Sep 12, 2019
Term Sheets

Get In Line: Liquidation Preferences in the Term Sheet

GoingVC Team

If you have been reading our term sheet series, then by now you know we are getting deep into the investing process.

An Intro to Liquidation Preferences

At this point, we’ve found a company we like, done the due diligence, decided to invest and reviewed the term sheet. We also touched upon the pre-money valuation of the company, which is arguably the most important number on the term sheet because it determines how much equity you get and at what value.

If you’ve stuck with us, then you are doing well and should be proud of where you’re at. But now is not the time to ease off the gas pedal – now is the time to be more alert than ever.

As an investor, the most important thing to do now is watch your own back and make sure the money you are investing is going to turn into a bigger pot of money down the road. Doing so will allow you to stay true to your limited partners, the people who are financing your fund. So keeping them happy is imperative.

This brings us to the next key phrase on the term sheet: Liquidation Preferences

Liquidation Preferences, as Brad Feld wrote in his blog back in 2005, “determine how the pie is shared on a liquidity event.” Furthermore, they help to protect an investor when a company is cashed out at a less than thrilling price, something which can happen often, because as we know, startups are risky business.

Liquidation Preference as Insurance

A liquidation event can occur under a number of different circumstances. It can happen when a company decides to wind itself down, possibly at a lower valuation than on the term sheet. It can also happen if a company gets acquired, merges with another company, or when there is a change of control in the company.

Some also consider an IPO to be a liquidation event, but when this occurs preferential stock is converted to common stock as part of the IPO, eliminating the issues over liquidity.

But let’s start broad and simple, as Liquidation Preferences can get pretty complex.

On its own, a liquidation preference is just a tool for preferred stockholders so that they may ensure they’re getting their investment back before common shareholders.

The preference is typically laid out in multiples. For instance, if you invest $10 million and you have a 1x multiple, then you are hypothetically guaranteed a return of $10 million when the liquidation event occurs. That means you get back $10 million before the common shareholders get anything. Under this scenario, a 2x multiple would entitle you to a $20 million return.

Once the multiple is determined, you then have to negotiate whether the liquidation preference will be participating or non-participating.

Charles Yu, an investor at TI Platform Management, actually does a great job of explaining this concept in his Medium post if you are looking for another source.

The distinction between participating and non-participating is a big deal, and unsurprisingly, also where things can get complicated.

The Details

To boil things down, we’ll start with participating preferential liquidation, which is usually what you want as an investor, as it is where you will see a return on investment during a liquidation event.

Under this scenario, an investor gets paid back their multiple and part of the remaining proceeds from the liquidation event.

If you’ve been wondering all this time whether or not equity would come into play, well, this is the moment it does. That’s because with participating preferential liquidation, the remaining proceeds after the multiple is paid back are also paid to the investor based on the investor’s equity stake. This additional payment right is commonly referred to as Pro-Rata.

To help you visualize all of the above, let’s go back to our earlier example, where we had a $10 million dollar investment and a 1x multiple. Only now, let’s add a 30% ownership stake in the company.

In this scenario, if the company we invested in was sold at $20 million, we would get back our initial $10 million, which covers the 1x multiple, and then also get 30% of the remaining $10 million, which equates to an extra $3 million.

Now, the total we get back is $13 million on a $10 million investment.

Not too shabby.

Before we move on, you should know there is a caveat to participating preferential liquidation. Just as the investor uses this clause to protect themselves, the founder of the startup will often put a cap on total proceeds to protect the company from having to forfeit too much of their profits. This cap is also often in a multiple.

To Participate or Not, That is the Question

Non-participating preference liquidation, on the other hand, essentially gives investors a choice between their multiple and equity, but never both.

These investors have the option of taking a multiple like 1x or 2x, or they can elect to convert their preferential stock to common stock and get paid out solely based on their equity.

If we go back to our example again, with the $10 million dollar investment, the 1x multiple, a 30% ownership, and the company being sold for $20 million, we have two options: You can take your $10 million dollar investment for your 1x multiple or take 30% of the $20 million sale price, which would pay out about $6 million.

Most of the time, non-participating investors will take their multiple because it is usually a higher amount. But occasionally, the conversion might make sense.

When will it make sense, you ask?

Easy. A non-participating investor would elect to convert his or her shares to common stock if the company was sold for an amount which makes taking their equity stake in the company a better return than receiving their multiple.

Going back to the example we’ve been using once more, at 30% ownership, if the company was sold for $35 million, the equity value would pay out $10.5 million, which is higher than the 1x multiple of $10M, making it the better option.

We’re $500,000 richer!

Rounding into Form

So, there you have it. We have now covered participating and non-participating Liquidation Preferences.

What did you think? Complicated? Still too easy?  (There is actually a great tool that Endeavor Global offers, which will help with some of the calculations, if you want to play around)

Well, we actually aren’t done yet. Everything that we have discussed up until this point assumes there was only one funding round.

Many companies go through Series A, B, and C funding rounds –  and some still even get to a Series F round or beyond. And it’s in these instances where things start to get much more complex.

With multiple rounds, investors – even those with Liquidation Preferences – still might not get back their full investment if a liquidation event occurs.

There are a few ways this can play out when there are multiple funding rounds.

Investors can be put into different seniority levels based on the funding round they were initially a part of. In this case, investors in the later funding rounds are entitled to their full Liquidation Preference before investors in earlier rounds of funding.

That means an investor in a Series B round will get their full liquidation before an investor in series A gets anything.

Pari Passu

Another structure companies tend to use is called Pari Passu.

This format really comes into play if a company does not have enough money to fully pay back investors. In this scenario, investors in all rounds – from A to F and beyond – have the same status and are paid out Pro-Rata based on how much they invested as a percentage of the total money raised.

So, if you invested $10 million and the company raised $30 million in total, but was only liquidated at $20 million, because you invested one-third of the total capital, you would be entitled to a $6.6 million pay out.

Ultimately, Liquidation Preferences can be super complicated or super simple; it really just depends on the funding rounds and specific companies and investors.

Unfortunately, there is no perfect game plan to follow when choosing which route to go down. As VC expert Brad Feld says, it really depends on a range of factors and, as with all things in VC, a little bit of luck:

“Determining which approach to use is a black art which is influenced by the relative negotiating power of the investors involved, the ability of the company to go elsewhere for additional financing, economic dynamics of the existing capital structure, and the phase of the moon.” – Brad Feld

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