What you need to know about Liquidation Preferences
This Friday -> Venture Deals by Brad Feld and Jason Mendelson Pt.2 [2 min reading]
Hey, it’s Fede!
Last week, I mentioned liquidation preferences and how they affect your payout.
From the weekly survey many people asked me to dive deeper into it, so here we are!
You already know it, we are talking about “Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist” Plus I will bring some knowledge from my daily life experiences.
Let’s start!
In short, liquidation preferences decide who gets paid first when your company exits (sale, IPO, etc.). Investors use them to make sure they get their money back before founders and employees and these are the most common types:
Non-participating preferred
Participating preferred
Participating preferred with a cap
With non-participating preferences, investors get their initial investment back first, and then the remaining money is divided among the other shareholders (founders, employees, etc.).
Example:
If there’s an exit of 10 million and the investor had a 1x non-participating preference after investing 5 million, the investor would first get their 5 million back (plus any dividends). The remaining 5 million would then be split among the other shareholders.
1x, 2x, 3x—What does that mean?
These numbers indicate how many times the investor will get their money back before others (one time, two times, etc…)
On the other hand, participating preferences are less founder-friendly. In this case, investors not only get their investment back but also take a portion of what’s left, reducing the founder’s payout.
Example:
If there’s an exit of 10 million and the investor had a 1x participating preference after investing 5 million, the investor would first get their 5 million back. Then, they would share the remaining amount (based on their pro rata) with other shareholders.
However, there is the possibility to add a cap to participating preferences, which limits the total amount investors can receive.
Example:
In an exit of 10 million, if an investor had a 1x participating preference with a cap of 6 million and invested 5 million owning 50% of the company, they would first get their 5 million back. Then, they would participate in the remaining funds but only up to a maximum of 6 million.
Common shares are typically held by founders and employees, with no special rights. Preferred shares, held by investors, come with benefits like liquidation preferences.
However, it’s important to keep in mind that investors always have the option to convert preferred shares into common shares during an exit.
This is done because liquidation preferences are great in cases of down rounds or poor exits. But, if the exit is particularly successful, investors often prefer to convert their preferred shares into common shares and split the big cake with the others.
See you next Friday,
Federico Lorenzon