You’ve heard this story before. A startup raises a lot of cash from venture investors over several rounds of fundraising. The company attains the mythical Unicorn status. The billion dollar valuation. You see pictures of the founders with big confident smiles, as if victory is assured. Then the company stumbles, growth slows, valuations fall.
And yet, the company ultimately sells for nine figures. It underperforms expectations, but it still sounds like a great result.
It’s only later on, after the headlines fade, we learn that the founders and employees received no cash from the sale. The investors walked away with all of the proceeds. Welcome to the world of liquidation preferences.
The press, and many entrepreneurs, are obsessed with valuation. That’s a trap, and your potential investors know this. In the end, when a company has a liquidation event, what matters most is how the proceeds from that event are distributed. If you think this is solely based on the ownership percentage of the various stockholders, you don’t understand the preferences associated with venture investments.
Liquidation Events and Preferences
Let’s start with defining a liquidation event. Here is a fairly standard definition of a liquidation event from an investment term sheet:
A sale of all or substantially all of the assets of the Company and a merger, reorganization or other transaction in which 50% of the outstanding voting power of the Company is transferred, will be treated as a liquidation event.
A liquidation preference outlines the rules governing how much preferred shareholders will receive in a liquidation event.
A liquidation preference actually has two components. The actual preference, which outlines the right to receive a multiple of the original investment by the preferred investor before earlier investors and the common shareholders. And participation rights which allow for the investor to receive additional proceeds from the liquidation event after their liquidation preference has been paid out. Participation rights can be capped or uncapped, as I’ll explain later.
It’s easier to see how this all comes together with a few simple examples. You will notice that I can show you how all of this works without dealing with valuation at all, which highlights how important these concepts are.
Common facts for our examples
We will use a very simple fact pattern for all four examples below. The company has raised $50 million from investors for 40% of the company in the form of preferred stock. Founders and employees hold the other 60% of the company, all in common stock.
Example 1: The Company is sold for $25 million.
Obviously, if the company raised $50 million and sold for only $25 million, it’s not a good result. When looking at how the proceeds from that sale are allocated, we have to first work through the liquidation preferences.
In this case, the preferred stock has a 1x liquidation preference. This means that before anything else happens, the investors are entitled to 1x their original investment. Since their original investment was $50 million, the full $25 million goes to the investors. There is nothing left to allocate to the common stock.
This is a good time to make a key point. Preferences matter much more in downside scenarios than they do if the company has a great exit. Preferences are designed to protect investor returns in the case of underwhelming outcomes.
Let’s look at a few more examples and you’ll see what I mean.
Example 2: The Company sells for $100 million, but the investors have a 2x liquidation preference.
The 2x liquidation preference in this example means that investors get 2x their investment of $50 million before anyone else gets any cash at all. The company sold for $100 million, but the founders and employees get nothing. Liquidation preferences in action.
Let’s get a bit more complicated and introduce the concept of participation rights.
Example 3: The Company sells for $100 million, and the investors have a 1x liquidation preference with participation rights.
When an investor has participation rights, this means that after they get their liquidation preference, they then participate in pro-rata distributions along with the other shareholders. In this case, along with their 1x $50 million distribution, the investors receive an additional $20 million from the pro-rata distribution of the remaining $50 million. This results in the investors receiving 70% of total distributions, even though they only own 40% of the company.
Note that there is a 2x participation cap on the preferred shares. In the above example, the investors receive $70 million, so they end up under that cap. Let’s take a look at one more example and we’ll see what happens when the preferred investors are capped by that participation multiple.
Example 4: The Company sells for $500 million, investors have a 1x liquidation preference, and participation rights with a 3x cap.
You can see the impact of that participation cap in this example. A 3x cap means that the preferred investors can’t receive more than 3x their original investment, or in this case, $150 million. So that’s a great result for the common shareholders, right? They get 70% of the proceeds, even though they only own 60% of the company.
Not so fast.
In any deal I’ve ever done, the preferred stock has a conversion feature, which allows the preferred stockholder to convert their shares to common stock. This conversion allows the investor to participate in the liquidation event pro-rata from the first dollar. In the above example, the preferred stockholders would simply convert to common, and therefore be entitled to 40% of the proceeds, rather than the 30% under their preferred stock preferences.
This results in the preferred stockholders receiving $200 million rather than being capped at $150 million.
As I mentioned earlier, preferences are primarily designed to protect the preferred investors in downside scenarios. If a company has an extraordinary exit, you will generally see the preferred investors convert their stock to common shares and simply participate in the liquidation event pro-rata to make the most of their investment. It’s the investor’s decision to convert, and they can choose the option that produces the greatest return for them.
Preference Stacks and Waterfalls
I’ve tried to make these examples as simple as possible to highlight the basic concepts. In practice, this can all get very complicated, particularly as you raise multiple rounds of financing.
The liquidation preference and participation rights are specific to each series of preferred stock. In other words, it’s possible, and quite common, for various series of preferred stock to have different liquidation preferences and participation rights. You might hear the phrase “preference stack”, which refers to the layers of preferences that are a part of your cap table after successive rounds of fundraising.
You’ll often hear the term ‘waterfall’ as it relates to calculating the distribution of proceeds throughout a cap table. That term refers to calculating the impact of stock preferences from investment round to investment round all the way down to the common shareholders.
I’ve found a 1x liquidation preference with participation and a 2x or 3x cap to be fairly standard terms. You really don’t want an uncapped participation right or a higher liquidation preference.
However, if you raise successive rounds, later investors will use preferences to give them a distribution advantage over earlier preferred stockholders, as well as the common stockholders. You should expect later investors to be more aggressive on these terms. This is a key reason why you need to create a competitive dynamic between competing investors in every fundraise, so that competitive pressures to get into your deal keep help keep these terms reasonable.
If your company gets in trouble and is raising a down round, or trying to get a series extension from existing investors, the preferences can ratchet up dramatically to mitigate the risk these later investors are taking on. This can end up leaving founders and early investors with nothing at all if the fortunes of the business don’t turn around.
And that’s how the story of the Unicorn that hit some bumps in the road ends with founders and employees holding a bag full of glorious press clippings instead of money.