Understanding Liquidation Preference Types
Introduction To The Liquidation Preference Types
Liquidation preference is a critical term in startup investment term sheets. It defines how investors are paid back in case of a company sale or bankruptcy. Understanding the different types of liquidation preferences and their implications is crucial for founders to negotiate effectively and protect their interests. This guide explores the various structures, negotiation considerations, and how they impact the outcome for founders and investors.
Basic Structures of Liquidation Preference
Simple Liquidation Preference
A simple liquidation preference offers investors a guaranteed return on their investment in case of a liquidation event (company sale or bankruptcy) before any remaining proceeds are distributed to common shareholders (typically founders and employees holding stock options).
Imagine an investor invests $1 million at a $10 million pre-money valuation (company value before investment). With a 1x simple liquidation preference, the investor gets their $1 million back first in a liquidation event.
This structure offers basic protection for investors, ensuring they recoup their investment before founders see any return. However, it doesn’t allow them to participate in any potential upside if the company sells for more than its invested amount.
Participating Liquidation Preference
A participating liquidation preference allows investors to receive their guaranteed return (like in simple preference) and participate in the remaining proceeds alongside common shareholders, up to a certain point.
Similar to the simple example, the investor gets their $1 million back first. However, they can also participate proportionally with common shareholders in the remaining liquidation proceeds.
This structure offers investors more protection and potential upside. They get their investment back for sure and can benefit if the company sells for a significant premium. However, the participation feature typically has a cap (e.g., participate up to a return of 2x their investment).
Advanced Structures of Liquidation Preference
Ratchet Liquidation Preference
A ratchet liquidation preference adds a layer of protection against future down-rounds (funding events where the company valuation decreases).
Let’s say an investor invests $1 million at a $10 million pre-money valuation (10x price per share). With a 1x ratchet liquidation preference, if a future down-round values the company at $8 million (8x price per share), the liquidation preference “ratchets up” to the higher valuation (10x). So, in a liquidation event, the investor would get $10 per share instead of $8.
This protects investors from a potential loss due to a declining valuation before a liquidation event. However, it can significantly increase the cost of a liquidation for the company.
Valuation Caps and their Interaction with Liquidation Preference
A valuation cap sets a maximum valuation used to calculate the liquidation preference.
Let’s say an investor gets a 1x liquidation preference with a $20 million valuation cap. Even if the company’s valuation at liquidation is higher (e.g., $30 million), the liquidation preference would be calculated based on the capped valuation ($20 million).
Valuation caps limit the potential payout to investors through liquidation preference, especially in high-growth scenarios. This can be beneficial for founders who retain more ownership and potential upside.
Negotiating and Analyzing Liquidation Preference
Key Factors to Consider When Negotiating Liquidation Preference
Seed rounds often have simpler preferences, while later rounds might involve participating or ratchet structures.
Angel investors might be more flexible, while VCs might seek stronger protection.
Riskier ventures might offer higher liquidation preferences to attract investors.
Strong negotiation leverage can secure more favorable terms.
How Liquidation Preference Affects Valuation and Dilution
Higher liquidation preference typically leads to a lower valuation for the company as investors get more protection.
Preference can increase dilution for founders as a larger portion of the company’s value goes to investors first in a liquidation event.
Understanding Dilution Protection alongside Liquidation Preference
Dilution protection mechanisms (e.g., anti-dilution provisions) can mitigate the ownership stake decrease caused by liquidation preference. They ensure founders maintain a certain ownership percentage even if the company issues new shares at a lower price.
Variations and Considerations for Different Situations
Structuring Multiple Liquidation Preference Classes
A company can have different classes of investors with varying liquidation preference terms. This allows for:
Angel investors might accept simpler preferences, while VCs might seek stronger participating or ratchet structures.
Seed rounds might have basic preferences, while later stages could have more complex structures.
However, managing multiple classes can be complex and requires careful negotiation to avoid conflicts and ensure fairness among investors.
Tailoring Liquidation Preference for Different Investor Types
Often more flexible, they might accept simple liquidation preference or participate in upside with a cap.
Typically seek stronger protection with participating or ratchet preferences to ensure a return on their investment.
Debt holders might receive priority repayment before any liquidation preference payouts.
Understanding investor priorities allows for tailoring terms that are attractive to different investment sources.
Understanding Outcomes and Analyzing Impact
Liquidation Preference Waterfall Provisions: A Breakdown
A liquidation preference waterfall provision outlines the exact order and amount paid to different classes of shareholders in a liquidation event. It typically follows this order:
All company debts are settled first.
Investors with liquidation preference receive their guaranteed return according to their class terms (simple, participating, etc.).
Any remaining funds are distributed to common shareholders (founders and employees) proportionally based on their ownership stake.
Understanding the waterfall provision is crucial for founders to know how much they might receive after investor payouts.
How Market Conditions Influence Liquidation Preference Terms
In a bull market, investors might be more flexible on liquidation preference as they are confident in the company’s potential upside.
During economic downturns, investors might seek stronger liquidation preference to protect their investment in case of a fire sale.
By understanding market conditions, founders can adjust their negotiation strategies to secure more favorable terms.
Conclusion
Liquidation preference offers a spectrum of options depending on the investment stage, investor type, and market conditions. Founders should carefully analyze these variations and negotiate terms that balance investor protection with their own long-term goals. By understanding the nuances of liquidation preference, founders can navigate fundraising conversations with greater confidence and secure a term sheet that fosters future success for their startup.
Schedule a free demo to see how foundercrate help you with uplifting fundraising efforts of founders in raising funds. You can also sign up directly on the foundercrate platform.
Related Posts
How to Improve Investor Communication
In the startup world, strong communication with investors is critical for success. Transparent, timely, and strategic communication helps build trust and maintain long-term investor relationships. However, managing investor updates and keeping them informed can often…
5 Fundraising Challenges and How to Overcome Them
Introduction Fundraising is a critical aspect of any startup’s journey, but it’s often one of the most challenging. From finding the right investors to keeping investor relations intact, entrepreneurs face several hurdles on their path…
