Key Economic Terms: The Liquidation Preference
This post is a continuation of the Series A discussion that covers everything a founder should know before raising their Series A. If you missed the first few posts, you can find them here.
This post continues the discussion around important economic terms in a term sheet with the liquidation preference.
The Liquidation Preference:
The Liquidation Preference is the amount an investor will get back on their investment following the sale or liquidation of your startup. The typical liquidation preference is 1x; meaning that the investor will receive funds equal to the amount of their investment. So, if an investor invested $1mm with a 1x liquidation preference in your startup, they would be getting $1mm back. This may lead you to ask “how do investors make money?”. The answer is that the preferred stock they are purchasing can be converted into common stock at their discretion, and at any time. What this means is the investor can convert their shares of preferred stock into common and receive the amount of the proceeds from the sale of your startup based on their equity percentage in it. It is important to note that the investor will always convert their shares to common if the amount they will receive is greater than the amount under their liquidation preference. For example, let’s say you have an investor who has invested $1mm into your startup with a 1x liquidation preference, and that the $1mm investment equates to a 10% interest. You then sell your startup for $5mm. With a 1x liquidation preference your investor will get $1mm back and the other $4mm will be disbursed to you. But remember, the investor can convert. So if the investor converts in this scenario they would receive back 10% of the $5mm, which equates to $500,000. So in this case the investor would not convert. If your startup sold for $20mm, the investor would receive $2mm if they converted versus the $1mm under the 1x liquidation preference; so in that scenario they would convert.
The liquidation preference is further broken down into what is called participating and non-participating. With a participating liquidation preference, the investor gets the best of both worlds. They get their investment back plus they partake in the rest of the proceeds based on their percentage in your startup. To help explain this, let’s go back to our previous example with a $1mm investment that has a 1x participating liquidation preference, and the investment amount equates to a 10% interest. If your startup is sold for $5mm under a 1x participating liquidation preference, the investor would receive their 1x liquidation preference of $1mm and then receive 10% of the remaining $4mm; total investor payout would be $1.4mm and the remaining $3.6mm would be disbursed to you. As you can see, and infer, a participating liquidation preference is not felt too hard when your startup is sold for a higher amount as it is with a lower amount. With a non-participating liquidation preference, the amount the investor receives is the same as with our original example above ($1mm under the 1x liquidation preference or $500k if they convert).
When it comes to liquidation preferences, there are a few tips that you should know. 1) If the liquidation preference is non-participating, the multiple of the liquidation preference should never be more than 1x (unless you are in a down round or the lights are about to go off); and 2) If the liquidation preference is participating, you should try to negotiate a cap on the total amount the investor receives back to 2x or 3x.
As always, it is important that you discuss any terms in a term sheet with an attorney who handles these matters. In my next post, we will continue the conversation around important economic terms in a term sheet by discussing anti-dilution protection.