Understanding Liquidation Preference: Types, Best Practices, and Key Considerations
Liquidation preference is a critical mechanism in startup funding that determines how proceeds from a company’s sale, merger, or liquidation are distributed. This concept protects investors while balancing the interests of founders and employees. In this article, we explore the types of liquidation preferences, industry best practices, additional key terms like anti-dilution and caps, and provide real-world examples.
What Is Liquidation Preference?
Liquidation preference specifies the payout priority and amount for investors in an exit event. It ensures that investors recoup their investment (or a multiple of it) before any remaining proceeds are distributed to common shareholders, such as founders and employees.
Types of Liquidation Preferences
1. Participating vs. Non-Participating
Participating Liquidation Preference:
- Investors receive their liquidation preference first (e.g., their original investment) and then participate in the remaining proceeds as if they were common shareholders.
- Impact: Can significantly reduce the share left for founders and employees.
Non-Participating Liquidation Preference:
- Investors either receive their liquidation preference or convert their preferred shares to common shares to share in the remaining proceeds, choosing the option that maximizes their return.
- Best Practice: A 1X non-participating preference is considered the industry standard. It balances investor protection while aligning incentives.
2. Multiplier (1X, 2X, etc.)
- 1X Liquidation Preference: Investors receive 100% of their investment amount first.
- Best Practice: This is the norm and aligns well with founder and investor goals.
- Below 1X: Rare, reserved for exceptional companies where investors take on more risk.
- Above 1X: Investors receive more than their original investment, e.g., 2X means they receive twice the amount invested before others share in the proceeds.
- Consideration: This serves as a safety net for investors but can raise concerns for founders if misaligned with the company’s growth potential.
3. Seniority Structure
- Standard Seniority: Later funding rounds have priority over earlier ones.
- Pari Passu: All investors are treated equally, regardless of the funding round.
- Junior Preference: Some investors voluntarily take a lower priority in payout.
4. Additional Terms to Consider
- Anti-Dilution Protection: Adjusts an investor’s ownership percentage if new shares are issued at a lower price than they originally paid.
- Types: Full Ratchet and Weighted Average.
- Hurdle Rate: Specifies a minimum return that must be achieved before common shareholders receive proceeds.
- Caps: Limits the amount investors can receive beyond their liquidation preference (e.g., 3X maximum).
- Founder Carve-Out: Reserves a specific amount or percentage of proceeds for founders in low-valuation scenarios.
Risks and Solutions for Founders
Founder Carve-Out: A Key Recommendation
A Founder Carve-Out is a crucial tool to ensure that founders remain incentivized, even in tough exit scenarios. By reserving a specific percentage or fixed amount of the proceeds for founders before applying liquidation preferences, it aligns founder motivation with achieving the best possible outcome.
Example:
If a company exits at $20M with $30M in 1X non-participating preferences, a 10% carve-out ensures founders receive $2M, encouraging engagement in exit negotiations.
Other Solutions:
- Caps on Participating Preferences: Limit payouts to a multiple of the investment.
- Scenario Modeling: Tools like Capboard can simulate different exit outcomes to help identify risks and structure deals effectively.
Real-World Example: Box Inc.
Box Inc., the cloud storage company, faced challenges during its IPO as it had multiple preferred shares with liquidation preferences. These terms required a valuation high enough to cover all liquidation preferences before benefiting common shareholders. This demonstrates the importance of structuring terms carefully.
How Capboard Can Help
Capboard simplifies managing liquidation preferences and related equity structures:
- Scenario Simulations: Model exit scenarios, including carve-outs, to assess the impact on all stakeholders.
- Cap Table Management: Maintain an up-to-date and transparent view of all equity arrangements.
- Anti-Dilution Calculations: Automate equity adjustments with precision.
- Customizable Reporting: Provide clear, detailed reports to investors, helping foster trust and transparency.
Conclusion
Liquidation preferences can shape the financial outcomes of an exit event. Best practices like adopting 1X non-participating preferences, implementing Founder Carve-Outs, and leveraging tools like Capboard for transparency and modeling are essential to ensuring balanced agreements. Proper planning can safeguard founders and investors alike, aligning everyone for long-term success.
