Beware the Liquidation Preference, the "Smooth Criminal"
Don't agree to anything other than 1x liquidation preference, non-participating.
TL;DR: “1x liquidation preference, non-participating.” When it comes time to raise your Series Seed round, this is the one phrase you need to remember from this entire post.
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I was having lunch with a friend…
“Your counsel agreed to 3x?!”
I nearly choked on my burger. It took a gulp of coke to push the remaining bite down my tied-up throat. My founder friend’s counsel had agreed to a 3x liquidation preference for the seed round, and they found out what that actually meant after closing.
“I know, it’s unbelievable,” my friend said as he cut his chicken fillet. “We had to spend a lot of money to fix it for the next round.”
“That’s crazy. 1x, non-participating – anything other than that is unacceptable.”
“Yeah, now we know. Fortunately, it’s fixed. Never again.”
What is a “liquidation preference”?
In the plainest of terms:
a liquidation preference is your investor’s right to get their money back first, before other stockholders, when the company shuts down or is sold.
Seems like an innocent, reasonable term if you don’t know the layers involved. Fact is, it can prove to be a “problem in disguise”.
Let’s break this down.
Shutting down or selling your company
The liquidation preference kicks in when your company shuts down (aka, dissolves) or exits (for example, in a sale of assets). When this happens, the company gets proceeds which it will then use to:
First, pay off its creditors (people it owes money to, such as vendors), and
Then, pay out its stockholders.
The liquidation preference comes into play when it’s time to pay out the stockholders.
Paid first among stockholders
A liquidation preference allows the investor to “dip first” into these proceeds in order to recoup their investment. After they get paid out, whatever remains is distributed to the remaining stockholders (unless the investor has a participating liquidation preference – more on this below).
By the way, we look at “seniority” to determine the order in which the investors get paid out, if there are multiple classes of investors. Normally, the investors – who hold preferred stock – will all get paid out before the common stockholders, who get paid out last. Reminds me Orwell’s famous line from Animal Farm, modified here:
All stockholders are equal, but some are more equal than others.
Paid how much?
This is where the multiple comes in. The liquidation preference is normally expressed as a multiple – 1x, 2x, 3x, etc. This multiple is in reference to the investor’s original investment.
So, as an example, if an investor invested $1M and has a liquidation preference of 1x, they’ll be paid out $1M before other, junior stockholders are paid. What if the multiple was 2x? The investor will be paid out $2M (or $1M times 2).
Participating preferred: Talk about double-dipping
After the investors have been paid out their multiples, there may be a balance left that we’re going to use to pay out the remaining stockholders.
But wait – can the investors dip into that remaining balance as well?!
You bet they can. That’s where “participating preferred” comes into play.
What is “participating preferred”?
This is preferred stock where the investor can “participate” in the distribution of the assets that remain after the senior stockholders are paid out, in proportion to their ownership percentage. In other words, participating preferred stockholders get paid twice:
First, through their liquidation preference multiple, and
Then, by getting their pro-rata share of the remaining assets.
What is “non-participating preferred”?
This is preferred stock where the investor must chose one of two pay-outs:
The liquidation preference or
The pro-rata share of the remaining assets.
I bring a couple scenarios below to flesh out both concepts hands-on.
Can we cap it?
Sure. If an investor has a participating liquidation preference, their total return can be capped in order to protect the founders. That investor will get their liquidation multiple and then participate in the distribution of the remaining assets, up to a certain amount (normally again expressed as a multiple).
Let’s get real
Here’s a hypothetical to help wrap your head around all these preferences.
Your investor has invested $10M.
They own 20% of your business.
You sell your business for $45M, and spend $5M paying off creditors.
$40M remains to pay out the stockholders.
Scenario A: 3x liquidation preference, participating
Your investor first takes triple their investment amount, or $30M.
This leaves $10M ($40M-$30M) to distribute to the remaining stockholders.
The investor has participating preference, so they’ll take another 20% of this remaining $10M, or $2M.
The balance of $8M ($10M-$2M) will then be distributed to the founders.
Section B: 1x liquidation preference, non-participating
Your investor has to decide whether to take their investment amount, $10M, or 20% of the proceeds, which is $8M (20% of $40M).
Since $10M is greater than $8M, they’ll take their multiple of $10M.
This leaves $30M ($40M-$10M) to distribute to the remaining stockholders.
Your investor has already been paid out, so they won’t participate in this residual distribution.
$30M will then be distributed to the founders.
Why though?
The theory behind the liquidation preference is that it incentivizes the investor to invest by reducing their risk in case the company isn’t as successful as initially expected.
Ultimately, this boils down to ownership and control being separate in the corporation: those who own the corporation (the stockholders) don’t have daily control over how it’s run (by the management). The investor is entrusting their money to the managers, whose actions will determine the fate of that money. By giving investors preferred stock (and, with it, the liquidation preference), the corporation de-risks their trust in a process they don’t have daily control over.
Conclusion
Nearly 100% of venture deals have 1x liquidation preference, non-participating. So, when you get that term sheet, if it has anything other than 1x liquidation preference, non-participating…
Run.
Startup Ecosystem Member Highlight
Over the past years, I’ve had the opportunity to meet with amazing people who are super passionate about startups. I’d love to introduce them to you through this newsletter, as they can be helpful to you as you start, grow, and scale your startup.
Meet Chris Hoffmann
Chris is the founder of Equity Admin Co., which helps companies manage their cap tables. After spending more than three years at Carta, he branched out to bring accurate and efficient cap table management services to startups all the way to pre-IPO. Whether it’s a cap table audit, securities transactions, or modeling your pro forma, his team has you covered.
I admire what Chris has built because it covers such a crucial cornerstone of your founder journey: maintaining a pristine cap table – the foundational document that shows who owns how much of your company. Imagine if your house deed or car registration didn’t list you as the owner – that would be so uncool, right? Well, same goes for cap tables – and with the amount of money at stake, even more so.
And by the way, along with being a cap table guru, he’s also a father of three!
Chris’s LinkedIn: https://www.linkedin.com/in/equityadmin/
Equity Admin Co.: https://www.equityadmin.co/
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Until next time!
Stepan
A bit about me: I’m a former corporate lawyer with 10+ years of experience helping 100s of companies navigate the legal journey, including early-stage startups and unicorns. I quit my private practice to start Corpora and help founders raise money faster and more affordably. Let’s connect on LinkedIn.