Liquidation

Preferences
in Startup Financing
What are they and
how do they work?!

Dirk Sahlmer
@dirksahlmer
If you're an entrepreneur
or a VC investor,
chances are you've come
across the term
"liquidation preference".
Maybe you already read
some articles about it
and noticed that..
The amount of in-depth
material on the topic
is inversely proportional
to its importance.
Let's see if I'll be able to
shed some light on it!
 What is a Liquidation
Preference?
A provision intended to
protect investors if a
company exits at a lower
value than originally
expected.
 Which is mostly
the case as you may know
 Let's take a look at the
legal language:
In the event of any Liquidation Event,
either voluntary or involuntary, the holders of
each series of Preferred Stock shall be
entitled to receive out of the proceeds or
assets of this corporation available for
distribution to its stockholders (the
“Proceeds”), prior and in preference to any
distribution of the Proceeds to the holders
of Common Stock…
 In easy words:

Preferred shareholders
receive their money back
before any of the
Common shareholders.
 Preferred Shares vs.
Common Shares

Both types of shares

grant the holder partial
ownership rights of
the company.
 However, investors
typically negotiate for
preferred shares, while
founders and employees
usually receive common
shares.
Liquidation preferences
are only attached to
preferred shares!
 Summary:
Common shares for
founders & employees
Preferred shares for
investors
Preferred shares come
with certain benefits incl.
liquidation preferences
 There are 4 primary
features of a liquidation
preference
 1. The Multiple

Determines the amount

an investor must be paid
back before common
shareholders receive any
remaining proceeds.
 Example:
Investor invests $1M at a
1x liquidation preference
In a liquidation event, they
will receive $1M back
– 1x their investment –
before common
shareholders receive
anything.
If the company gets sold
for <$1M, they'll get
everything.

If it gets sold for >$1M,

they would be guaranteed
at least $1M no matter
what.
Sometimes, you'll see 2x
or even 3x liquidation
preferences.
That's pretty nasty!
 With a 3x liquidation
preference, the investor
in our previous example
would be paid back $3M
– 3x invested capital –
before common
shareholders are paid
anything.
Typically, it's between
1–2x depending on
market conditions.
 2. Non-Participating vs.
Participating
Non-participating: Investor can either
1.) exercise liquidation preference OR
2.) convert preferred shares into
common shares.

Participating: Investor 1.) will get paid

back liquidation preference AND 2.)
will receive additional “participation” in
the remaining proceeds proportional to
their ownership.
Small but important
difference!
 Let's take our
previous example:

$1M investment with

1x liquidation preference
and assume
20% ownership.
Now the company
gets sold for $2M.
 With a non-participating
liquidation preference, the
investor has 2 options!
Exercise liquidation preference
and get $1M back.

OR

Convert preferred shares into

common shares for $400k
(20% of $2M)
Pretty sure they'd pick
option .
What if the company gets
sold for $5M?

Exercise liquidation preference

and get $1M back.
OR

Convert shares for $1M

(20% of $5M)
 You see?
Now they would get the
same amount with both
options!
This point is called
Conversion Threshold.
 As an investor, of
course, you always
choose the option that
earns you more.
 Now we look at the
participating liquidation
preference!
 Same situation:

$1M investment
1x liquidation preference
20% ownership
Company gets sold
for $2m
 Investor exercises
liquidation preference and
gets $1M back.

AND

Additional "participation" in the

remaining proceeds ($1M)
according to 20% ownership
(=$200k).
Non-participating
$1M
vs.
Participating
$1.2M
 Non participating
"Choose the best option
that brings you the most."
vs.
Participating
"Double-dipping into
the proceeds pool."
 Conclusion:

Founders should try to

avoid participating
liquidation preferences!
 3. The Cap

While we were talking a

lot about protection of
investors, this is about
protecting founders!
The cap is a conversion
threshold for investors
with participating
liquidation preferences.

🚧
 After exercising their
liquidation preference,
they may only participate
in the remaining proceeds
until the cap is reached.
 Payout caps
are typically around 3x
the invested amount.
 You remember our
example?
$1M investment with a
1x participating
liquidation preference
 Assuming a 3x cap,
this will lead to up to $3M in
total proceeds.

$1M by exercising
liquidation preference
+
$2M in participation
 Note:

Participating investors
with a cap
will usually still be able to
fully participate
– without a cap –
alongside common
shareholders..
 If they waive their
liquidation preference and
convert all their preferred
shares into common
shares!
 4. Seniority Structures

Typical payout structures

are a bit more
complicated than shown
in the previous examples..
 As there are different
seniority levels for
liquidation preferences.

They determine where

investors stand in the
payout order.
 Standard Seniority*
Liquidation preference
payouts are done in reverse
order from latest round to
the earliest round.

*Most common structure

 Pari passu

Investors across all stages

have the same seniority
status.
 Tiered Seniority

Investors from different

rounds are being grouped
up into tiered seniority
levels.
I hope this has given you
some good insight!
 @dirksahlmer

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