liquidity event anywhere in the range between $10 million and $50 million — it’s a “dead spot” in the company’s valuation.
Participation prize
The other aspect of a liquidation preference is whether or not it participates, that is whether it joins the ords in sharing whatever proceeds are left after the liquidation preferences are paid out. If the investor has a “2x participating liquidation preference”, then the waterfall looks like this:
- Step 1: Pay the prefs $10,000,000; and
- Step 2: Share out the remaining proceeds among the ords and the prefs.
Here, instead of the remaining $20 million going entirely to the ords in Step 2, it would be split 80/20 between the ords and the prefs. The result is a $14 million total payment to the investor, and $16 million to the founder group.
Return on prefs which participate like this (sometimes called “full participation”) will always be better than return on the ords, so there is no size of exit at which it makes more sense for the investor to convert, and therefore also no dead spot in the company’s valuation.
Capping it off
There is an alternative type of participation, known as “capped participation”, which retains the preference-then-participation structure but with the prefs only participating up to a certain return. This leaves you with a waterfall along these lines:
- Step 1: Pay the prefs $10,000,000;
- Step 2: Share out the next $15,000,000 of proceeds among the ords and the prefs; and
- Step 3: Share out the remaining proceeds among the ords.
The dead spot is $15 million higher ($25–65 million) than on a non-participating return, and the investor would convert above $65 million rather than $50 million because there’s participation in the second slice of $15 million. The investor would take home $13 million in our $30 million exit scenario, and the founders $17 million.
Investor Influences
It’s crucial for founders to understand the waterfall because of what it means for their share of an exit, and also because it can influence how your investor will behave. The dead spot is key here, as every valuation within that range will deliver an identical outcome for the investor. As your valuation heads towards the dead spot, bear in mind that your interests are no longer necessarily aligned.
Let’s say that your dead spot is $25–65 million and you get an acquisition offer at $45 million. You think that things are going well and in 12 months you would be looking at an offer closer to $60 million, so you might be willing to turn this one down and push on. Your investor, though, won’t make any extra return at $60 million above what they’d make at $45 million. They might want to sell now, to avoid the risk that the business drops off in the 12 months, or hold on until the valuation is above $65 million.
Also bear in mind that the “offer price” that you start a sale process with is always subject to negotiation, usually downwards, as the process goes on. The sellers may have to accept risk, or give up other points, to preserve it. For a sale comfortably within the dead spot your investor will have no purely economic incentive to resist a price decrease, because their return won’t change — they may therefore want to take the hit on price, rather than somewhere else.
Cheat Sheet
To recap, we’ve been working through a scenario where the investor is putting in $5 million at a $20 million pre-money valuation, and the business is then sold for $30 million. The table sets out various different liquidation preferences on those numbers:
Note that a 1x Non-Participating preference converts at $25 million, i.e. the post-money valuation of the investment transaction. On our $30m exit, it’s effectively the same as not having one.
Conclusion
The key takeaway here is that knowing your valuation is only half the story, you must also model the liquidation preference. Plot out whatever has been offered and try to establish the division of proceeds, dead spot, and conversion point — then you can get a true picture of what your eventual exit will look like.
As you grow, you will probably have to build multiple series of prefs into your cap table. You will have to understand several preferences, dead spots, and conversion points — and how they overlap and interact to influence the behaviour of different investors.
Dig into and understand these terms from the start, and you’ll find it much easier to layer on the new ones — and to understand the true value of the termsheet that’s on your table.
