Startup Lawyer | Avoid Offensive Liquidation Preferences
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Avoid Offensive Liquidation Preferences

Posted 10 Jan 2012

In most equity financing rounds, an investor will ask for (and get) a term called a liquidation preference. A liquidation preference is the amount that must be paid to a preferred stock holder before any sale proceeds may be paid to the holders of common stock (i.e., founders, option holders, etc.).

The amount of the liquidation preference is usually expressed as a multiple, with the most common liquidation preference being “1X non-participating.”

This means that in the event the investor elects to use the 1x non-participating preference, the investor will receive up to 1 times the amount of the investment, but the investor will not get to participate with the common stockholders pro rata in the remainder of any sale proceeds. (Liquidation preferences that “participate” get to participate with the common after payment of the X multiple preference.)

Since an investor would only elect to use a 1x non-participating preference if the sale of the startup was for a “low” price, a liquidation preference typically is a defensive mechanism used to protect the investor’s downside.

However, 1x (or greater) participating or non-participating preferences with a multiple greater than 1 are just price negotiations, and anything better than a 1x non-participating liquidation preference is an investor offensive maneuver. The investor is maneuvering to increase returns and/or potentially blind you with a high valuation (only to be offset with a high multiple liquidation preference) so that you’ll take his or her deal.

Thus, if you see greater than a 1x preference and/or a ‘participating’ preference attached, know that your investor is just negotiating on price. If it were up to me, I’d rather have the startup and investor come to terms on the pre-money valuation rather than toying with anything other than a 1x non-participating liquidation preference.

4 Comments
  • Berislav Lopac
    Posted at 01:28h, 11 January Reply

    I’m not sure I quite understand what does “the investor will not get to participate with the common stockholders pro rata in the remainder of any sale proceeds” means? I’m reading this as if the “1x non-participating” investor is getting back only the amount of their investment, but that can’t be true, right?

  • Ryan Roberts
    Posted at 09:26h, 11 January Reply

    Berislav,

    When the liquidation preference is “non-participating”, the investor can choose either (i) take the X multiple liquidation preference proceeds or (ii) take the pro rata percentage stock ownership proceeds. Participating gets both (i) and (ii), but (ii) is based on the remainder of the proceeds after (i) is paid out.

  • Berislav Lopac
    Posted at 15:18h, 11 January Reply

    Ah, I see. The non-participating investor gets to choose, so in the case of a low-valuation sale they will get back at least their original investment. Thanks for the clarification! :)

  • James Liu
    Posted at 22:12h, 27 March Reply

    I’m not entirely sure it’s hidden price negotiating. What it really does is change the premoney valuation depending on the outcome. If the outcome is a successful IPO, then the premoney valuation is the true value, but if the result is anything less than that (E.g., an early buyout by private equity), the premoney valuation starts getting eaten away by the liquidation preference. It amounts to a monetary incentive to go big or go home.

    I think it’s tied to the underlying funding model for VC capital. Right now, there’s a contraction in the amount of money available for investment by LPs. Only funds that hit home runs survive. If the VC gets cut whether she hits a single or strikes out, the obvious strategy is to swing for the fences.

    That means offensive liquidation preferences are here to stay, which means the company (or the lawyer) will have to do the legwork in Excel to figure out what the liquidation preferences actually mean.

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