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The Latest Changes in VC Deal Terms — Liquidation Preferences

by kirkcoburn
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Liquidation preferences are a crucial aspect of negotiating the terms of your VC deal. They are as important as your company’s valuation (and I discuss more about valuation here). A liquidation preference is an economic provision included in the term sheet. It serves as the mechanism for preferred stockholders to receive their returns when a significant company event occurs.

Each component of a liquidation preference (and whether or not they are included at all) provide leverage for you when negotiating with venture capitalists. I want you to have a strong understanding of what liquidation preferences are, their purpose, and who gets them. Then I will discuss:

  • The components and structuring of liquidation preferences in VC deals.
  • How those structures have changed.
  • Potential outcomes for the type of liquidation preferences you negotiate in your VC deal.

What Is a Liquidation Preference?

Brad Feld, an investor, entrepreneur, and co-founder of the Foundry Group, offers an example of the language which most often makes up a liquidation preference, in his book Venture Deals:

In the event of any liquidation or winding up of the Company, the holders of the Series A Preferred shall be entitled to receive in preference to the holders of the Common Stock a per share amount equal to [X] times the Original Purchase Price plus any declared but unpaid dividends…

I will delve deeper into structure later on, but for now, concentrate on the X in Feld’s example. That’s the liquidation preference multiplier. This number changes based on the market and serves as one of the main points of negotiation in the liquidation preference of a VC deal. The most frequently used multiplier is 1. This means for each dollar an investor spends, he or she will get a dollar back in the event of a liquidation event. In fact, Cooley reports less than 10 percent of all VC deals have liquidation preferences in the last few years. In situations where startup companies must really entice investors, they might offer 1.5X, 2X, or 3X liquid preference returns.

What Company Events Trigger a Liquidation Preference Payment?

Specific company events may initiate the need for a company to pay preferred stockholders for their liquidation preference. These events, sometimes referred to as liquidation events, include mergers, acquisitions, sale of voting control, and dissolution of your company.

In some cases, a qualified IPO (Initial Public Offering) will also trigger a liquidity event. An IPO can result in an automatic conversion of preferred stock to common stock. A liquidation preference is an investor’s legal right to get his or her investment returned before those who hold common stock. Depending on the type of liquidation preference, investors might get their money back. In other cases, once preferred stock converts to common stock in a qualified IPO, the liquidation preference goes away.

The Purpose of Liquidation Preferences

Raising venture capital for your business typically requires issuing preferred shares or preferred stock. You can expect investors to not offer you any capital in exchange for common stock. Investors who have preferred stock get privileged treatment compared to common stockholders and others. A liquidation preference is only one special right, typically the most important one, for preferred stockholders (investors, let’s discuss, do you agree?).

Liquidation preferences serve as protection for investors, and they typically demand them to mitigate any risk associated with giving you capital. If your startup business is successful, you might never have to deal with liquidation preferences coming into play. But if your business tanks or you sell it for less than its valuation, you will have to make a liquidation preference payment to ensure investors get their money back first. This payment happens before you, your partners, and any common stockholder. When negotiating my first equity raise, as an entrepreneur, I did not want to believe my idea, my projections (my my me me…dangerous words and something to monitor) would ever fall below expectations. However, investors are modeling your expected future free cash flows and discounting it to their opportunity cost of capital (no one explains this better than Kevin Kaiser). In other words, they also have to consider the probability of you not achieving your “promise” and thus have negotiated an important term to protect their downside.

Although immediate profit is not the primary reason for the existence of liquidation in a round of venture capital financing, companies do benefit. Liquidation preferences give companies the justification for higher-priced preferred stock in comparison to the fair market value of the common stock. This translates to immediate ‘paper profit’ for shareholders.

Who Gets Liquidation Preference Rights?

I’ve mentioned liquidation preferences in reference to preferred stockholders, but just to be clear: liquidation preferences are never attached to common stock in venture capital-backed companies (this is not entirely true as I have learned when dealing in certain regions of the world, but almost never). Liquidation preferences are a right for Series Preferred Stock. Each series of preferred stock has a specific liquidation preference attached.

What Happens When You Have Multiple Series of Preferred Stock Liquidation Preferences?

people at different heights parachuting to a island

Your plan may have different tiers of investors who get different payouts — make sure your deal terms are clear.

If you have multiple rounds of financing for your company, you will have a capital structure that includes multiple series of preferred stock. This means you also have multiple liquidation preferences. These preferences are stacked based on the seniority structure of your company. Companies use two main seniority structures or a hybrid of the two. They are as follows:

Standard Seniority

Most startup companies and those in the early stages of raising capital follow standard seniority when honoring liquidation preferences. You have probably heard standard seniority referred to as ‘last in, first out’ for investors. This means your most recent round of investors will get paid before the first round of investors. For example, when an event triggers liquidation preferences, Series B investors get paid, then Series A investors, and then Series Seed investors. And this is why early investors need to retain enough capital to keep going.

Pari Passu Seniority

Pari Passu is the Latin phrase for “on equal footing.” When companies use this structure, all preferred investors have equal seniority. This means, if liquidation preferences come into play for your company, all investors share in the proceeds. Sometimes a sale and the subsequent dissolution don’t leave enough funds to cover all liquidation preferences adequately. In these cases, the company’s payout proceeds based on the percentage portion invested.

Tiered Seniority

In this hybrid structure, investors from different rounds of financing are placed into different groups. Tiered seniority follows the ‘first in, first out’ structure of standard seniority. However, all investors within each group are on equal ground, following the pari passu seniority structure.

Types of Liquidation Preferences

So, far I’ve referred to liquidation preferences for investors as one-size-fits-all. This is not the case. Not all liquidation preferences are the same. Below I explain the differences between components of each type, which center around participation. You need to have a clear understanding of these differences because they can substantially impact an investor’s return.

Participating Liquidation Preferences

Sometimes referred to as ‘full participation,’ ‘preferred participation,’ or the ‘double-dip,’ these liquidation preferences are favored by investors. If a VC deal includes preferred stock with full participating liquidation preferences, the investor will receive payment to recoup his or her initial investment and share in any proceeds in accordance with his or her equity ownership in the company. That is, after preferred payback, the investor can participate pro rata with common stockholders — hence the nickname ‘double-dip.’ Investors will push especially hard for participating liquidation preferences when they sense higher risk or you don’t have much leverage.

Non-Participating Liquidation Preferences

Also referred to as ‘straight preferences’ or ‘actual preferences,’ non-participating liquidation preferences are the most common in venture capital deals. This is especially true in early-stage companies, where simple liquidation preferences without participation can benefit the company and the investor. In non-participating liquidation preferences, investors recoup their initial investment multiplied by the specified multiplier discussed above. As previously mentioned, a dollar-to-dollar return, or 1X, is the most common straight preference.

Historically, these preferences haven’t gone above 2X, or two-to-one for each dollar invested.

One of the biggest changes in VC deal terms is the appearance of 3X preferences, which are usually associated with companies in later financing rounds that are desperate for money. And with all of the wild swings associated with Covid and oil price volatility and collapse, this is coming back again. Offering a 3-to-1 return can also help reduce competition for companies to snatch up money from a VC. Cooley reports between 2 percent and 4 percent of all VC deals they’ve tracked in the last few years have included 3X preferences. Yet, when 3x liquidation preferences are present in a VC deal, they are typically capped at a certain amount.

Participating Liquidation Preferences with a Cap

Sometimes referred to as ‘partially participating preferred’ liquidation preferences, capped preferences are a hybrid of participation often seen as a middle ground favorable to companies and investors alike. In these cases, investors recoup their initial investment times whatever multiplier (1X, 1.5X, 2X, 3X) and shares in proceeds based on his or her proportion of ownership. However, the investor’s returns are capped at an agreed-upon amount.

The Impact of Liquidation Preferences on Companies

Liquidation preferences remain one of the most crucial terms which can impact investor returns. That makes them among the most important of all VC deal terms. Early-stage investors need to understand preferences and how they can affect their returns. Entrepreneurs need to understand the specific features of liquidation preferences, so they have an idea about leverage for VC deal negotiations.

Entrepreneurs must also understand how the decisions they make surrounding liquidation preferences can negatively impact their organization down the road.

Let’s say you give up too much in high liquidation preferences and a few months later you receive an acquisition offers. This type of deal would normally be lucrative, even life-altering, for partners and employees. But giving up too much in liquidation preferences eliminates a large chunk of profit, making the acquisition deal less attractive. And when you have misalignment amongst your investors, this can become a company killer.

These types of situations can be frustrating, so it’s always best to discuss your strategy for raising capital and VC deal terms with a trusted advisor and lawyer to consider the long-term impact. It’s also a good idea to debate, discuss, and refine your knowledge about these important deal terms. So, if you’d like to add your voice to the debate, talk to me here about recent liquidation preference shifts and how VC deals are changing.

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