Liquidation preference: A guide for startup founders

As a startup founder, the complexities and challenges that come with running a business can throw anyone off the straight and narrow. Liquidation preference is a key factor you’ll need to consider during funding rounds.

In this guide, we’ll simplify the concept of liquidation preference, explore its implications for founders, and provide the information you need to position your startup for success. 

What is liquidation preference?

Liquidation preference refers to the order in which various stakeholders receive their share of the proceeds when a company undergoes a liquidation event. 

This event could be a sale, merger, or acquisition that results in the distribution of the company’s assets.

During a liquidation event, the proceeds are distributed among the stakeholders, including investors and founders, according to their liquidation preferences.

What do liquidation preferences mean for founders?

Preferred shareholders have a higher priority in receiving their investment back before common shareholders, which often include founders, can claim their share of what’s left.

While liquidation preferences provide protection to investors who take on higher risks, founders should be cautious about negotiating terms that overly dilute their ownership. This will prove definitive in ensuring that the interests of founders are preserved during a liquidation event.

What are the two preference classes?

The number of classes of preference depends on a number of factors, such as your business model, funding stage, and investor expectations. Typically, there are two common classes of preference: participating and non-participating.

• Participating preference: This type of preference allows investors to receive their initial investment back first, along with their share of any remaining proceeds. 
• Non-participating preference: Investors have the right to receive a predetermined amount of their investment back before any other equity holders receive any proceeds. However, they do not participate in any further proceeds beyond their agreed-upon initial investment.

Moreover, finding the right balance between the interests of founders and investors is crucial when determining the classes of preference for your startup. This is where convertible notes become relevant to the liquidation proceedings. These are financial instruments that have the potential to be transformed into equity under specific circumstances, such as during a funding round or a company sale. 

What factors go into determining the valuation cap?

The valuation cap is the maximum valuation at which a convertible note can convert into equity. 

They may also include liquidity preferences, granting investors the privilege to receive a predetermined portion of their investment before any other equity stakeholders receive any proceeds. Several factors influence the valuation cap, including:

• Stage of the company: Early-stage startups may have a lower valuation cap compared to more established companies.
• Market conditions: Current market trends and conditions can impact the valuation cap.
• Investor demand: The level of investor interest and competition can affect the valuation cap.
• Growth potential: This has a significant impact on the valuation cap since firms with strong development prospects often have higher valuation caps that put investor rewards ahead of other equity stakeholders in the event of a bankruptcy.

Here, it is absolutely crucial to strike a balance that reflects your startup’s value while remaining attractive to potential investors.

How do liquidation preferences work in practice?

Consider the following scenario to demonstrate liquidation preferences:

Assume your startup is purchased for $10 million. You’ve raised $5 million in fundraising, with investors owning preferred stock and the founders owning common stock. According to the liquidation preference terms, investors enjoy a 2x non-participating preference. 

The “2x” indicates that preferred shareholders are allowed to receive up to two times their initial investment before common stockholders (often founders and employees) can get any proceeds. 

Following that, these stakeholders will no longer be able to partake in the liquidation proceeds.

In this case, the investors would first be reimbursed for their initial $5 million investment (2x preference). The remaining proceeds would then be distributed proportionally among all.

What is a preference stack?

The order in which different classes of investors receive their share of proceeds during a liquidity event is referred to as a preference stack. This is an essential aspect in determining which class would take priority during payouts. 

Ordinarily, the preference stack is organized as follows:

• Senior debt: Senior debt is the first tier of a company’s liabilities, and it is often secured by a lien against some sort of collateral. 
• Preferred stock: Next in line are investors with preferred shares, often venture capitalists and institutional investors. Multiple classes of preferred shares may exist based on investment rounds (e.g., Series A, Series B), each with its specific liquidity preferences.
• Common stock: Holders of such stock, such as founders, employees, and early-stage investors, stand to receive their share last.

Takeaways

In the game of liquidation preferences, negotiating terms that protect your interests is paramount to your success. When you understand the different classes of preference, consider factors influencing the valuation cap, and consult with experts, you can ensure you get the best outcome during a liquidation event.

Remember, while liquidation preferences may seem daunting, with the right knowledge and guidance, you can protect your interests and pave the way for your startup’s future prosperity.

At Firstbase, we specialize in helping tech startups with incorporation and business expansion. With our expertise, you can rest assured that your startup has the right structures in place to optimize its growth and success.