Liquidation Preference

What is a liquidation preference?

A liquidation preference is a key term in any investment or lending agreement. It gives the investor or creditor the right to have their investment repaid before any other creditors in the event of a company's bankruptcy or liquidation. This protection can be vital for investors and creditors, as it ensures that they will not lose out if the company goes under.

How do liquidation preferences work?

Liquidation preferences can be triggered based on a number of circumstances, primarily: bankruptcy and acquisitions. They are structured based on a number of factors which can include the company's secured and unsecured loans, and the number of outstanding shares (both preferred and common). They function similarly to the repayment waterfall, in that investors with liquidation preferences are paid out before those who do not have them.

Why is understanding liquidation preferences important?

Liquidation preferences vary widely and can have a drastic impact on the proceeds of a business in the event of liquidation or acquisition.

For example: 

• When used in conjunction with “liquidation multipliers'', investors may receive a “multiple” of their liquidation preference prior to converting their preferred shares into common shares.
• Some may only apply when the company is sold or liquidated. Others may be more flexible, applying when the company suffers cash flow issues or misses growth targets.
• Some may specify the order in which investors are paid. In the “last in, first out” structure, the most recent investors will be paid out first, whereas in the “first in, first out” structure, the opposite is true.

Why might an investor require liquidation preferences?

The main reason why an investor would require a liquidation preference is to protect their investment. In the event of a dissolution, they have the rights to any proceeds up to their initial investment.  Anything above that is distributed to the other shareholders according to their ownership stake.

Another reason why an investor may ask for them is for liquidity purposes. This means that in the event of a sale, they have the right to be paid first before any others.

Why would startups agree to liquidation preferences?

Startups agree to liquidation preferences because they can help ensure that they attract the right type and caliber of investors. High-quality investors are more likely to invest in companies that offer them some protection against downside risk.

What is an example of liquidation preferences in action?

Say a venture capital company invests $5 million in a startup in exchange for 50% of the company's common stock and $2.5 million of preferred stock with liquidation preference.

If the startup's founders invest $2.5 million for the remaining 50% of the common stock, then the startup will have $10 million in total funding.

If the company is sold for $12 million, the VC firm would receive its initial investment of $5 million back, plus 50% of the remaining $7 million, for a total of $9.5 million. The founders would receive the other 50% of the remaining $7 million, for a total of $3.5 million.

However, if the company sold for $5 million, the venture capital firm will receive its initial investment of $5 million, but the founders would not receive anything.

How would I find out if my investors have liquidation preferences?'

Startup founders can find out if their investors have liquidation preferences by reading their term sheets.

What are the pros of offering liquidation preferences?

The main advantage of offering liquidation preferences is that it can attract high-quality investors. Investors are more likely to invest in a company if they know that they will be first in line to receive money back in the event of a sale or liquidation.

What are the cons of offering liquidation preferences?

The main disadvantage of offering liquidation preferences is that it gives investors priority over common shareholders in the event of a sale or liquidation. This means that common shareholders could potentially receive nothing while investors receive all of their investment back, plus more (especially when they have liquidation multipliers).

What are the common terms that come with liquidation preferences?

Some of the common terms that are associated with liquidation preferences include:

• Participating, Non-Participating, and Capped Liquidation Preference: This refers to the requirement to pay back investors their initial investment plus share any additional proceeds in proportion to their equity ownership.
• Liquidation Preference Multiple: This outlines the amount that must be returned to investors before a company’s founders or employees receive returns. 
• Seniority/”FIFO or LIFO”: This refers to the structure in which investors with liquidation preferences are repaid. With the “last in, first out” structure, investors are paid out in reverse order from the latest round to the earliest round. In other words, Series B investors would receive distributions before Series A investors, and so on. The reverse is true for those that are structured as “first in, first out”.

What are some of the common pitfalls to avoid when agreeing to liquidation preferences?

Some of the common pitfalls to avoid when agreeing to liquidation preferences include:

• Not understanding the terms: It is important to make sure that you understand the terms of the agreement before agreeing to it. Make sure to review the term sheet and seek council if you are unsure about a particular stipulation.
• Not negotiating: Negotiation is key to making sure that you are not sacrificing too much upside for the potential downside risk.
• Agreeing to unfair terms: It is important to make sure that the terms of the agreement are fair. If the terms are not fair, do not agree to them as they could potentially cost you and your other investors a ton of money upon exit.

Can you negotiate the terms that come with liquidation preferences? 

Yes, the terms of liquidation preferences can and should be negotiated. Founders should consult with their council to make sure that they understand how they are structured and the terms around them.