Term Sheets: What do I need to know about liquidation preference?
This week we continue our series on key VC financing deal terms.
This week’s question: What do I need to know about liquidation preferences?
Our answer: Liquidation preferences determine how investors get paid in an exit (e.g. asset sale, merger, dissolution, etc). Investors with preferred stock get paid back before the common stockholders (ie. founders, employees). However, two key terms – (i) the multiple and (ii) the participation right – can dramatically impact your payout. For protection, negotiate for a 1x non-participating protection, as anything else can significantly reduce your and your team’s payouts.
Multiples
A liquidation preference multiple defines how much an investor gets before common stockholders are paid. For example, if an investor puts in $1M and has a 2x multiple liquidation preference, then the investor gets back $2M before other payouts.
A 1x multiple is standard, although multiples above 1x are seen in distressed financings or highly investor-friendly markets. If a multiple above 1x is proposed, negotiate it down..
Participation
Participation determines whether investors take only their liquidation preference or also share (ie. participate) in remaining proceeds. There are 3 types of participation.
Non-participating lets the investor choose either its liquidation preference or to convert into common stock for a pro rata share of the proceeds. This is the most founder-friendly.
Participating lets an investor get both its liquidation preference and a pro-rata share of the remaining proceeds. This is the most investor-friendly.
Capped participating lets an investor gets both their liquidation preference and pro-rata share of the remaining proceeds, but only up to a capped amount. This balances between non-participating and participating, but its impact depends on the exit size (generally small exits favor investors, large exist favor founders).
Example of Participation
An investor who puts in $10M for 20% ownership, has a 1x multiple, and the startup is exiting for $100M.
Non-Participating: investor gets $20M total by choosing the better of (i) getting back its $10M investment or (ii) converting to common stock and getting $20M (ie. 20% of $100M).
Participating: investor gets $28M total by receiving both (i) its $10M investment back and (ii) $18M (ie. 20% of the remaining $90M proceeds).
Capped Participating (e.g. 2x cap): investor gets $20M total by receiving (i) its $10M investment back and (ii) an additional $10M because the 2x cap limits the participation to $20M total payout.
Why It Matters
Liquidation preferences directly impact your exit payout. 1x non-participating is standard, while higher multiples and participation rights can severely dilute founder and employee returns. Always intensely negotiate these terms upfront – they can make, break or limit your financial upside!
