Liquidation preference determines who gets paid, and when. It’s often an essential element of every equity financing deal — especially as private company leaders may likely face an uncertain fundraising market.
Simply put, failing to understand liquidity preferences can put the equity of you and your employees at risk.
During a liquidity event – such as a sale, acquisition or bankruptcy — shareholders are given their returns. Liquidation preference determines which shareholders get paid first, and how much they receive. The higher the liquidation preference for an investor, the more pressure on the company to return value to that preferred shareholder.
This past year, founders faced more tightened budgets, shortened runways and stricter term sheets. Venture capital (VC) firms are facing their own set of pressures and risks, meaning VC financing is likely harder to come by. To curb their downsides, many firms are offering term sheets with higher liquidation preferences.
Private companies should beware of these deals. While securing fundraising can be difficult in this economy, a deal with a bloated liquidation preference might be more trouble than it's worth down the line.
Liquidation preference can be a difficult concept to grasp. However, it’s usually a critical provision in the term sheet for equity financing—and it’s probably best to gain an understanding before you get to the table with your investors. We’ll explain the concept of liquidation preference, suggest some parameters when considering your next term sheet and introduce our equity management platform, which helps reduce financing stress for private companies:
What is liquidation preference?
Liquidation preference gives an investor the right to be paid out first, before common shareholders such as founders and employees, in any liquidity event (i.e. an acquisition or bankruptcy).
This concept represents a vital protection for investors in a term sheet, as it limits the chance that they lose their investment if the company’s performance drops. Liquidation preference is negotiated in the term sheet, then enshrined in the amended charter.
If your investor has a 1x liquidation preference, they receive $1 for every $1 they invested, should a liquidity event occur.
Let’s say your VC invests $5 million with a 2x liquidation preference. If your private company is acquired for $15 million, the VC firm gets $10 million ($5 million multiplied by the 2x liquidation preference) before any proceeds are paid out to the common shareholders, i.e founders and employees. If your company is acquired for $10 million flat, then you and your employees would receive nothing — the VC firm gets paid out first.
So why would private companies accept this concept? Liquidation preferences allow companies to attract high-quality investors, as these firms typically desire protection from potential downsides. For a deeper dive into liquidation participation and preferences, check out our guide to understanding the liquidation stack.
Why liquidation preference matters in a down market
As you’ve likely gathered, higher liquidation preferences + economic uncertainty = increased risk for private companies.
A high liquidation preference is generally fine as long as a company’s valuation continues to grow. If each new fundraising round brings a markup, then everyone is probably happy.
However, the past two years have brought on a surge of down rounds for many private companies. As soon as your valuation drops, a high liquidation preference for your investors can represent a real threat to any hard-earned returns that you or your employees were expecting.
How to navigate liquidation preference
In a vacuum, a liquidation preference isn’t necessarily an inherently bad thing. It can help you connect with the right investors, who understandably may want to protect their downside.
However, it’s important to be extra careful as capital becomes scarcer and runways shorten. Here are three tips:
Understand your term sheet.
It may be essential to understand the liquidation preference that your investors are asking for.
Be thorough in reviewing your term sheet. Chat with mentors and colleagues to understand how they navigated liquidation preferences in their deals. Read as much as you can (this is a great start!) and prepare yourself for every option.
Don’t be afraid to negotiate.
Even though the financing pendulum currently favors VCs more, private companies can still have the power to tastefully negotiate their term sheets. If you’re wary of your investors’ liquidation preferences, it’s possible you can find another concession to offer them. Seek legal advice from your counsel as necessary to help ensure that you’re not signing a deal that could put your company at a disadvantage.
Familiarize yourself with other investor protections.
Liquidation preference is usually not the only way that investors protect their downside. Study up on some other investor protections that might be more favorable to your company:
- Anti-dilution provisions provide insurance in case of a down round.
- Protective provisions give investors the right to vote on key decisions.
- Preemptive rights grant investors the right to participate in future financing rounds and IPOs.
- Board representation allows investors the right to sit on your board of directors.
Know your alternatives.
Capital-desperate companies might be willing to take higher liquidation preference risks in the current market. However, there may be other other ways to secure financing without exposing yourself to the dangers of liquidation preference.
Take control of equity management with Fidelity
Especially in a down market, private company leaders may need to spend their energy generating revenue and keeping their business on an upward trajectory. The last thing you might want to focus on is legal documents and cap table math.
Fidelity’s equity management platform helps founders stay on top of their equity, ownership and the liquidation preferences of all their stock classes. The platform’s Next Round Planner can help you stay prepared for any scenario and gain visibility into the effects of any potential financing deal.
Learn more about how Fidelity’s equity management platform can help you stay financing-ready.
Sample scenarios are for illustrative purposes only.
Fidelity does not provide legal or tax advice. The information herein is general in nature and should not be considered legal or tax advice. Consult an attorney or tax professional regarding your specific situation.
Fidelity provides cap table management and other administrative services to private companies and their equity compensation plans.