Navigating Liquidation Preference Clauses – Why Founders Should Tread Cautiously

Founders should remember to tread cautiously when navigating liquidation preference clauses. Raising money for a startup is understandably challenging. To attract investor interest, they often make crucial errors like accepting toxic terms that enable investors to claim preferential treatment.

Although these clauses lower the risk factor for investors, they can be a downside when you’re ready to sell the company. They can walk away with a substantial chunk of the returns you get from the sale. You, along with other shareholders and employees, could be left with next to nothing.

As the company founder, you’d expect to exit the company with a nine or ten-figure acquisition or an IPO. But what happens when the liquidation preference clauses determine who gets priority with the payouts and the percentage they claim?

When raising capital, work with your legal counsel to foresee this situation and prepare the payout hierarchy accordingly. Ensure that you, team members, and primary and minor shareholders also stand to profit significantly from the sale. Or, get at least some returns even in the case of a bankruptcy.

Get legal advice when negotiating the conditions in the term sheet, carefully watching for toxic terms that impact financial outcomes. Understand how liquidation preference provisions work. And, how to create an optimum balance between attracting investors and protecting your interests.

Here’s a quick overview of the in-depth nuances of liquidation preference you should know about.

What are Liquidation Preference Clauses?

If you’ve been watching this space, you’ll have read in detail about what liquidation preference is and how it works. In a nutshell, this provision in the investor agreement entitles investors to top priority when getting a share of the proceeds. That is, the proceeds from the sale of the company when it happens.

This clause acts as a guarantee that investors will get back their capital when the company is liquidated through an acquisition. Or, if it goes bankrupt and you’re selling off its assets. Assigning preferential treatment offsets some of the risk they carry, particularly in high-risk and capital-intensive sectors.

However, liquidation preference can be of different types and may allow investors to claim more than a fair share. They can get a larger exit value, leaving behind little or almost nothing for other investors and shareholders. This is why founders should be cautious about accepting these terms.

As a rule, investors holding preferred shares have the option to claim priority when getting proceeds. Or, they can convert their preferred shares into common equity and sell the shares at the current market price. Ultimately, they can make decisions depending on which option drives higher returns.

Types of Liquidation Preference

Some of the main types of liquidation preference clauses include:

• The Multiple: This is where investors can claim multiple times the value of their preferred stock, as opposed to the standard 1x. This multiple can be 2x or 3x, depending on the conditions in the investor agreement. The standard 1x is a fair and equitable ratio, ensuring that investors and other shareholders get fair treatment.
• Participating preferences: This is where investors can claim a share in the remaining proceeds, over and above their preferred share. Essentially, it enables “double-dipping” and is unfair to the founders and other shareholders.
• Capped participation: This is where investors can claim shares in the proceeds pool, but with a pre-determined cap or limit.
• Seniority in liquidation preference clauses can be of three types, including standard, pari passu, and tiered. This provision determines the hierarchy or priority with which different investors get treatment. For instance, initial lead and seed investors and later, Series A, Series B, Series C, and subsequent investors. You’ll create a balance here since lead and initial investors carried the maximum risk when investing in a new company. However, later-stage investors may offer larger amounts of capital to support accelerated growth or stabilize the company during a crisis.

Each of these liquidation preference types comes with certain downsides that you should be wary of. Before accepting the term sheet, you’ll explore how investors can use them and their possible impact on the company.

In-Depth Nuances of Each Type of Liquidation Preference

Participating Liquidation Preference

Founders should be extremely cautious about offering participating liquidation preference clauses to prospective investors as part of their investment criteria. Offering this provision invariably results in their getting a higher value per share than common shareholders.

For starters, investors can claim the same value per share as common equity when the company is sold. In addition, they can demand a share of the balance proceeds as you share them among other stakeholders. The double-dipping allows them to generate a substantial exit value.

The risk of getting only a small portion of the returns is very high for the founders. This is why you’ll aggressively negotiate for non-participating liquidation preference. Also, remember that investors participating in subsequent funding rounds might have their own liquidation preference clauses.

As you continue raising funding for the company, your ownership share, along with that of the team and common shareholders, also depletes. Although offering liquidation preference can be an incentive for investors, it can also act as a deterrent for subsequent rounds.

Investors might hesitate to offer capital if earlier investors already have priority for getting back their capital.

Higher Liquidation Multiples and Caps

Investors may push for higher multiples of 2x or 3x in an attempt to offset the risks they carry. In this case, they have the option to claim 2x (twice) or 3x (three times) the capital they invested. This option is available to them if they choose not to convert their preferred shares into common stock.

A good solution is to introduce a cap or a threshold on the maximum amount investors can claim. For instance, you agree to a 3x multiple and the investor provides $2M in capital. In that case, they can claim a total of $6M in payouts from the sale proceeds.

But, if you have set a cap at $5M in the investment agreement, that’s the maximum they can claim. Investors can, however, choose not to exercise their liquidation preference clauses.

That is, if the sales proceeds bring them higher returns than what they can claim by converting their stock into common equity. To go with the earlier example, investors may value their stock at $8M after converting it into equity. Accordingly, they may choose the latter option and get a bigger share.

Caps typically don’t apply if investors choose to convert their preferred shares into common stock, similar to other shareholders.

Seniority Payouts

When it comes to seniority payouts, later-stage investors get priority when receiving payouts from the proceeds pool. For instance, if a company is sold for $20M, then the series B investors who have invested $15M, receive payouts.

You’ll distribute the remaining $5M among the Series A investors, lead investors, and the team. Most startups follow this format since later-stage capital can sometimes be crucial to keep the company running. Earlier investors don’t have much choice since the fresh infusion is vital for survival.

These liquidation preference clauses can prove to be disadvantageous for founders, the team, and seed-stage and early investors. You’ll negotiate them and look for solutions to ensure other common shareholders also get fair treatment in case of losses.

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Pari Passu Payouts

The pari passu system assigns all investors the same seniority status, regardless of the series in which they invested. When making payouts, you’ll distribute the money according to the capital each investor contributed to the company. Or, on a pro rata basis.

This system is a fair and equitable distribution method. However, it can create complications for investors holding non-participating preference shares. This category of preferred shares enables them to choose from two options–claim returns on priority or convert into common equity.

Converting into common equity can be advantageous if the price per share is higher than the price for preferred shares. However, if these investors choose to convert their preferred shares into common stock, they can no longer expect seniority preference.

They will receive returns only after the investors with higher seniority status get their pro rata payouts. This is why, although all the investors have equal seniority, decisions always start with those with the highest conversion points. Or, typically with later-stage investors.

Investors with lower conversion points or early investors are lower down on the seniority structure. When calculating distributions according to pari passu, don’t overlook the tiers in seniority levels. You must group investors according to the series in which they invested and allocate money accordingly.

Pari Passu Structure in Unicorns

The pari passu structure is more common among unicorn companies, particularly those started by successful repeat founders. Unicorns typically have multiple investors offering capital, which is why no single party can claim leverage and seniority.

Repeat founders starting unicorns typically invest their personal capital to start the company. As a result, they are unlikely to accept any liquidation preference clauses or seniority structure. Specifically, if it can mean losing their status to other investors.

Impact on Employee Motivation and Morale

Offering option pools to employees is crucial for talent acquisition and retention. You may include options with vesting schedules to workers that convert into common equity at the time of company liquidation.

However, if you agree to liquidation preference clauses, you risk forking over most of the proceeds to investors. Be aware of the impact of such investment terms on employee motivation and morale. More so, if your option pools are part of their salary and compensation structure.

If workers suspect that their shares won’t have much value when the company liquidates, that could result in attrition.

Liquidation preference starts with issuing preferred shares. If you need more information about what they are and how to manage them, check out this video I have created.

Solutions for Navigating Liquidation Preference

Create a Cap Table and Exit Seniority Framework

Creating a detailed cap table is always advisable for founders since it can help them clearly organize the ownership percentages. At a glance, you’ll know who your investors are and the capital contributions made by each. You’ll also list your ownership stake and option pools.

Having an exit seniority framework enables a detailed analysis of how you’ll distribute the proceeds from the company’s sale. You’ll also include the priority in which you’ll pay off investors. As a result, visualizing the financial outcomes for you and the team is quickly done.

You can compare different outcomes according to the liquidation preference clauses investors may expect in the term sheet. You’ll make informed decisions about accepting the terms and capital from the investor. Thus, you’ll continue with further negotiations or reach out to other investors.

Remember to Factor in Cumulative Dividends

Many preferred shares come with an added clause–cumulative dividends. This clause lets investors accrue the dividends they earn on their shares and collect them during a liquidation event. When the dividends add up over an extended time, their payouts could result in a depleted proceeds pool.

Look for other solutions to manage the unpaid dividends, such as setting aside reserves to deal with the payments. It’s preferable not to rely on the returns you’ll earn from the exit to manage them.

The Bottom Line!

Liquidation preference clauses may seem straightforward when you’re raising the initial funding rounds. But, honoring them when the company goes through an acquisition or bankruptcy can be exceedingly complex. You should also factor in the risk of being left with almost nothing.

Avoid this risk by working closely with your legal advisors and understanding the in-depth nuances of these provisions. Ensure you read the term sheet to recognize the long-term implications of accepting the conditions of preferential treatment.

Avoiding participating preferences is always advisable, as is maintaining fair and reasonable capital payout multiples. Look for solutions that will safeguard your interests as the founder, as well as the interests of early investors. You’ll also protect the option pools you offer employees for their work.

Ultimately, it comes down to accepting a term sheet only after understanding its impact on future funding rounds. Factor in prospective investors’ thought processes when they see that earlier investors have preferential treatment. Also, think about the company’s continued growth and success.

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