The Liquidation Preferences Debate

March 16 2011 No Commented

The terms and conditions under which angel investors fund startup entrepreneurs are defined by non-binding term sheets.  Liquidation preferences are a commonly negotiated term and come in several flavors:

1X non-participating liquidation preference – At exit, this preference give investors the option of getting their money back or participating pro rata in the exit with other shareholders.  Investors choose at exit to utilize the liquidation preference or simply participate as shareholders in the exit.  If the investors paid $500,000 for 25% of the company but the exit price is only $1 million, then the investors would exercise their liquidation preference for the return of $500,000 in capital.  The rest of the shareholders would split the remaining $500,000.  The preference may include an interest accrual.

1X participating liquidation preference – At exit, this preference provides return of capital to the investors after which investors participate pro rata in division of the proceeds.  In the case above, the investors would receive their $500,000 and then 25% of the remaining $500,000.  Or, if the exit price were $10 million, the investors would first receive their $500,000 in capital and then 25% of the remaining $9.5 million.

Multiple liquidation preferences – Instead of return of capital invested, the investors can negotiate multiple returns prior to distributions to other shareholders.  For example, a 3X liquidation preference would give investors in the case above $1.5 million of the proceeds at exit; all other conditions above unchanged.  Liquidation preferences greater than 1X are typically only negotiated for follow-on rounds in troubled companies, especially during economic downturns (such as in 2001 and 2009).  Under most conditions, multiple liquidation preferences are considered onerous terms.

Capped liquidation preferences – Participating liquidation preferences are often capped, that is, if the proceeds to an investor exceed a predetermined amount or multiple of investment, then the liquidation preference disappears.   For example, if $500,000 investors have  a 1X participating liquidation preference and the proceeds of the exit would result in a their enjoying more than a predetermined amount, say $2.5 million, then the liquidation preference is void.

Some feel liquidation preferences are unfair to entrepreneurs.  But, I disagree…and let me provide an example.  Let’s assume angels invest $1 million into a company (for 33% ownership) and six months later it is clear the company is has no traction (perhaps due to lack of execution on the part of the entrepreneur).  The entrepreneur and investors execute a sale of the venture for $1.5 million.  With no liquidation preference, the investors lose half their money while the entrepreneur walks off with a cool $1 million.  In this example, a liquidation preference would at least give the investors a return of capital and still yield $500,000 for the entrepreneur.  An appropriate liquidation preference can be quite fair to entrepreneurs and investors alike.