Fundraising Terms: Liquidation Preference (Part 1)

Welcome back! 

In the last Fundraising Terms post, we explored the concept of employee stock options (ESOPs) and how they can impact your startup's valuation. This week, we continue our journey through fundraising terms to demystify a crucial term: "Liquidation Preference” 

It is important for you to understand the effect of this term because, as a founder, you hold common shares and the liquidity preference determines how much you get in a liquidation event.

So let's dive right in!

What exactly is a liquidation event?  

Picture a grand transformation—a merger, an acquisition, or a sale that shakes the foundations of a company, where the shareholders lose their majority control and the company assets are exchanged for wealth.

It is typically defined like this:

A merger, acquisition, sale of voting control in which the shareholders of the Company do not own a majority of the outstanding shares of the surviving corporation or sale of all or substantially all of the assets of the Company shall be deemed to be a liquidation. Any acquisition agreement that provides for escrowed or other contingent consideration will provide that the allocation of such contingent amounts properly accounts for the liquidation preference of the Preferred Stock.

Now, let's delve deeper into the heart of the matter—liquidation preference.

This term is composed of two distinct components.  Though many people consider the term liquidation preference to refer to both, it’s important to separate the concepts.

The first concept is preference.  

Preference refers to a certain multiple of the original investment per share being returned to the investor before the common stock receives any consideration. A common standard is a 1× liquidation preference, symbolising the amount of money invested. In this situation, the investors (with preferred shares) get 100% of their money back before anyone else in the company receives any proceeds from the sale of the company. This makes sense, as an investor wouldn’t want to fund a company with $5 million and have the company sold the next day for $5 million and have the proceeds split among all shareholders.

See a sample expression below:

Liquidation Preference: In the event of any liquidation or winding down of the Company, the holders of the Series A Preferred shall be entitled to receive in preference to the holders of the Common Stock a per share amount equal to [X] times the Original Purchase Price plus any declared but unpaid dividends.

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The second is participation. 

Here, investors get the participating stock, granting them a chance to gain additional proceeds once the preference has been fulfilled. There are three varieties of participation: no participation, granting investors a fixed reward; full participation, allowing investors to partake in all the proceeds; and capped participation, where the rewards are bound by certain limits.

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Before we proceed, let's briefly touch on the term "conversion." 

Conversion occurs when preferred shareholders decide to convert their preferred stock into common stock. The number of shares they receive is determined by a conversion ratio. Typically, this ratio is 1:1, meaning each preferred share converts into one common share. However, adjustments for anti-dilution can modify this ratio.  In the case where the conversion ratio is 1:1 when a preferred holder converts to common stock, they maintain their ownership percentage but relinquish the rights associated with preferred stock, such as liquidation preferences. The ability to convert allows preferred shareholders to maximise their payoff during a liquidity event. This will become clearer as we explore the three different types of participation.

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Now, let's delve into one of the participation types:

No Participation

This means that in a liquidation event, the investor receives their liquidation preference amount and nothing more. You might hear it referred to as "simple preferred" or "nonparticipating preferred." 

Let’s explore the outcomes of 2 cases of liquidation preference with no participation under varying liquidation event circumstances.

Before we begin, here’s a background of the ownership and value of the company

• Preferred shareholders investment amount: $10 million
• Post-money valuation at the time of investment: $40 million
• Preferred investor ownership: $10 million / $40 million = 25%
• Common shareholders (founders, ESOP holders, etc.) ownership = 75%

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Liquidation Event Scenario 1 — Acquisition price: $10 million

Case 1 – 1x liquidation preference non-participating:

With their liquidation preference, the preferred shareholders would receive $10 million (their initial investment amount) and the common shareholders would receive nothing.

However, if they choose to convert to common shares, they would receive 25% of $10 million, equalling $2.5 million, and the common shareholders would receive the remaining $7.5 million.

In this case, the preferred shareholders would most likely keep their preferred stock because this gives them better returns.

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Case 2 – 2x liquidation preference non-participating:

Given that the acquisition price is the same as the shareholders' investment amount, we will get the same outcome as case 1 above.

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Liquidation Event Scenario 2  — Acquisition price: $40 million

Case 1 – 1x liquidation preference non-participating:

With their liquidation preference, the preferred shareholders would receive $10 million (their initial investment amount) and the common shareholders would receive the remaining $30 million.

If they choose to convert to common shares, they would receive 25% of $40 million, equalling $10 million, and the common shareholders would receive the remaining $30 million.

In this case, the preferred shareholders could choose to either keep their preferred stock or convert to common. Both would give them the same returns.

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Case 2 – 2x liquidation preference non-participating:

With their liquidation preference, the preferred shareholders would receive $20 million (two times – 2x – their initial investment amount) and the common shareholders would receive the remaining $20 million.

However, if they choose to convert to common shares, they would receive 25% of $40 million, equalling $10 million, and the common shareholders would receive the remaining $30 million.

In this case, the preferred shareholders would most likely keep their preferred stock because this gives them better returns.

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Liquidation Event Scenario 3 — Acquisition price: $100 million

Case 1 – 1x liquidation preference nonparticipating:

With their liquidation preference, the preferred shareholders would receive $10 million (their initial investment amount) and the common shareholders would receive the remaining $90 million.

If they choose to convert to common shares, they would receive 25% of $100 million, equalling $25 million, and the common shareholders would receive the remaining $75 million.

In this case, the preferred shareholders would likely convert to common stock because this gives them better returns.

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Case 2 – 2x liquidation preference non-participating:

With their liquidation preference, the preferred shareholders would receive $20 million (two times their initial investment amount) and the common shareholders would receive the remaining $80 million.

However, if they choose to convert to common shares, similar to case 1, they will receive $25 million and would likely choose this option.

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I hope these scenarios paint a good picture of how non-participating liquidation preferences affect outcomes for shareholders in a liquidation event. The same logic applies irrespective of the company’s valuation, amount invested, ownership, and acquisition price in a liquidation event. The preference effectively provides downside protection for the investors while allowing them to have the upside in an exit where they choose to convert to common stock.

In the next post, we will discuss the effects of full participation and capped participation on liquidation event outcomes.