Liquidation preference is a critical aspect of startup financing that impacts both shareholders and founders. As investors seek to safeguard their investments and maximize returns, startups must navigate these preferences to secure funding while ensuring long-term growth.
This article delves into liquidity preferences in startups, discussing their implications for shareholders and founders, and providing insights into optimizing these arrangements for the benefit of all stakeholders.
What Are Liquidation Preferences?
Liquidity preferences are provisions in investment agreements that give investors the right to receive a certain amount of their investment back before other equity holders receive any proceeds from a sale or liquidation of the company. This gives investors some protection against downside risk, as they are guaranteed a return on their investment regardless of how the company performs.
Liquidity preferences come in different forms and can be structured in different ways. The most common types of liquidity preferences are:
- Non-participating preferred stock: This gives investors the right to receive a predetermined amount of their investment back before any other equity holders receive any proceeds. However, they do not participate in any further proceeds beyond their initial investment.
- Participating preferred stock: This gives investors the right to receive a predetermined amount of their investment back, as well as the ability to participate in any further proceeds beyond their initial investment. This means that investors can receive a higher return on their investment if the company performs well.
- Convertible notes: These are debt instruments that can be converted into equity under certain conditions, such as a subsequent funding round or a sale of the company. Convertible notes can also have liquidity preferences attached to them, giving investors the right to receive a predetermined amount of their investment back before other equity holders receive any proceeds.
How does liquidation preference work?
Liquidity preferences are typically structured as a multiple of the investor's original investment or a percentage of the sale price. For example, an investor with a 2x liquidity preference will receive two times their original investment back before other equity holders receive any proceeds from a sale or liquidation of the company.
Let's consider an example to illustrate how liquidity preferences work in practice. Imagine a startup raises $5 million in funding from investors, with a 2x participating preferred stock liquidity preference. The startup then sells for $10 million. In this scenario, the investors would receive $10 million in proceeds from the sale, as they are entitled to receive two times their original investment back. The remaining $5 million would then be distributed among the other equity holders.
Multiples in liquidation preferences refer to the factor by which an investor's initial investment is multiplied to determine their payout during a liquidity event. The multiple is a key component of the liquidation preference clause and can significantly impact the distribution of proceeds among different stakeholders.
When investors provide funding to a startup, they often negotiate a liquidation preference multiple as part of their investment terms. This multiple serves as a mechanism to protect their investment and ensure they receive a minimum return before other shareholders.
Here's how multiples work in liquidation preferences:
- A startup raises funds from an investor, who negotiates a specific multiple as part of their liquidation preference. For example, let's assume an investor provides $1 million in funding and negotiates a 2x multiple.
- During a liquidity event, such as the sale of the company or an IPO, the investor with the 2x liquidation preference is entitled to receive $2 million (2 times their initial investment of $1 million) before any proceeds are distributed to other shareholders.
- If there are sufficient proceeds from the liquidity event, the investor receives their $2 million payout, and the remaining proceeds are then distributed according to the preference stack and the agreed-upon terms for each shareholder class.
- In a scenario where the proceeds from the liquidity event are not sufficient to fulfill the 2x liquidation preference, the investor will still receive priority in the payout, but their return may be less than the agreed-upon multiple.
It is essential to understand that higher liquidation preference multiples can significantly impact the distribution of proceeds among shareholders, often leading to lower returns for founders and common shareholders. Therefore, it is crucial for founders to carefully consider and negotiate the liquidation preference multiples as part of their investment agreements, aiming for a more balanced and equitable distribution that aligns the interests of all stakeholders
What is a Preference Stack?
The preference stack is a term used to describe the order in which different classes of investors receive their share of proceeds during a liquidity event. It is an essential aspect of the liquidation preference structure that determines the priority of payouts for each investor class. The preference stack typically consists of multiple tiers, with each tier representing a different class of shares or investors.
In a typical startup financing scenario, the preference stack is organized as follows:
- Senior Debt: Lenders or creditors who have provided loans to the startup are typically the first to be paid back during a liquidity event. This includes banks, venture debt providers, or other institutions that have extended credit to the company.
- Preferred Stock: Investors who hold preferred shares, usually venture capitalists and other institutional investors, are next in line to receive their proceeds. Within this tier, there may be multiple classes of preferred shares based on the investment rounds, such as Series A, Series B, and so on. Each class of preferred stock may have its own specific liquidity preferences and payout multiples.
- Common Stock: Finally, holders of common stock, including founders, employees, and early-stage investors, receive their share of the proceeds. This tier is often considered the lowest priority in the preference stack, and common shareholders are paid only after all other stakeholders have received their respective payouts.
The preference stack plays a significant role in determining the financial outcomes for various stakeholders during a liquidity event. By understanding the implications of the preference stack, founders can negotiate investment terms that ensure a more balanced distribution of proceeds and maintain a healthy relationship between all parties involved. It is essential to keep in mind that a highly skewed preference stack in favor of preferred shareholders may result in lower returns for founders and common shareholders, impacting the overall success and growth of the startup.
How Does Liquidation Preference Influence A Startup?
Liquidity preferences can have a significant influence on startups, particularly in terms of their ability to raise funding and grow their business. Here are some of the ways that liquidity preferences can influence startups:
- Funding Preferences: Investors with a strong preference for liquidity may be more likely to invest in startups that offer early-stage exits or convertible notes, rather than equity investments. This can make it more difficult for startups to raise funding through traditional equity investments, which can impact their ability to grow and scale their business.
- Valuations: Startups that offer early-stage exits or convertible notes may be valued differently than those that offer traditional equity investments. This can impact the overall valuation of the company and affect its ability to raise funding in the future.
- Exit Strategy: Liquidity preferences can also impact a startup’s exit strategy. If investors have a strong preference for early-stage exits, the startup may need to prioritize a quick exit over long-term growth and profitability.
- Risk Profile: Startups that prioritize liquidity may be more likely to take on riskier investments or make short-term decisions that prioritize cash flow over long-term growth. This can impact the overall risk profile of the company and affect its ability to attract investors or secure funding in the future.
- Incentive Alignment: Liquidity preferences can create misaligned incentives between investors and founders, especially when the preferences are heavily skewed in favor of investors. Founders may be more focused on achieving short-term milestones to trigger a liquidity event rather than focusing on long-term growth and value creation.
Liquidation preference in low valuation acquisition
When a startup sells for a low valuation, it is common for founders to receive less money than they had hoped for. This is because of the impact of liquidity preferences on how the proceeds of a company sale are distributed.
Liquidity preferences are provisions in investment agreements that give investors the right to receive a certain amount of their investment back before the founders and other equity holders receive any proceeds. This can be in the form of a multiple of their original investment or a percentage of the sale price.
For example, if an investor has a 2x liquidity preference and invested $1 million in a startup, they will receive $2 million back before any of the founders or other equity holders receive any proceeds from a sale. If the company sells for $10 million, the investor will receive their $2 million first, leaving only $8 million to be distributed among the other equity holders.
This means that if a startup sells for a low valuation, the impact of liquidity preferences can be particularly significant. If the sale price is below the total amount of the liquidity preferences, the founders may not receive any proceeds at all, and may even have to contribute their own money to cover the shortfall.
Additionally, even if the sale price is higher than the total amount of the liquidity preferences, the impact on the founders' earnings can still be significant. Depending on the size of the liquidity preferences, the founders may only receive a small fraction of the proceeds, even if they were the ones who created the value in the company.
According to data from venture capital database PitchBook, the prevalence of liquidity preferences has been increasing over time. In 2009, 67% of venture capital deals had some form of liquidity preference, while in 2019, this had risen to 92%.
Liquidity preferences are an important concept for startups to understand as they can have a significant impact on their ability to raise funding and grow their business.
Investors with a strong preference for liquidity may be more likely to invest in startups that offer early-stage exits or convertible notes, rather than traditional equity investments. This can impact the overall valuation of the company, its exit strategy, and its risk profile.
It’s important for startups to carefully evaluate their funding options and consider the preferences of their investors when making decisions about their business.