Understanding the Liquidation Preference - 08/29/2009

Summer is over; I am back from vacation, time to catch up on some blogging…

I wanted to talk a bit about the liquidation preference. I recently received a distribution from one of my investments that did not succeed.  The company was struggling, was out of cash, and took an opportunity to sell out at a fairly low price. The price was much less than the total capital they had raised. I got some money back, not all of my capital but at least some of it. Many other investors in the company got nothing.

The distribution of funds was dictated by a key right that that was attached to my preferred stock, the liquidation preference. This is the most common, and in many ways most important, right that comes with preferred stock. Investors insist on it. The liquidation preference is very important to protect the investors’ capital. Any entrepreneur needs to understand this term and how it works if they are meeting with investors.

The fact is that in this weak economy, more start-ups are failing. Many of those that do not fail are being forced to do down rounds. When a start-up fails, often there is some money that becomes available depending on the liquidation process – an acquisition or asset-sale will usually generate some cash. First to get paid are the lawyers who did the deal, then any debt holders. If there is additional money available, it goes to holders of preferred stock with a liquidation preference. Then, only after they have been fully repaid the original investment amount (or another amount that is negotiated), remaining funds may be available to non-preferred shareholders.

When companies raise multiple funding rounds over time, it is not unusual to actually build up a hierarchy of preferred stock holders. Each later investor might get priority treatment over the prior investors, or what is called a senior liquidation preference. So if a company raised three rounds of money, let’s call them the A, B, and C rounds, then the company may have four separate classes of stock, common shares and three different classes of preferred shares. If senior liquidation preference rights are present, then the series C preferred stockholders take priority over B, who take priority over A, who take priority over the common shareholders. Each class is entitled to get their original investment dollars back before anyone else can get any of the cash.

Let’s look at a simple example:

  1. Founders start a company called New Corp and put in their life savings to get it off the ground. They hold common shares.
  2. Investors put 1 million dollars into the company in a series A round. They get series A preferred stock with a liquidation preference over the common shareholders. Sorry, founders.
  3. Later, additional investors put 2 million more dollars into the company. They get series B preferred stock with a senior liquidation preference over the series A holders.
  4. And some time later, new investors put 5 million dollars into the company and get series C preferred stock with a senior liquidation preference over the series B and A preferred shareholders.

New Corp struggles and burns through cash. The CEO the series C investors brought in likes to fly first class and lavishly decorate his office. New Corp eventually get rid of the CEO but has run out of money and is unable to raise additional capital because the market and economy have soured. Nobody is buying their products anymore. They are approached by a larger competitor and presented with an opportunity to sell the company for 4 million dollars, which will ensure the remaining employees can keep their jobs and the existing customers will be supported. The board decides to take the deal.
It is a better option than shutting the doors.

Where does the 4 million dollars in proceeds go? After the lawyers are paid and any outstanding debt holders are paid, the remainder goes to the series C preferred stock holders. The B, A, and common stockholders get nothing. The senior liquidation preference ensures that the series C stockholders will be entitled to get their full 5 million dollars back (assuming a 1x liquidation preference) before any of the other stockholders get anything. In this case, the series C stockholders will get up to 80% of their money back, but everyone else, including the founders, will lose all their money.

Not all financing’s involve senior liquidation preferences. Sometimes all preferred stockholders share that preference on an equal basis. It is one item to be negotiated and in some ways will be driven by the terms of whatever the last investment round was. Once a precedent gets set, it is likely to continue into all funding rounds. Therefore terms in early financing’s turn out to be very important in setting the tone for later rounds.

This has covered the basics of the liquidation preference, but there are many scenarios and configurations. Sometimes investors can be entitled to take out more than they put in. Sometimes they can be entitled to be paid dividends. “Participating preferred” terms mean not only does the investor get their money first, but is then entitled to their share of leftover funds as if they were a common shareholder too (“double dipping”). Amounts can also be capped.

The situation points out the risks to earlier investors, especially angel investors, who tend to lose control over their investments when later rounds are done. They get pushed down the stack. The founders, unfortunately, never win unless the company succeeds. That is usually what investors insist on. The founders need to be motivated.

I was lucky in my investment. I participated in the last funding round, had a senior liquidation preference, and when the company was sold off I got about half my money back. I would like to think I was really smart but the fact is the terms were negotiated before I got involved. And, unfortunately, the company did not make it, which is never a good outcome.

In reality, the majority of companies experience some sort of exit event that is not ideal. Liquidation preferences play a very important role in these cases. It can even play a role in “good exits” in that it can direct outsize proceeds to preferred stockholders, or create funny incentives when the investors are entitled to receive identical payouts under different scenarios that treat common shareholders unequally. Founders and investors need to clearly understand these terms and work through what happens in various scenarios.

This has been a basic overview of the liquidation preference. For more information, I suggest some follow-on links, which include sample text, examples and language from actual deals.

http://www.burningdoor.com/askthewizard/2007/04/venture_terms_liquidation_pref.html
http://www.feld.com/wp/archives/2005/01/term-sheet-liquidation-preference.html
http://www.altgate.com/blog/2008/05/how-liquidation.html

2 Responses to “Understanding the Liquidation Preference”

  1. Berislav Lopac Says:

    While I can understand the benefits for the investor, I have never really understood why would any entrepreneur accept liquidation preference. To me, equity investors always seemed as an alternative to more traditional, debt investors, since they share the risk together with the entrepreneur. With liquidation preference a VC is no better than a bank, and in some ways it’s much worse; a bank takes just the interest, but with liquidation preference an investor essentially provides a loan while still taking a share in the company. And don’t let me even start on the multiple liquidation preferences.

  2. jstjean Says:

    Thank you for your comment.

    The types of businesses taking equity investment are usually not qualified for debt financing, at least the early stage ones. So equity financing is often the only option. Some type of liquidation preference is standard and accepted by both entrepreneurs and investors (for some very interesting reading on this visit http://www.cdixon.org/?p=271).

    Some early investors may take common shares, but it can be risky especially for larger dollars. Without a liquidation preference, it is possible for the founder to fold the company shortly following the investment and legally walk away with a portion of the investors money. This is real risk if the investor does not have majority control. The 1x liquidation preference is a reasonably fair way to mitigate that risk. I agree that high multiples and participating sweeteners seem draconian, but even they can have their place when they set a minimum return level for an investor that otherwise cannot control the parameters of an exit event.

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