All You Need to Know About Liquidation Preferences in Venture Investing
We all agree that valuations are paramount for setting a road map for the future of a company and its financing. The Liquidation Preferences is one of the second most fundamental term founders run into and is crucial to understand when evaluating a term sheet.
The liquidation preference clause applies when the investor exits the Company through a liquidation event. Liquidation event can be either a bankruptcy, the transfer of all the company shares (through sale or merger) or the sale of the Company’s business.
This clause enables favourable treatment for preferred shareholders in the event of liquidation as downside protection of the invested capital in low-return scenarios.
There are two basic types of equity ownership in a corporation: common stock and preferred stock. Preferred stock provides its holders certain rights above and beyond those of holders of common stock. The two key features that change the exit returns in the investor’s favour are liquidation preference and dividends. In this post, I am going to focus on the former.
The liquidation preference provides the investor to recover the invested amount (or a multiple of the invested amount) with priority over the rest of the shareholders, including founders and early employees of the business. Common stock is the basic equity interest in a company. It is typically the type of stock held by founders and employees.
Liquidation preferences are structured in a number of different ways based on liquidation preference and participation clauses — non-participating, fully participating (also referred to as participating) and, participating with a cap.
Non Participating Liquidation Preferences (NPLP): This type of liquidation preference is the most founder-friendly option. It grants the investors the right to recover an amount equal to their investment in the business or a multiple of it (1x or more multiples). The market standard for liquidation preference is a 1x multiple, which means that the VC investor receives 100% of its investment back in a liquidity event before holders of common stock such as founders and employees can get any money from that event. After receiving the preferred amount, the remaining proceeds are distributed among the rest of the shareholders. Therefore, the investor does not participate in that distribution. With a conventional liquidation preference, the preferred stockholder needs to choose between receiving the liquidation preference or converting to common stock in order to share pro-rata in the total proceeds.
For example, let’s assume the investor buys Series A Preferred for a 50% ownership in the Company for a total of £10 million. The preferred shares have a liquidation preference equal to the original price paid for those shares, which are 50%, or £10 million. Let’s say that the Company is liquidated for £50 million later. The investor has two choices here. It can either take £10 million (from liquidation preference) or will take his pro-rata share of 50% for a payout of £25 million. In this example, converting to common would produce a better ROI for the investor. The founders share the remaining £25 million among them. But if the Company had £15 million to distribute after the sale, the investor will keep its preferred shares and receive £10 million and the founder and employees will share £5 million between them.
For example, the convertible preferred shares Microsoft bought 1.6% of Facebook for about $240 million back in 2007, had 1x nonparticipation liquidation preference.
If Facebook were ever liquidated by sale, Microsoft would get back either its actual cash of $240 million under Non-Participating Liquidation Preferences terms or 1.6% of the purchase price, whichever yields higher ROI. According to The Facebook Effect, David Kirkpatrick’s book, Microsoft’s legal team was in a hurry to close the deal, and they didn’t negotiate liquidation preference and participation clauses and agreed on NPLP. Their main concern was Google. They wanted Facebook to give Microsoft notice if Facebook ever began to take a buyout offer from Google seriously.
Fully Participating: This option is the least friendly for the founder. It provides the investors with the right to recover their investment (or a multiple of it, 2x or 3x) and, also, to participate in the distribution of the remaining liquidation proceeds, on a pro-rata basis with the rest of the shareholders with no cap.
For example, let’s say the investor buys £10 million of 1x fully participating Series A Preferred at £20 million valuations. When the Series A Preferred stock is converted into common stock, the investor would own 50% of the common stock. If the Company is sold for £50 million, the investor will receive £10 million first after that the investor will still have the right to participate along with the ordinary shareholders (usually the founders) on a pro-rata basis in the distribution of the remaining assets which will bring extra £20 million for the investor for a total of £30 million from its £10 million initial investment. The founders will share the remaining £20 million between each other.
Participating with a Cap: This is a less founder-friendly option in comparison to NPLP but better than fully participating. It grants the investor the right to recover the amount of their investment with priority over the rest of the shareholders plus, to participate in the distribution of the remaining proceeds, on a pro-rata basis with the common shareholders until cap amount hits the threshold.
For example, let’s say that a VC invests £10 million with 1x liquidation preference with 2x cap, and that £10 million represented a 50% ownership stake in the Company. In this case, the investor would receive proceeds from the deal until those proceeds reached £20 million. Because of the combination of liquidation preference and participating in pro-rata, and the total can’t exceed £20 million. If the exit value were £50 million, the rest of the shareholders usually founders would distribute £30 million between them.
The participation feature is not only downside protection for investors, but it also a mechanism to increase the preferred stock return in the event of an adverse outcome.
Non Participating Liquidation Preferences (NPLP) has been used more commonly than Fully Participating clause since the last ten years. I believe this is beginning to change in Series A, B, C, D investment rounds at least for a couple of years as the investor will try to lock a minimum level of return and minimise their risk in an uncertain market environment like the one we experience due to Covid 19.
None of us wants to see participating clause to come back, but it is going to come back because investors have their own partners, and they need to justify their investment to their LPs.
Fully Participating feature favours, the investor and it could make the deal extremely onerous to founders and fundamentally unfair. Founders must pay attention to different participation features and understand the implication of each one well and negotiate as their life depends on it.
