Liquidation Waterfall

What is a liquidation waterfall?

A liquidation waterfall outlines the order in which the company's funds will be paid out to holders of its various classes of shares in a “liquidation event”, such as a merger, acquisition or public listing. It also outlines the order in which debt holders will be paid out in a “liquidation event”. The liquidation waterfall is typically set forth in a company's articles of incorporation or bylaws.

How do liquidation waterfalls work?

The liquidation waterfall determines how assets are distributed among a company's creditors and shareholders. The most senior creditors, such as bondholders and banks, will receive their money first, followed by less senior creditors, such as trade creditors. Followed then by the preferred shareholders, and last but not least, the common shareholders. It's important to note that not all companies have a liquidation waterfall.

Effect of “Seniority” on the liquidation waterfall?

One stipulation usually included as part of the liquidation waterfall is the “seniority” clause which determines the investors that will be paid back first and those that will be paid last. Typically, the “seniority” clause flows downwards, meaning that more “senior” creditors & lenders will get priority over “junior” creditors, followed by the founder and employees of the company.

Liquidation preference clause in a liquidation waterfall?

A ‘liquidation preference’ is a stipulation of the liquidation waterfall that outlines the proceeds that an investor (holding preferred shares) is entitled to receive prior to the company’s common shareholders.

It is typically expressed as a multiple between 1-10x, and is included to ensure that investors are able to recover the amount they invested (at a minimum) in the event that the company is sold for a less-than-expected amount.

If Ribbon has a 2x liquidation preference and their investment company IPOs at a valuation of $3M, the company is entitled to $2M (a return of 2x their initial investment).

Participation preference clause in a liquidation waterfall?

A ‘participating preference’ is typically expressed as a percentage—it enables investors to receive additional proceeds of a liquidation event once their liquidation preference has been exhausted. As such, it is requested in conjunction with the ‘liquidation preference’ clause.

Let’s revisit the earlier example again. Without a participation preference Ribbon’s proceeds are capped at $2M if we model out the scenario where the investors have a 2x liquidation preference.

However Ribbon’s proceeds would be significantly greater if it also had a 60% participating  preference in addition to its liquidation preference. In this new scenario Ribbon is also entitled to an additional $600k in proceeds (60% of the remaining $1M in valuation) for a net total of $2.6M.

Why is understanding liquidation waterfalls important?

Understanding liquidation waterfalls is important because it can help you understand the order-and-amount in which your creditors and shareholders will be paid out in a “liquidation event”. The amount that you (and your employees) will receive as common shareholders is directly impacted by the liquidation waterfall, liquidation preferences, and preferred preference that you agree to, so make sure to understand the implications before you agree to them.

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

As with any financial agreement, it is important to read and understand the terms of a liquidation waterfall before agreeing to them. Some of the common pitfalls to avoid include:

• Underestimating the impact of liquidation & preferred preferences: Many first-time founders underestimate the impact that these clauses will have on their proceeds in a liquidation event. If both apply, and there is a preferred preference of 60%, that means the founders and the employees will only be left with 40% of proceeds after all of the creditors and shareholders have been paid. This can be the difference between literally millions or billions of dollars.
   
• Failing to negotiate the terms: As with all contractual provisions, the terms are negotiable. Don’t just simply accept them, without considering the implications otherwise all your work might not be as worthwhile.
   
• Not leveraging a participation cap: Participation caps limit the amount of proceeds that an investor receives to ensure that founders, employees and other shareholders get a fair share of the proceeds.
   
• Not understanding “dead spots”: dead spots occur where investors' returns don’t change despite a bump in the valuation of the company, creating a misalignment of interests between common and preferred shareholders.

Our thoughts on the liquidation waterfall

When utilized correctly, liquidation and participation preferences can help you structure an equitable liquidation waterfall that rewards investors, founders, and employees appropriately in the event of a potential upside.

When negotiating the shareholder’s agreement, founders have to critically think through the liquidation rights and the impact they can have on the interests of every party involved.