Term Sheet: What Da Heck Is Liquidation Preference (Part 2)

In Part 1, we answered Judd Aston’s question on liquidation preference by illustrating how it protects investors’ downside. What isn’t as obvious is that it also prevents the founders from selling early at investors’ expense.

Before you click away thinking that you got a lawyer and you don’t need to understand the terms, check out what Mark Suster of GRP Partners wrote:

Another big “gotcha” for me is that you expect lawyers to help you negotiate good deals.  What I found is that most lawyers will tell you what all the terms mean and sometimes will tell you what is commercially normal but they NEVER explain to you just how certain terms can be used to screw you in the future.  You cannot just say these clauses are “legalese” and I’ll let my lawyer figure them out.  You need to own your legal agreements.  You need to know how liquidations preferences work …

Suster’s post speaks to entrepreneurs but it’s every bit relevant to investors. Investors, especially new investors, did get screwed up because they didn’t really know what they were getting into.

Back to liquidation preference. Below is a simplest example of how the right can prevent founders from selling early on your dimes:

• You invested $1m in AppleSoft and own 33.33% of the company.
• Bill and Steve sold AppleSoft for $1m a week later.
• Without liquidation preference, you receive 33.33% of the proceeds, that is, $0.33m (33.33% ownership x $1m). You lost $0.67m ($1m – $0.33m), which ended up in the founders’ pockets.
• With 1x liquidation preference, you receive $1m (1 x original price paid per share), and the founders receive nothing.

As you can imagine, the founders are less inclined to sell the company at $1m if a liquidation preference is in place.

Multiple Funding Rounds

In Part 1, we assumed that the company needs only one round of funding and there are only 2 classes of stocks, Series A and Common. Life’s good when things are simple. In reality, a company might need multiple rounds. And the situation can get complicated when it builds up separate classes of preferred stocks.

Let’s look at this scenario:

• You pumped $3m into AppleSoft
• You’re a Series A preferred stockholder with 1x liquidation preference
• AppleSoft needs another round of funding
• A new investor, Larry Ventures (LV), invested $12m in the 2nd round
• LV is a Series B preferred shareholder with 1x liquidation preference
• Total preference amount = $3m + $12m = $15m
• For various reasons AppleSoft’s time’s up and it’s time to exit
• AppleSoft is liquidated at $10m, not enough to cover the total preference amount
• Assume there’s no debt and no other fees to pay

One of the two can occur:

A. Pari Passu: All preferred shareholders share the same rights and privileges. Available liquidation proceeds are distributed in proportion to each series’ share of preference.

Your portion of liquidation proceeds = $3m / $15m = 1/5 = 20%
LV’s portion = $12m / $15m = 4/5 = 80%

At $10m exit, you receive $10m x 20% = $2m
LV receives $10m x 80% = $8m

B. Senior Liquidation Preference: Later investors receive priority treatments over prior investors. For example, Series D’s preference is paid first, then Series C’s, then Series B’s, then Series A’s.

In this case, LV, a Series B preferred shareholder, gets paid before you, a Series A preferred shareholder.

Since the $10m exit isn’t enough to satisfy LV’s $12m preference, LV gobbles down the entire $10m and you receive nothing.

In other words, you won’t get any money back unless AppleSoft is liquidated at a value higher than $12m.

If there are more than 2 rounds of funding, with each later investor’s preference stacking on top of each prior investor’s, you can see how early rounds preferred shareholders might not see a penny unless the company’s liquidated at a fairly high valuation.

Negotiation

Early series favor pari passu while later series might want senior preference. How do you structure the preferred stock?

You can ask for pari passu in the Series A term sheet but whether later investors accept it or not would depend on each party’s relative bargaining power.

As Brad Feld of Foundry Group puts it, “Determining which approach to use is a black art.” It’s influenced by the

• relative negotiating power of the investors involved;
• ability of the company to go elsewhere for additional financing;
• economic dynamics of the existing capital structure; and
• phase of the moon

Now that you understand the basics, it might help you make faster decisions in the future and impress those who are easily impressed. Consult your lawyer before signing on the dotted line, but you also need to be detail-oriented and own your outcomes, Suster adds, “Lawyers are your support staff not your brain.”