Entrepreneurs raising venture capital must have come across the liquidation preference clause, but they may not fully grasp the specifics of how they work. In this article, we demonstrate how liquidation preference functions and how different participation features can impact the founders’ and investors’ payoffs.
What is Liquidation Preference?
The liquidation preference sets a return hurdle that the preferred stock investor will receive before proceeds are paid out to the common stock holders when the company gets liquidated, which is usually defined as the sale of the company or the majority of the company’s assets. The liquidation preference clause is normally worded as such:
Liquidation Preference: In the event of any liquidation or winding up 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 (the Liquidation Preference).
Types of Participation
In addition to the preference, investors have come up with creative ways to generate a higher return on their investment using a feature called “participation.” This is the next thing to consider when analyzing liquidation preference clauses.
There are 3 types of participation: full participation, capped participation, and no participation.
Fully Participating Preferred Stock
The “fully participating” feature of preferred stock enables investors to not only receive the liquidation preference but also share into the proceeds with the common stock holders. In other words, the investor can “double dip” by getting their original investment back through the preference and also tap into the remaining proceeds with the common holders through the participation. The fully participating clause commonly reads like this:
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.
Capped Participation Preferred Stock
Capped participating preferred stock is similar to participating but, as the name suggests, the liquidation proceeds is capped after a certain return multiple is reached. This is done to prevent the preferred holder from taking excessive proceeds and leaving founders and employees with little. Sample clause is as follows:
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.
It is important to note here that the inital preference is included in the cap. For example, if the entrepreneur receives a term sheet with 3x cap and 1x liquidation preference, the total return the investor can receive without conversion to common is 3x, not 4x (3x cap + 1x preference).
Non-participating Preferred Stock
This type of preferred stock is the most founder-friendly as non-participating preferred stock holders do not share in the liquidation proceeds on an as-converted basis with the common stock holders after their liquidation preference is paid. However, if the proceed on an as-converted basis is greater than the amount they would receive with just the liquidation preference, the preferred stock holder has the option to convert their preferred stock to common to maximize their proceeds.
Participation: Preferred stock will not share in the liquidation proceeds on a pro rata basis with common stock after payment of the liquidation preference. The provision is similar to the language above. If the proceeds are sufficient, then the holders of the preferred stock will voluntarily convert their preferred stock to common stock to maximize their share of the proceeds.
Let’s use an example to demonstrate how the features above work in greater detail. Assume that a new startup has raised $10M in Series A financing at a $20M pre-money valuation. Post financing, the Series A investor will own 33.3% of the company and the founding team would own 66.7% collectively. Let’s further assume after the Series A, the company gets acquired for $50M.
Non-participating preferred with 1x preference
With the non-participating preferred stock, the Series A investor will have the option to either not convert to common and receive his $10M back or convert into common and receive $16.6M (33.3% x 50M). Since 16.6M > $10M, the investor will convert and earn a 1.67x on his original investment. The founders will earn 33.3x each on their original investment.
Participating preferred with 1x preference
With the participating preferred, the investor gets to “double dip” by not only getting his preference but also share into the remaining proceeds as if the shares were converted into common. In this case, the Series A investor will get his $10M preference and also 33.3% of the remaining $40M for a total payoff of $23.3M. This is a 2.33x return on the original investment, materially higher than the 1.67x in the non-participating case. Because of this “double dipping,” the founders return will be reduced to 26.7x each.
Capped participating preferred with 1x preference and 2x cap
Similar to the participating preferred, capped participating preferred holders can “double dip” but only up to a certain multiple of the original investment. In our example, the Series A investor is capped at 2x and will choose to not convert to common stock because $16.7M (33.3% x 50M) is less than the $20M (2 x $10M investment) he can get with the preferred stock. Therefore, the investor will receive the $10M preference and share in the remaining proceeds until his total proceeds is equal $20M. The remaining $30M will be shared ratably among the co-founders.
As we can see, the non-participating feature is the most friendly on the founders while the fully participating feature is the most onerous. With non-participating preferred, the founders will receive a 33.3x on their investment while with the participating preferred they will receive 26.7x.
In dollar terms, this is a difference of $6.7M. As such, it is important that founders spend the time required to analyze different liquidation clauses in their term sheets when raising capital as their payoff can vary materially from one term sheet to another. Our suggestion is for founders to build a robust model that can acommodate different participation features, so they understand the implications of these securities before committing to them. Furthermore, we suggest that founders negotiate for non-participating preferred stocks especially in the early stage. This is because having a participation clause in the early rounds will likely lead to more participation clauses in subsequent rounds, which can lower investors’ and employees’ payoff significantly. Rational investors will not gouge the company on these terms, but it is best to be mindful of the impact these participation features can have on the company.