Let’s say your company is acquired for $1B. Congratulations! Once the champagne stops flowing, you might begin to wonder: exactly who gets how much? Let’s talk about the allocation of proceeds from your exit: the liquidation preferences.
Liquidation preference gives preferred shares the right to be paid out first following a liquidation event (e.g., an acquisition or IPO), which is one of the reasons that many investors want these preferred shares as opposed to the common stock that founders and employees typically receive. If a startup is liquidated for less than the investors invested, then their liquidation preference would allow them to get money while the common shareholders get nothing.
Let’s dive into the details of who gets paid how much after a liquidity event (in our case an acquisition). The proceeds are distributed in two steps: liquidation preference and participation.
Liquidation preference: I call first dibs!
Liquidation preference refers to the right to receive a chunk of the proceeds from the liquidity event first, before any of the common shareholders. The specific terms are first negotiated in the term sheet, then enshrined in the amended charter.
Let’s take a look at a sample liquidation preference term in the National Venture Capital Association’s model term sheet:
“First pay [one] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred.”
The key to understanding liquidation preference is the liquidation preference multiple (bolded). The text lists a “1x liquidation preference,” which means that a Series A Preferred share purchased for $1 will return $1 (because $1x1=$1). Similarly, investing $1 with a 2x liquidation preference would return $2.
Let’s say that Cool Ventures (the VC) invested $5M with 2x liquidation preference into Unicornzzz, Inc. (the startup). Unicornzzz is acquired for $15M, and Cool Ventures gets $10M before any of the proceeds are paid out to the common shares (founders and employees).
Participation: I also call seconds.
What about the rest of the proceeds? After the Preferred Shares have received their preferential payment, the remaining proceeds will be distributed pro rata (in plain English, proportionally) to holders of Common and/or Preferred Stock, depending on the terms. Who gets paid in this distribution process depends on the participation rights of the Preferred shares, and these rights can offer downside protection to investors to potentially make risky investments more palatable. There are three types of participation:
1. Full participation (fully participating Preferred Stock)
With full participation, “the Series A Preferred participates with the Common share pro rata on an as-converted basis.”
This means that holders of Series A Preferred stock get their liquidation preference, i.e., the payments that are paid to them before anything is available for distribution to common stockholders, and then they also get to share any of the proceeds that are left over, with the common stockholders. They effectively get to “double dip” in the proceeds from a sale of the company.
For example, let’s say a VC invests $10M of 1x fully participating Series A Preferred at a $10M pre-money valuation. When those Preferred Shares are converted into common stock, the VC would own 50% of the common stock. If the startup is acquired for $60M, the VC will take $10M (from liquidation preference) + $25M (from participation), for a total of $35M.
How do we get $35M? The total proceeds were $60M. Before anything, $10M is taken off for liquidation preference, and there is $50M left over for participation. Since the VC owned 50% of the common stock, they take 50% of the $50M, which is $25M. Note that preferred may not always convert to common on a one-to-one basis, but for the sake of simplicity we have used that conversion basis here.
2. Capped participation (partially participating preferred)
With capped participation, “Series A Preferred participates with Common share pro rata on an as-converted basis until the holders of Series A Preferred receive an aggregate of [_____] times the Original Purchase Price (including the amount paid pursuant to the preceding sentence).”
This means that holders of Series A Preferred stock are paid their liquidation preference preferentially (meaning before common stockholders get a dime) and then they also get to share any of the proceeds that are left over, with the common stockholders until an aggregate of X times the original investment is reached. It should be noted that even in capped participation, the VC still has the option to convert their shares to common and participate fully in the proceeds (while giving up their preferred shares); however, the entire class of shareholders must agree to forego their participation rules in favor of this conversion for it to take place. Investors in the same class can’t pick and choose. Depending on the exit value, choosing participating preferred with a cap or converting to common may result in a better outcome for investors.
For example, let’s say that a VC invests $10M with 1x liquidation preference with a $30M (3x) cap, and that $10M represented a 50% ownership stake in the company. In this case, the investor would receive proceeds from the deal until those proceeds reached $30M (combining both liquidation preference payout and pro rata share of the remaining proceeds), after which the rest of the shareholders would split up the remaining proceeds. In this example, an exit value above $60M is the point at which converting to common would produce a better ROI (return on investment) for the investor. If the company sold for $60M, the investor would get $10M (liquidation preference) plus $20M of the remaining proceeds to hit their cap of $30M (50% of the remaining proceeds, $22.5M, would put them above their cap). If they converted all their shares to common and took 50% of the proceeds, they would also receive $30M.
If the exit value were $65M, the investors will usually get a better outcome by converting to common ($32.5M) than they would following their participating preferred and cap rule, which has a ceiling at $30M.
3. Non-participation (straight preferred)
With non-participation, “the balance of any proceeds shall be distributed pro rata to holders of Common share.”
This one’s easy: holders of Series A Preferred Stock only get paid their preferential amounts or decide as a class to convert to Common Stock; they don’t get to take their preference and participate. Depending on the exit amount they may choose the option that gives the larger payout. The entire class must agree to take this action, however—individually stockholders cannot pick and choose their option.
For example, let’s say a VC invests $10M on 1x non-participating Series A Preferred for a 50% ownership stake in the company. If the startup is acquired for $60M, the VC can either take $10M (from liquidation preference) + $0M (due to non-participation), for a total of $10M, or will take his pro rata share of 50% for a payout of $30M. In this case, the pro rata share will yield a better outcome.
Liquidation Preference Can Have a Big Impact
If your startup is acquired for a lot more than the total investment amount, we could say all is well. The investors will most likely get their money, as well as you and your employees. However, if your startup is acquired for less than the total amount invested, then there probably won’t be enough remaining proceeds for the common shareholders after the initial payout for liquidation preference.
The Liquidation Stack: For When You Have Multiple Classes of Preferred Shares
Up until now, we’ve been looking at one class of preferred shares: the Series A Preferred. However, most companies that get acquired have multiple rounds of equity financing under their belts. This means they have multiple classes of preferred shares: Series B Preferred, Series C Preferred, Series D Preferred, and so on. We also know that each of those classes of preferred shares has its own liquidation preferences. What happens when the liquidation preferences of each of those classes of shares get piled on?
This stack of liquidation preferences is called—quite conveniently—a liquidation stack. There are three types of seniority structure that determine which class of shares get paid out first:
Standard. Later stage investors receive their liquidation preference first (e.g. D, C, B, then A).
Pari passu. All investors receive their liquidation preference at the same time.
Tiered. Classes are grouped together (e.g. F and E, D and C, B and A). Then, the tiers receive their liquidation preference in standard order. Within each tier, classes receive payouts in a pari passu manner.
Liquidation preference isn’t an easy concept to grasp. However, it’s a critical provision in the term sheet for an equity financing—and you won’t want to wait until your liquidity event to really understand what it means.
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 Model Legal Documents - National Venture Capital Association - NVCA
Third party mentioned and Fidelity are not affiliated. Sample scenarios are for illustrative purposes only.