Fundraising Terms: Liquidation Preference (Part 2)

Hello founders, 

In the last post, we started the first part of this 2-part article on Liquidation Preference. We introduced you to terms like liquidation event, preference, participation, and conversion. We also discussed the first of the three types of participation — No participation.

Today, we’ll discuss the two types of participation — full participation and capped participation. Before that, let's do a quick revision of the key definitions of some terms:

• Preference: This is a certain multiple of the original investment per share being returned to the investor before the common stock receives any consideration. 
• Participation/Participating stock: This grants investors a chance to gain additional proceeds once the preference has been fulfilled. 
• Conversion: This 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, which is typically a ratio of 1:1.
• No Participation: This means that In a liquidation event, the investor receives their liquidation preference amount and nothing more. It is sometimes referred to as "simple preferred" or "nonparticipating preferred". 

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Now, on to today’s topics.

‍Full Participation

Here, the stock receives its liquidation preference (typically 1×), and then shares in the remaining proceeds on an "as-converted" basis. "As-converted" means the stock was already converted into common shares based on the conversion ratio. 

The provision usually reads as follows:

Participation: After the payment of the Liquidation Preference to the holders of the Series A Preferred, the remaining assets shall be distributed proportionally among the holders of the Common Stock and the Series A Preferred on a common equivalent basis.

This scenario is like eating your cake and having it! The preferred holder receives their liquidation preference and also gets to share in the remaining proceeds as if they had converted to common stock. Full participation stock guarantees that the preferred holder never converts to common stock unless the conversion ratio has been drastically changed by some other event.

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Now let’s explore the outcomes of this under varying liquidation event circumstances.

Before we begin, here’s some context 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%

Liquidation Event Scenario 1: 

Acquisition price: $10 million; 1x liquidation preference and full participation 

With a full participation clause, the investors would receive the entire $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 likely keep their preferred stock because this gives them better returns. 

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Liquidation Event Scenario 2: 

Acquisition price: $100 million; 1x liquidation preference and full participation 

With a full participation clause, the investors would receive an initial $10 million (their initial investment amount) and 25% of the remaining $90 million shared amongst the common shareholders, that is, $22.5 million, giving them a total of $32.5 million.

However, 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 most likely keep their preferred stock because this gives them better returns. 

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Liquidation Event Scenario 3: 

Acquisition price: $100 million; 2x liquidation preference and full participation 

With a full participation clause, the investors would receive an initial $20 million (2x their initial investment amount because of the 2x liquidation preference) and 25% of the remaining $80 million shared amongst the common shareholders, that is, $20 million, giving them a total of $40 million.

However, 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 most likely keep their preferred stock because this gives them better returns.

‍Capped Participation 

This indicates that the stock will receive its liquidation preference, and share in the proceeds on an as-converted basis until a specific multiple of the original purchase price is reached. Once the return surpasses the cap, participation stops.

Here’s a sample expression:

Participation: After the payment of the Liquidation Preference to the holders of the Series A Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock and the Series A Preferred on a common equivalent basis, provided that the holders of Series A Preferred will stop participating once they have received a total liquidation amount per share equal to [X] times the Original Purchase Price, plus any declared but unpaid dividends. Thereafter, the remaining assets shall be distributed ratably to the holders of the Common Stock.

One interesting thing to note in this section is the actual meaning of the multiple of the original purchase price (the [X]). If the participation multiple is three (three times the original purchase price), it would mean that the preferred would stop participating (on a per share basis) once 300% of its original purchase price was returned, including any amounts paid out on the liquidation preference, plus any declared but unpaid dividends. This is not an additional 3× return, but rather an additional 2×, assuming the liquidation preference was a 1× money-back return.

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Let's explore the outcomes of this under varying liquidation event circumstances.

Before we begin, here’s some context on 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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Before we begin looking at the different liquidation event scenarios, note that due to the 3x cap, the preferred shareholders cannot receive more than $30 million (3 x their initial investment amount) irrespective of the acquisition price.

Liquidation Event Scenario 1: 

Acquisition price: $10 million; 1x liquidation preference and full participation

With a 3x capped participation clause, the investors would receive the entire $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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Liquidation Event Scenario 2: 

Acquisition price: $100 million; 1x liquidation preference and full participation

With a 3x capped participation clause, the investors would receive an initial $10 million (their initial investment amount). They would then benefit from the remaining $90 million shared amongst the common shareholders based on their 25% ownership up to $20 million (instead of $22.5 million if they had a full participation clause), bringing their returns to $30 million (3x their initial investment amount).

However, 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 most likely keep their preferred stock because this gives them better returns. 

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Liquidation Event Scenario 3:

Acquisition price: $100 million; 2x liquidation preference and 3x capped participation 

• With a 3x capped participation clause, the investors would receive an initial $20 million (2x their initial investment amount because of the 2x liquidation preference) and would then benefit from the remaining $80 million shared amongst the common shareholders based on their 25% ownership up to $10 million (instead of $20 million if they had a full participation clause), bringing their total returns to $30 million (3x their initial investment amount).

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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In early-stage financings, it’s actually in the best interest of both the investor and the entrepreneur to have a simple liquidation preference and no participation. In future rounds, the terms are often inherited from the early-stage terms since investors love precedents from earlier rounds that favour them. So if you have a participating preferred in your first priced round, you could expect to have a participating preferred in all subsequent rounds. As a result, we recommend keeping it simple and lightweight in early rounds and as you progress be mindful of how the preference and participation clauses would affect you based on the insights shared. 

Most investors will not want excessive liquidation preferences since the greater the liquidation preference, the lower the potential value of the management or employee equity. There’s a fine balance here and each case is situation-specific, but a rational investor will want a combination of the best price while ensuring maximum motivation of management and employees.

I hope this was an insightful read.