This post was originally part of my weekly “Ask the Attorney” series which I am writing for VentureBeat (one of my favorite websites for entrepreneurs). Please shoot me any questions you may have in the comments section – or feel free to call me directly at 415-979-9998. Many thanks, Scott
I’m the co-founder and CEO of an e-commerce startup, and I’ve been meeting with different VC firms regarding an initial round of funding. I’ve started doing some reading on term sheets and the issues we will need to address, and I’m a little confused with some of the VC terminology. Could you please explain to me what a liquidation preference is and how we should negotiate it. Thanks!
Welcome to the world of venture capital. A liquidation preference is one of the essential components of preferred stock and is generally considered to be the second most important deal term in a VC investment (the first being the company’s valuation prior to the investment, commonly referred to as the “pre-money valuation” or “pre”).
Let’s start with the basics: A VC investor will be issued shares of preferred stock, not shares of common stock. Preferred stock, as the name suggests, is preferable to common stock because it grants certain key rights to the preferred stockholders – making it far more valuable than common stock. One such right is a liquidation preference.
The word “liquidation” is broadly defined in the VC documentation to include not only the actual liquidation of the company (i.e., the disposition of the company’s assets) upon dissolution or bankruptcy, but also the sale of the company (whether via stock, assets or merger) to a third party or a change of control.
The word “preference” flows from “preferred” and means that the shares of the preferred stock will have a priority over (i.e., will be treated better than) the common stock in the event of a liquidation. For example, in bankruptcy, once the company’s creditors have been paid off, any remaining assets would be distributed to the holders of the preferred stock prior to the holders of the common stock.
Similarly, if the company were sold, the proceeds of the sale would be distributed first to the holders of the preferred stock and then to the holders of the common stock, based upon the terms of the liquidation preference.
There are three types of liquidation preferences:
- Straight (or Non-Participating) Preferred – this liquidation preference is most favorable to the company/founders. Upon the sale of the company (or any other liquidation), the preferred stockholders would be entitled to the return of their entire investment (plus any accrued dividends) prior to the distribution of any proceeds to the common stockholders. Alternatively, the preferred stockholders could choose to convert their preferred stock to common stock and simply be treated the same as the common stockholders (i.e., share ratably in the proceeds).
- Participating Preferred – this liquidation preference is most favorable to the investor (and is sometimes referred to as “double-dip preferred”). Similar to straight preferred, the preferred stockholders would be entitled to the return of their entire investment (plus any accrued dividends) prior to the distribution of any proceeds to the common stockholders; however, the preferred stockholders would then also be treated like common stockholders and would share ratably in the remaining proceeds – thus, in effect, being paid twice (or “double”). Indeed, issuing participating preferred has the same economic effect as issuing a promissory note and shares of common stock (or a warrant) to the investor.
- Capped (or Partially) Participating Preferred – this liquidation preference is often viewed as an intermediate approach. The preferred stockholders have the same rights as participating preferred (i.e., return of investment, plus share ratably in the reminder), but their aggregate return is capped; once they have received the capped amount, they no longer have the right to share in the remaining proceeds with the other common stockholders.
Fully participating preferred is the exception (about 20% of the deals today) — particularly in the Series A round of funding. You should thus push hard for a straight preferred liquidation preference and settle for capped participation as a fallback position. Remember, whatever you agree to with your initial investors will carry forward to future rounds; that’s why fully participating preferred should be avoided.
As part of the negotiation of liquidation preferences, there is also a concept called a “multiple” (e.g., “2X multiple,” 3X multiple,” etc.). Watch out for this one! It means the preferred stockholders are entitled to a multiple of their original investment (e.g., double or triple the amount) before the common stockholders get anything.
Based on the foregoing, it is imperative that, before you agree to any participating preferred and/or multiples, you should require the VC to run spreadsheets/models demonstrating how much you and the other founder(s) will receive based on various sales price scenarios. For example, if your company were sold for $40 million, and the VC had invested $5 million for one-third of the company, with a 2X participating preferred, the VC would receive $10 million off the top (not including any accrued dividends, if applicable), plus another $10 million (one-third of $30 million), for a total of $20 million.
The VC would thus receive 50% of the sale proceeds even though it only owned one-third of the company.
I hope the foregoing is helpful. My colleague, Susan Morgan, has actually created proprietary software to help entrepreneurs create spreadsheets relative to liquidation preferences and the amount of proceeds they would receive under different sales scenarios. Indeed, liquidated preferences (particularly when they are stacked onto different series of Preferred Stock) can be quite difficult to understand – until it’s too late.