Don’t get washed by liquidation preferences
By Justin Hall August 14, 2015
- Liquidation preferences are essentially get-out-of-jail-free cards for investors
- If sale isn’t properly sized, might be nothing left for ordinary shareholders
INVESTORS live and breathe term sheets and waterfall tables, and so things that might be simple for them to understand can be downright byzantine for most others, including entrepreneurs.
If there’s one topic I get asked more questions about than any other, it’s liquidation preferences, or as investors might call them, their get-out-of-jail-free card.
In simple terms, a liquidation preference entitles investors to an amount equal to or, in some instances, greater than what they put in.
This right applies only to preferred stock. Investors with preferred stock cannot benefit from that class’s liquidation preference and still receive a financial windfall greater than what’s explicitly guaranteed in said preference.
So in the case of non-participative liquidation (participative and capped participative will thankfully not be the subject of today’s column), in the event of a sale, investors will always get their investment back first.
After they do so, whatever is left will get apportioned to the ordinary shareholders. Investors no longer receive any more money.
When you hear of big wins, like a mammoth acquisition or an IPO (initial public offering), investors will generally waive their liquidation preferences and convert into ordinary shares.
Why? Ordinary shareholders get paid at the same rate as every other shareholder. Investors will waive because their percentage stake in a company – and consequently, how much profit they’re getting – ends up being greater than their liquidation preferences.
So if there’s enough money from a sale, investors will opt out of being paid first if it means they will ultimately get paid more.
And in the event of a losing deal, where the liquidation preference is greater than the investor’s share of the sale, this right means that investors can get out unscathed.
In the end, it’s always an economic choice: Either investors remain preferred shareholders and get paid first, and that’s it; or they convert into the same ordinary shares as employees and founders, and get paid alongside them.
A 1X liquidation preference, i.e. a 100% return on investment, is the bare minimum on the vast majority of agreements. You’ll rarely find preferred shares without this right.
It’s a hedge on risk, and given that investors are often putting in more investment into a company than the founders themselves, investors think it fair.
But occasionally, you’ll see investors asking for more than a 1X. This is uncommon and, unless negotiated into the agreement, is not entirely founder-friendly. With a 2X liquidation preference, investors are guaranteed two times their initial investment.
In the event of a poor sale, investors are not only protected, but they come away with more money; their increased take is literally taken from the ordinary shareholders.
But even if the sale is considered good, investors might actually prefer to exercise their liquidation rights as opposed to converting into ordinary shares.
So far, so good.
Where things get tricky is in multiple rounds of funding. Beyond their inherent superiority over ordinary shares, more recently issued preferred shares will always take precedence over previous classes, hence the distinction between Series A, B, and C, et. al., shares.
Each class of shares will have its own liquidation preference. This means that in the event of a sale, liquidation preferences will be stacked in order of most recent to earliest, the last class being ordinary shareholders.
For example, assume a company is sold after its Series C. If its liquidation preference is exercised, Series C shareholders will be paid the sales’ proceeds first; the remainder is then passed on, at which Series B shareholders might opt to exercise its own right; again, the remainder is passed on.
This continues until the remaining funds are finally distributed amongst the ordinary shareholders.
If the sale isn’t appropriately sized, there might literally be nothing left for ordinary shareholders – that includes employees that hold stock options.
This phenomenon is called liquidation overhang, and it can have a dramatic knockdown effect on shareholders. This effect is exponentially more harmful in the instances when investors have a 2X or greater liquidation preference.
The more rounds there are, the higher the valuation and the greater the chance that the economics of a sale won’t make sense and investors are forced to exercise their liquidation preference. This much has been made clear.
But when later-stage investors exercise their liquidation preference, by definition they reduce the amount of available proceeds for earlier investors.
If they take enough, earlier investors who might previously have opted to convert their preferred shares and get paid alongside ordinary shareholders are now forced to liquidate. This cascade effect continues until the ordinary shareholders are left carrying the (empty) bag.
Liquidation preferences are perhaps one of the most important economic terms on a term sheet, and can literally determine whether founders see any proceeds in the event of a sale. Again, it’s their responsibility to understand exactly what they mean.
But never, ever treat liquidation in isolation, especially if you are raising multiple rounds of funding. Always understand what the best economic outcomes are for your investors, not just you and your employees, and if working towards an exit, always work with those numbers in mind.
Justin Hall is a principal at Golden Gate Ventures, an early-stage fund based in Singapore. A former Rakuten Network manager and scholar at NUS, he sources investable early-stage technology companies from South-East Asia. You can reach him via Twitter at @JVinnyHall.
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